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Corporate and Project Finance Modeling: Theory and Practice


The comprehensive, step-by-step guide to successful financial modeling

Corporate and Project Finance Modeling offers anyone interested in creating, interpreting, and understanding financial models a comprehensive guidebook with real-world applications. Based on Edward Bodmer's years of experience creating, reviewing, and teaching corporate finance modeling, project finance modeling, acquisition modeling, and real estate modeling, this important text explains how to master difficult problems and build highly structured models from the ground up.

Step by step, this comprehensive guide shows how to create flexible, efficient, and stable model structures, and contains unique solutions that address complex issues. Filled with essential information and detailed techniques, Corporate and Project Finance Modeling offers those new to the subject as well as experienced professionals a guide for taking their skills to a higher level.

Included with the text is a website that offers a wealth of exercises, model examples, video explanations, and case studies. It contains hundreds of customized exercises, many corporate finance and acquisition model templates, and a number of featured example models of business enterprises from a wide variety of industries.

Using the examples and information presented in this text will help develop the skills for solving modeling problems and creating effective financial models.

EDWARD BODMER is an experienced financial and economic consultant, trainer, and lecturer. He has conducted many training programs around the world to both large corporations and public programs that have covered project finance, corporate finance, energy analysis, and mergers and acquisitions. Formerly, Bodmer was the Vice President at the First National Bank of Chicago, where he directed analysis of energy loans and also created financial modeling techniques used in advisory projects.

Preface xvii

Acknowledgments xxiii


CHAPTER 1 Financial Modeling and Valuation Nightmares: Problems That Financial Models Cannot Solve 3

CHAPTER 2 Becoming a Black Belt Modeler 9

CHAPTER 3 General Model Objectives of Structuring Transactions, Risk Analysis, and Valuation 13

CHAPTER 4 The Structure of Alternative Financial Models 17

Structure of a Corporate Model: Incorporating History and Deriving Forecasts from Historical Analysis 21

Use of the INDEX Function in Corporate Models 26

Easing the Pain of Acquiring PDF Data 28

Structure of a Project Finance Model That Accounts for Different Risks in Different Phases over the Life of a Project 30

Reconciliation of Internal Rate of Return in Project Finance with Return on Investment in Corporate Finance 33

Structure of an Acquisition Model: Alternative Transaction Prices and Financing Terms 35

Structure of an Integrated Merger Model: Forecasting Earnings per Share 37

CHAPTER 5 Avoiding Bad Programming Practices and Creating Effective Auditing Processes 41

How to Make Financial Models More Efficient and Accurate 44

CHAPTER 6 Developing and Efficiently Organizing Assumptions 55

Assumptions in Demand-Driven Models versus Supply-Driven Models: The Danger of Overcapacity in an Industry 55

Creating a Flexible Input Structure for Model Assumptions 60

Alternative Input Structures for Project Finance and

Corporate Finance Models 62

Setting Up Inputs with Code Numbers and the INDEX Function 62

CHAPTER 7 Structuring Time Lines 67

Timing in Corporate Finance Models: Distinguishing the Historical Period, Explicit Period, and Terminal Period 67

Development to Decommissioning: Phases in the Life of a Project Finance Model 69

Timing in Acquisition Models: Separating the Transaction Period, the Holding Period, and the Exit Period 70

Structuring a Time Line to Measure History, Explicit Periods, and Terminal Periods in Corporate Models and Risk Phases in Project Finance Models 72

Computing Start of Period and End of Period Dates 73

TRUE and FALSE Switches in Modeling Time Periods 75

Computing the Age of a Project in Years on a Monthly, Quarterly, or Semiannual Basis 77

The Magic of a HISTORIC Switch in a Corporate Model 78

Transferring Data from a Corporate Model to an Acquisition Model Using MATCH and INDEX Functions 82

CHAPTER 8 Projecting Revenues, Expenses, and Capital Expenditures to Derive Pretax Cash Flow 85

Transparent Calculations of Pretax Cash Flow 85

Inflation and Growth Rates in Calculations of Pretax Cash Flow 88

Valuation Analysis from Prefinancing, Pretax Cash Flow 90

CHAPTER 9 Moving from Pretax Cash Flow to After-Tax Free Cash Flow 91

Working Capital Analysis 91

Problems in Computing Depreciation Expense in Corporate Models Involving Asset Retirements 92

