Smart Task 02
Q1) While preparing a financial model what are the
assumptions we need to take. Please list down the list of
assumptions with the values, assuming the project will be setup
in India.
Answer: - List of assumptions with the values used in Project finance.
1) Inflation – 4.1%
2) Tax Rate – 22%
3) Debt rate – 4% to 6% for 15 to 20 years
4) Depreciation – 5% to 10%
5) Discount (WACC) – 12.1%
6) Minimum alternate tax – 18.5%
7) Risk-free rate – 6.503%
8) Market Risk premium – 4.5% to 5.5%
Q2) Explain the function of revenue, cost and debt sheet of
financial model.
Answer: - A revenue model explains the revenue earning strategy of the business. It
includes the product and/or service of value, the revenue generation techniques, the
revenue sources, and the target consumer of the product offered.
Revenue can be generated from a many of sources, can be in the form of
commission, arbitrage, rent, bids, etc. and can include recurring payments or just a
one-time payment. Revenue model includes every aspect of the revenue generation
strategy of the business. Revenue model is important for the company’s long-term
business projections as it gives an overview of the company’s current and future
potential to earn profits.
Cost models are mathematical equations used to estimate the costs of a
product or project. The results of the models are typically necessary to obtain
approval to proceed, and are factored into business plans, budgets, and other
financial planning and tracking mechanisms. Cost modelling is linked to various
different variables. There are some costs which are linked to sales; some are linked
to each other whereas some more are linked to a totally different variable. All these
complications need to be taken into account while creating a cost model.
A debt schedule model is made to lay out the debt that a business has
accrued based on its maturity. A debt schedule is commonly used by businesses to
build a cash flow analysis. In the debt schedule model, interest expense flows into
the income statement. Most of the time, an analyst will have to build a supporting
schedule that outlines interest and debt when they are building a financial model in
Excel.
A debt schedule model is made up of:
Opening balance
Draws
Repayments
Interest expense
Closing balance
These components allow tracking of the debt until maturity.
Usually a debt schedule model is made because once a debt matures; it’s
useful to be able to estimate the total amount of money that a company has to pay. A
debt schedule model is also used so that the company can monitor the maturity of
the debt, which is then used to make decisions. An example of a decision made
based on debt maturity would be considering the refinancing of debt through a
different source or institution when the interest rate declines.
As well as, the debt schedule model is able to be used to negotiate a new line
of credit for the business. Lenders will consider the balance between risk and reward
using the report before they grant a new credit.
Q3) Explain in detail the various steps involved (with the
importance) in the Cash flows sheet. Why and what the bank
need to check before financing the project.
Answer: - The basic information required for the preparation of a cash flow
statement is obtained from the following three sources:
(i) Comparative balance sheets at two points of time, i.e. in the beginning and at the
end of the accounting period.
(ii) Income statement of the current accounting period or the profit and loss account.
(iii) Some selected additional data to extract the hidden transactions.
The Cash flow statement is one of the three key financial statements that report the
cash generated and spent during a specific period of time.
Three sections of the statement of cash flows:
1) Operating activities: - any cash flow from current assets and current
liabilities.
2) Investing activities: - any cash flows from the acquisition and disposal of
long term assets and other investments not included in cash equivalents.
3) Financing activities: - any cash flow that result in change in the size and
composition of the contributed equity capital or borrowings of the entity
Steps for Preparation of Cash Flow Statement:
Step 1:- Operating Cash Flow
Operating activities are the principal revenue producing activities of the
entity. Cash Flow from Operations typically includes the cash flows
associated with sale, purchases, and other expenses.
The company’s chooses between the direct and indirect method of
operating cash flow.
Direct method: Operating cash flows are presented as a list of cash
flows, cash inflow from sales, cash outflow from capex, etc.
Indirect method: Operating cash flows are presented as reconciliation
from profit to cash flow.
The items in the cash flow statement are not all actual cash flows, but reasons why
cash flow is different form profit. Depreciation expense reduces profit but does not
impact cash flow as it is a non cash expense, hence it is added back.
Step 2:- Investing Cash Flow
Cash flow from investing activities includes the acquisition and disposal of
noncurrent assets and other investments not included in cash equivalents. It
typically include the cash flows associated with buying or selling property,
plant, and equipments, other non-current assets, and other financial assets.
Step 3:- Financing Cash Flow
Cash flow from financing activities result in changes in the size and
composition of the equity capital or borrowings of the entity. It includes cash
flows associated with borrowing and repaying bank loans, and issuing and
buying back shares. The payment of dividend is also treated as a financing
cash flow.
What the bank need to check before financing the project.
First, give the bank a business plan. Show them that your business is solid
and you have a strong track record of performance. Convince the bank that you don't
really need their money, but if you had it, here's what you could do with it. Banks get
queasy about lending to desperate borrowers. Be specific about how much money
you need, what you will do with it and how you will pay it back.
After the banker understands your business, the purpose of the loan and the
method of repayment, he will evaluate the bank's risks by using the five Cs:
Character
Collateral
Capacity
Capital
Conditions.
The Importance of Character
Foremost on the list is character. If bank doesn't trust you or think you're an honest
person, they will not approve your loan request. It doesn't matter how much collateral
you have, it will not be enough to offset a lack of trust.
The lender needs the confidence that the borrower has the experience, education
and industry knowledge to successfully manage the Project. The borrower's
reputation plays a significant part in getting a bank loan. Your credit history will show
your track record for repaying debts.
The Need for Collateral
When a bank makes a loan, it determines a plan of how the borrower will repay the
loan. If the borrower defaults on the loan, then the bank falls back on the collateral. A
lender never wants to use the collateral to repay a loan, because the sale of the
collateral may not be enough to pay off the loan.
Banks like to take property and assets as collateral as a way to recover their loan in
the event the borrower fails to pay as planned.
Capacity to Repay the Loan
The borrower must show that he can repay the loan out of the company's cash flow.
The bank will analyze a company's debt-to-income ratio and the amount of its free
cash flow. Lenders like these ratios to provide a cushion in case the project takes a
downturn.
The Need for Capital
Banks feel more comfortable when the owner has his own money invested in the
business. Lenders like to know the owner will lose something if the business fails. If
the owner is not investing in his own business, why should the bank?
Banks like lending to companies with a lot of capital because it means the owners
have some "skin in the game." When owners have more personal capital in the
project, they will fight harder and sacrifice more to save a business and repay their
debts.
Overall Economic Conditions
Besides analyzing the borrower, bankers will look at the overall economy, industry
trends and even the direction of politics. They are thinking about factors beyond the
control of the business owner that will affect the performance of the company.