Types of Financial Models in Investment Banking

Financial models are spreadsheet-based abstractions that help forecast a company’s future financial performance. They are mathematical models designed to represent the performance of financial assets, portfolios, projects, or any other investment. The forecast is based on the company’s historical performance and assumptions about the future.

 

Financial models require the preparation of an income statement, balance sheet, and cash flow statement known as the three-statement models. In this article, we will be discussing briefly the most common types of financial models in investment banking, namely DCF (Discounted Cash Flow), LBO (Leveraged Buyout), M&A (Merger & Acquisition), and the three-statement models.

 

DISCOUNTED CASH FLOW (DCF)

Discounted Cash Flow (DCF) determines the intrinsic value of a company or an asset by forecasting its future cash flows and discounting them to present value. It is based on the principle that a rupee today is worth more than a rupee in the future due to factors like inflation, the opportunity cost of capital, and the risk involved in the future. This model is also known as the valuation model and is widely used for valuing companies, projects, and assets.

 

DCF model is used when a company wants to identify whether the stock is undervalued or overvalued, to determine the price of shares at the time of IPO, to determine the value of the entity at the time of bankruptcy, and also to evaluate fair takeover price for the entity.

 

DCF are helpful to Investment Banks as this model provides

 

i) Detailed estimate of a company’s intrinsic value

ii) Assist in capital budgeting by evaluating the financial viability of the projects and investments 

iii) Helpful in strategic planning, which supports in the long run financial planning and strategy formulation.

iv) Lastly, helpful in taking effective investment decisions by helping investors determine whether a particular stock is undervalued or overvalued.

 

LEVERAGED BUYOUT (LBO) MODEL

The leveraged buyout model is one of the most detailed and challenging models that require complicated modeling debt schedules to evaluate the feasibility and potential returns on leveraged acquisitions. LBOs are focused on internal rate of return and are mostly used by private equity (PE) firms to evaluate the target company acquisition. The goal of the Leveraged Buyout Model is to calculate the multiple rates of return one could earn by investing in a company by holding stake and eventually selling it.

 

LBO Models are used to determine the acquisition price, decide on how much equity, amount of debt the acquirer will invest, forecast the target company’s future revenues, costs, EBITDA, and cash flow to assess its ability to service the debt. It is also used to estimate the interest expenses and principal repayments to ensure whether the company’s cash flow is sufficient to cover it or not. The model also considers possible exit strategies and calculates the expected internal rate of return (IRR) and equity value at the end of the investment period.

 

USES

  • LBO Models are used by the private equity firms as the model helps them to assess the feasibility and potential returns of the buyout investment.
  •  Investment Banks uses this model to advised their clients on financing structure and valuation of the buyout transactions.
  • Helpful in analyzing the creditworthiness and risk profile of the leveraged transactions
  • This model also helps the corporate development teams to evaluate the strategic acquisitions using leverage.

MERGERS & ACQUISITIONS (M&A)

Mergers & Acquisition are a more advanced model used to evaluate the purchase of a target company, focusing on dilution (decreasing) or accretion (increasing) analysis. In other words, the M&A model is used for determining the potential benefits and risks of the consolidated companies.

 

M&A models are helpful to determine the transaction structure, defining the type of deal, form of consideration, and other transaction details. Estimates the target company’s net worth to determine the appropriate purchase price and premium. It helps in deciding how the transaction should be financed and how the cost should be calculated. This model identifies synergies, creates pro forma financial statements, analyzes the financial impact, and then conducts the accounting and dilution analysis.

 

Uses

i) Investment Banks apply this model to advised their clients on potential mergers and acquisitions including the deal structuring and valuation of the companies.

ii) Equity apply the model by assessing acquisition targets and evaluates the financial impact of leveraged buyouts.

iii) Corporate Development used it for internal evaluation of potentials mergers & acquisition.

 

THREE STATEMENT MODELS

The three-statement model includes the income statement, balance sheet, and cash flow. This is the most basic model, and the goal is to set it up in such a way that all the accounts are connected and a set of assumptions can drive changes in the entire models.

 

The income statement displays the company’s revenues, expenses, and net income over a specific period of time and is prepared annually or quarterly.

 

The balance sheet reflects the company’s assets, equity, and liabilities and shows the financial position of the company at the end of the reporting period.

 

The cash flow statement provides detailing of the company’s cash inflows and outflows across operating activities, investing activities, and financing activities during the same period.

 

The three statements link the income statement to the balance sheet and the balance sheet to the cash flow statement, enabling the investment banks to understand how the different business activities, such as revenue growth, expenses, net profit, or loss, affect the performance. This understanding will help investment banks in assessing the companies’ financing requirements and projecting a company’s performance.

 

Uses

i) Investment Banks use this model to forecast the outcome of operational and financial decisions by analyzing past data and making assumptions.

ii) This model enables the investment banks in assessing how well a business process functions determining the financial impact of the entire process.

 

 

CONCLUSION

 

We can conclude that financial modeling is useful for valuing companies and determining how a company can grow their business through acquisition or raising funds. It is a combination of accounting, finance, and business metrics to accurately project and forecast a company’s future performance. 

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