Portfolios of Assets with a Vintage Process 94

Accounting for Asset Retirements in Corporate Models 99

Alternative Methods for Deriving Retirements Associated with Existing Assets in Corporate Models 103

Depreciation Issues in Project Finance Models 109

Modeling the Change in Deferred Taxes in Corporate Models 110

Adjusting the Tax Basis in an Acquisition 111

CHAPTER 10 Adding Debt to a Corporate or Project Finance Model by Programming Cash Flow Waterfalls 113

Adding the Debt Schedule to a Financial Model 114

Modeling Scheduled Debt Repayments 116

Connecting Debt to Cash Flow in Corporate Models 117

With a Structured Process, You Can Model Any Cash Flow Waterfall 119

Defaults on Debt and Measuring the Debt Internal Rate of Return 124

Assessing Risk and Return Characteristics of Subordinated Debt 127

CHAPTER 11 Alternative Calculations of Equity Distributions 131

Modeling Dividend Distributions 132

Computing a Target Capital Structure through Simulating New Equity Issues and Buybacks 136

CHAPTER 12 Putting Together Financial Statements and Calculating Income Taxes 139

Computation of Taxes Paid and Taxes Deferred 140

Cash Flow Statement and Balance Sheet 144


CHAPTER 13 Risk Assessment: The Centerpiece of All Valuation, Contracting, and Credit Issues in Finance 149

Six Alternative Ways to Assess the Risk of a Company, a Project, or a Contract 151

Using Direct Risk Assessment to Measure Cash Flow and Financial Ratios 154

CHAPTER 14 Defining, Describing, and Assessing Risk in a Risk Allocation Matrix 159

CHAPTER 15 Presentation of Risk Analysis through Adding Sensitivity Analysis to Financial Models 165

Setting Up Data for Making Graphs by Converting Periodic Data into Annual, Semiannual, or Quarterly Data 167

Using the INDIRECT Function to Automate Conversion to Time Period Data 172

Making Flexible Graphs for Sensitivity Analysis 173

CHAPTER 16 Using Financial Models to Establish Break-Even Points for Key Input Variables with Data Tables 185

Establishing Break-Even Criteria When Analyzing Financial Models 188

Mechanics of Using Data Tables to Compute Break-Even Points Automatically 193

Creating Data Tables Using VBA Instead of the Data Table Tool 201

Summary of Break-Even Analysis 205

CHAPTER 17 Constructing Flexible Scenario Analysis for Risk Assessment 207

Mechanics of Scenario Analysis 210

Using VBA Code to Create a Scenario Analysis 221

Getting the Best of Both Worlds: Creating a Special Custom Scenario That Allows Use of Spinner Buttons and Drop-Down Boxes 223

CHAPTER 18 Generating Tornado Diagrams, Spider Charts, and Waterfall Graphs 231

Tornado Diagrams That Display Which Variables Have the Largest Effect on Value and Which Variables Have the Least Effect on an Output Variable 232

Creating a Tornado Diagram by Extending Scenario Analysis 234

Creating a Tornado Diagram Using a Two-Way Data Table 242

Spider Diagrams That Illustrate How Each Range in Input Variables Affects an Output Variable 246

How to Create a Spider Diagram Using a Two-Way Data Table 247

Presenting Sensitivity Analysis with a Waterfall Chart 250

CHAPTER 19 Adding Probabilistic Risk Analysis and Time Series Equations to Financial Models 253

Definition of Some Terms for Adding Stochastic Analysis to Your Financial Models 256

Using Probability Distributions with Spreadsheet Functions Rather Than Equations with Greek Letters 258

CHAPTER 20 Taking the Mystery out of Applying Time Series Analysis and Monte Carlo Simulation in Financial Models 263

Step-by-Step Procedure to Incorporate a Monte Carlo Simulation into Your Models 266

CHAPTER 21 Constructing Probability Distributions with Trends, Mean Reversion, Price Boundaries, and Correlations among Variables 277

Starting Point for Developing Time Series Equations--Brownian Motion and Normal Distributions 279

Testing the Assumption That Input Variables Are Normally Distributed 281

Price Boundaries and Short-Run Marginal Cost 285

Mean Reversion and Long-Run Equilibrium Analysis 286

Modeling Correlations among Variables in Time Series Equations 289

CHAPTER 22 The Difficult Problem of Estimating Volatility, Mean Reversion, Time Trends, Correlations, and Price Boundaries from Historical Data or Market Data 295

