“If you can’t describe what you are doing as a process,
you don’t know what you’re doing”
W. Edwards Deming

Model Optimisation – Turning theory into practice

Posted by Andrew Berkley, Managing director at F1F9

Coming to accountancy studies late in life, I found myself in the classroom for my 30th birthday. We were on a light industrial estate on the outskirts of Cambridge and the topics for the day – taught by a tutor who is still a legend in the world of financial reporting – were deferred tax and accounting for pensions.

I’ve spent better birthdays – but at least this one was memorable.

The other memorable topic from my accounting studies that has served me well through my thirties and my forties has been Modigliani and Miller. I like the highly theoretical world in which they live: no taxes; no transaction costs; perfect information; infinite debt availability; and infinite projects with a positive NPV.

But like the best theories, I find that you can take Modigliani and Miller into the real world. Their theory of capital structure, for example, lies at the heart of model optimisation.

Their starting point is that capital structure is irrelevant – how you raise money has no impact on value. So we can conclude that there is no point in optimising models.

And that is not good enough when you start to consider taxes. Bring tax into the equation and debt finance becomes advantageous. Borrow as much as you possibly can, we conclude. So an optimised model would by default go for maximum gearing.

And that is not good enough when you take real debt investors into account. Or risks of bankruptcy. Or credit rating agencies. Or the particular features of debt markets: right here, right now.

So Modigliani and Miller tell us how far we need to travel from an idealised world to enter the real world. And as we start to breathe in the polluting atmosphere and swim the muddy waters, so models begin to have a role – describing the real world in some imperfect but nonetheless appropriate and useful way.

FAST financial models, with transparency at their core, are designed to satisfy key stakeholders quickly and easily that their objectives are being met. For debt and equity investors, it is all about Modligliani and Miller – finding the optimal mix of debt and equity at levels that satisfy appetites for risk. And a price conscious project sponsor will seek a price point such that the project generates sufficient cash to generate a minimum return for investors but not so much cash as to be uncompetitive.

Click here to download F1F9’s Model Optimisation ebook

 

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