CORPORATE FINANCIAL MODELING

In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders.

It is not possible to eliminate the agency problem completely, but the manager can be motivated to act in the shareholders' best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing ,etc.,

Lack of perfect alignment between the interests of managers and shareholders results in “agency costs”.

Agency costs are defined are difference between the value of an actual firm and value of a hypothetical firm.

Agency problem

To mitigate agency problems, effective monitoring has to be done and appropriate incentives have to be offered.

Monitoring may be done by bonding managers, auditing financial statements, limiting managerial discretion in certain areas, reviewing the actions and performance of managers periodically and so on.

Incentives may be offered in the form of cash bonuses and perquisites that are linked to certain performance targets, stock options and so on.

On asset value

In an inflationary period, the book value of assets, typically reflecting historical cost less accumulated depreciation, do not reflect their true values.

Hence it may be worthwhile to consider revaluation of assets periodically so that the asset values shown in the balance sheet reflect economic reality more accurately.

Effect of inflation

On firm value

If the actual rate of inflation is equal to the anticipated rate of inflation, the value of the firm remains more or less unaffected. 

When the actual rate of inflation differs from the anticipated rate of inflation, the firm value is likely to change.

On returns

In an inflationary period, the current rupees at the time of receipt will have lesser purchasing power than the rupees deployed to buy the security.

As a consequence, the real rate of return on the security will be less than its nominal rate of return.

For eg. If the nominal rate of return is 15% and the inflation rate is 10% the real rate of return will be approximately 5%.

Financial planning is part of a larger planning system in the firm.

Planning process begins with a statement of the firm’s goal or mission.

A long term financial plan represents a blueprint of what a firm proposes to do in the future.

Financial planning

Economic assumptionsSales forecastPro forma statementsAsset requirementsFinancing planCash budget

Elements of financial plans

Most of the financial variables are projected in relation to the estimated level of sales.

Hence the accuracy of the financial forecast depends critically on the accuracy of sales forecast.

Sales forecast for a period of 3-5 years may be developed to aid investment planning.

Sales forecast method

Sales forecast for a period of year is basis for financial forecast.

Sales forecasts for shorter durations may be prepared for facilitating working capital planning and cash budgeting.

Sales forecasting techniques are broadly categorized into three types

1. Qualitative Techniques

2. Time Series Projection Methods

3. Causal Models

There are two commonly used methods for preparing the pro forma profit and loss account:

The percent of sales method The budgeted expense method.

Pro Forma Profit & Loss Account

Basically this method assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship.

When using this method, a decision has to be taken about which historical cost ratios to be used: Should these ratios pertain to the previous year, or the average of two or more previous years?

Percent of Sales Method

The budgeted expense method, estimates the value of each item on the basis of expected developments in the future period for which the pro forma profit and loss account is being prepared.

This method requires greater effort on the part of management because it calls for defining likely developments.

Budgeted Expense Method

A pro forma balance sheet is a financial document that discloses a business’s assets, liabilities, and equity at a specific point in time. 

Projection of various items in balance sheet may be derived as follows:

1. Employ percent of sales method to project items on asset side except ‘investments’ and ‘miscellaneous expenditure and losses’.

Pro Forma Balance Sheet

Estimate the expected values for ‘investments’ and ‘miscellaneous expenditure and losses’, using specific information applicable to them.

Use the percent of sales method to derive the projected values of current liabilities and provisions.

Obtain the projected value of reserves and surplus by adding the projected retained earnings to the reserves and surplus figure of the previous period.

Set the projected values for equity and preference capital to be tentatively equal to their previous values.

Assume that the projected values for loan funds will be tentatively equal to their previous levels less repayments or retirements as per terms and conditions applicable to them.

Compare the assets side and liabilities side and determine the balancing item.