Calculation of Volatility from a Random Walk Process 296

Attempting to Measure the Presence of Mean Reversion in Historical Data 297

Attempting to Measure the Presence of Mean Reversion by Evaluating Changes in Periodic Volatility 300

Risk Analysis Summary 303


CHAPTER 23 Overview of Issues When Computing Normalized Cash Flow and Terminal Value 307

CHAPTER 24 Computing the Return on Invested Capital for Historical and Projected Periods in Corporate Models 313

Working with a Free Cash Flow Perspective, an Equity Cash Flow Perspective, or Both in Computing Financial Ratios 314

Presenting Return on Invested Capital in Financial Models 316

CHAPTER 25 Calculation of Invested Capital 321

Dissecting the Financial Structure of a Corporation to Understand the Bridge from Enterprise Value to Equity Value 323

Drawing an Imaginary Line underneath EBIT to

Understand the Financial Structure of a Corporation 326

Constructing a Long-Term Model to Create Proof of Corporate Finance Concepts 328

CHAPTER 26 Complex Items in Balance Sheet Analysis: Deferred Taxes, Operating Cash, and Derivative Assets 337

Treatment of Accumulated Deferred Taxes Arising from Depreciation 337

Classification of Operating Cash That Produces Interest Income below the EBITDA Line 341

Treatment of Derivative Assets and Liabilities Depending on How Derivatives Affect EBITDA 344

CHAPTER 27 Four General Terminal Value Methods 347

Method 1: Stable Growth Using the (1 + g)/(WACC - g) Formula 349

Method 2: Value Driver Method--Incorporating the Return Relative to Cost of Capital in Terminal Value 351

Method 3: Use of Multiples from Comparative Analysis 352

Method 4: Derived Multiple Formula 353

CHAPTER 28 Terminal Value and Philosophy: Company Growth Rates and Overall Economic Growth 357

Computing Transition Periods Using Compound Growth Rates and Switch Variables 359

Computing Explicit Period Cash Flow and Terminal Value with Different Starting and Ending Points 362

Computing Value with Changing Weighted Average Cost of Capital and a Midyear Convention 365

CHAPTER 29 Normalizing Terminal Year Cash Flows for Stable Working Capital Investment 369

Effect of Changes in Growth on Working Capital Investment, Capital Expenditures, Depreciation, and Deferred Taxes 370

Developing a Simple Equation for Normalizing Working Capital 371

Incorporating Terminal Period Normalized Cash Flow in a Corporate Model 375

CHAPTER 30 Relationship of Growth, Capital Expenditures, Depreciation, and Return on Investment 377

The Long-Term Stable Ratio of Capital Expenditures to Depreciation and the Ratio of Depreciation Expense to Net Plant 378

Computing the Ratio of Capital Expenditures to Depreciation When Historical Growth Differs from Prospective Growth 385

Computing the Ratio of Capital Expenditures to Depreciation 390

Implementing the Stable Ratio of Capital Expenditures to Depreciation in Valuation Analysis 393

CHAPTER 31 Computing Normalized Deferred Tax Changes 399

Stable Ratio of Deferred Tax to Capital Expenditure without Change in Growth Rate 400

Normalized Deferred Tax with Change in Growth Rate 404

CHAPTER 32 Terminal Value and the Ability of a Company to Earn Returns above the Cost of Capital 407

The Myth of Convergence of Return on Capital to Cost of Capital 408

CHAPTER 33 Errors and Distortions in Applying the Value Driver Formula 415

Deriving the Value Driver Formula for the Price/Earnings Ratio and Equity Value 416

Deriving Implicit Assumptions about the Progression of the Incremental Return on Equity in the Equity-Based Value Driver Formula 418

Deriving the Value Driver Formula Using the Return on Invested Capital and the Weighted Average Cost of Capital 425

Biases in the Value Driver Formula in a Case with Only Working Capital 427

Problems of the Value Driver Formula When Invested Capital Includes Net Plant 432

CHAPTER 34 Computing Implied Price/Earnings Ratios for Use in Terminal Value Calculations 435

Model for Deriving the P/E Ratio from Value Drivers 438

CHAPTER 35 Computing an Implied EV/EBITDA Ratio in Terminal Value Calculations 445

Simulation Model to Derive Implied EV/EBITDA Ratio from Invested Capital with Constant Growth 446

Function to Derive Implied EV/EBITDA Ratio 448

Comprehensive Analysis to Derive Implied EV/EBITDA Ratio with Changing Growth, Deferred Taxes, and Working Capital 449

CHAPTER 36 Developing Value Drivers for P/E and EV/EBITDA Ratios with Benchmarking and Regression 453

Benchmarking Multiples to Derive Cost of Capital 454

Downloading Data for a Sample of Companies from the Internet into a Spreadsheet 455

Running Regression Analysis on Financial Data 458

Advanced Corporate Modeling Summary 460


CHAPTER 37 Resolving Circular References in Acquisition Models: Computing Interest Expense on the Average Balance of Debt 465

Circular References and Use of Opening Balances in Annual Models 466

Alternative Techniques for Solving Circular Reference Logic Problems in Financial Models 468

Resolution of Circular References from a Cash Flow Sweep Using the Iteration Button 470

Solving Circular References from Cash Sweeps with Goal Seek and Solver 472

Solving Basic Circular References from Cash Sweeps with a Horrible Copy and Paste Macro 474

Solving Circular References Related to a Cash Sweep Using Algebra 475

Solving Circular References with Functions That Iterate around Equations That Cause the Problem 479

CHAPTER 38 Creating a Structured Cash Flow Process in a Corporate Model to Resolve Circular References 483

Structuring a Corporate Model with a Cash Flow Waterfall 483

Resolving Circular References in a Corporate Model Using an Iterative User-Defined Function 487

CHAPTER 39 Overview of Complex Project Finance Modeling Structuring Issues 491

Difficult Project Finance Problems: Structuring versus Risk Analysis Elements of a Model 493

Items in Project Finance Models That Cause Circularity 495

CHAPTER 40 Funding Techniques in Project Finance and the Associated Circular Reference Problems 497

Case 1: No Circular Reference--Pro-Rata Funding, Interest Paid during Construction, and Debt Size from Cash Flow 499

Case 2: Circular Reference from Pro-Rata Funding with Capitalized Interest or Debt Ratio Input 501

Case 3: Pro-Rata Funding with Capitalized Fees 506

Case 4: Cascade with Equity Funded before Debt That Can Be Solved with Backward Induction 508

Case 5: Bond Financing in a Single Period 513

CHAPTER 41 Debt Sculpting in a Project Finance Model 515

Sculpting Method 1: Use of Solver 517

Sculpting Method 2: Goal Seek and Algebra 519

Sculpting Method 3: Net Present Value of Target Debt Service 521

Sculpting Method 4: Backward Induction 524

Sculpting Approaches in Complex Cases with Taxes, Debt Service Reserve Accounts, and Interest Income 526

Solving Difficult Sculpting Problems with User-Defined Functions 532

CHAPTER 42 Automating the Goal Seek Process for Annuity and Equal Installment Repayments 539

Debt Sizing with Level Repayments or Annuity Repayments Using a Goal Seek Macro 541

Computing Debt Size for Equal Installment Structuring with a User-Defined Function 542

Computing Debt Size for Annuity Structure with User-Defined Function 545

CHAPTER 43 Modeling Debt Service Reserve Accounts 547

Structuring the Debt Service Reserve Account in a Project Finance Model 548

Avoiding Circular References in Funding Debt Service Reserve Accounts through Separating Construction Debt from Permanent Debt 550

Avoiding Circular References Due to Cash Flow Sweeps and the Debt Service Reserve Account 552

CHAPTER 44 Modeling Maintenance Reserve Accounts 555

MRA Case 1: Constant Maintenance Time Period Increments and Level Expenditures 556

MRA Case 2: Constant Time Period Increments and Changing Expenditures 557

MRA Case 3: Varying Time Period Increments and Changing Expenditures Using the MATCH Function 559

CHAPTER 45 Refinancing and Valuing a Project Given Risk Changes over the Life of a Project 563

Computed Internal Rate of Return with Changes in Discount Rate over Project Life 563

Effects of Refinancing on the Value of a Project 565

Mechanics of Implementing Refinancing into a Project Finance Model 568

CHAPTER 46 Covenants and Cash Flow Sweeps in Project Finance Models 571

Mechanics of Modeling Covenants and Cash Flow Sweeps 572

CHAPTER 47 Asset Portfolios, Progress Payments, and Lease Rolls in Real Estate Models 577

Modeling a Single Real Estate Project 579

Modeling Multiple Projects That Are Part of a Combined Portfolio with Percent of Time Function 580

Modeling a Portfolio with the INDEX Function and Data Table Tools 584

About the Author 589

About the Website 591

Index 593