CHAPTER ONE
INTRODUCTION TO FINANCIAL MODELING:
1. Meaning and definitions of financial modeling
A model is a numerical or mathematical representation of a real-life situation. A financial model is one
which relates to business and finance contexts. The typical objectives of financial modelling include to
support decisions relating to business plans and forecasts, to the design, evaluation and selection of
projects, to resource allocation and portfolio optimization, to value corporations, assets, contracts and
financial instruments, and to support financing decisions.
In fact, there is no generally accepted (standardized) definition of financial modelling. For some, it is a
highly pragmatic set of activities, essentially consisting of the building of Excel worksheets. For others, it
is a mainly conceptual activity, whose focus is on the use of mathematical equations to express the
relationships between the variables in a system, and for which the platform (e.g., Excel) that is used to
solve such equations is not of relevance. In this text, we aim to integrate theory and practice as much as
possible. However, modeling is a specific discipline that often but not exclusively uses spreadsheets.
Financial modeling is, in fact, a part of financial analysis and emphasizes the interpretation and output of
inputs and variables. A suitable definition should mention processes, variables, and quantitative relations,
hence the following definition:
“The process by which a firm constructs a financial representation of some, or all, aspects of the firm or
given security. The model is usually characterized by performing calculations, and makes
recommendations based on that information. The model may also summarize particular events for the end
user and provide direction regarding possible actions or alternatives.”
Financial modeling is a theoretical construction of a project, process, or transaction in a spreadsheet that
deals with the identification of key drivers and variables and a set of logical and quantitative relationships
between them. Financial modeling is the process of creating a summary of a company's expenses and
earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision
(Wikipedia).
Financial modeling is the construction of spreadsheet models that illustrate a company's likely financial
results in quantitative terms. Financial modelling is the process by which a firm constructs a financial
representation of some, or all, aspects of the firm or given security. The model is usually characterized by
performing calculations and makes recommendations based on that information. The model may also
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summarize particular events for the end user such as investment management returns or the Sortino ratio,
or it may help estimate market direction, such as the Fed model.
A financial model is a mathematical representation of the financial operations and financial statements of
a company. It is used to forecast future financial performance of the company by making relevant
assumptions of how the company would fair in the coming financial years. It is also a risk management
tool for analyzing various financial and economic scenarios and also provided valuations of assets. These
models involve calculations, analyzing them and then provide recommendations based on the information
gathered.
A financial model generally includes projecting the financial statements such as the income statement,
balance sheet and cash flow statement with the help of building schedules such as the depreciation
schedule, amortization schedule, working capital management, debt schedule etc. It encompasses the
company’s policies and restrictions imposed by lenders that would impact the financial position.
1.1. Overview of excel functions for modeling.
Excel is a spreadsheet program that is used to record and analyze numerical data. Think of a spreadsheet
as a collection of columns and rows that form a table. Alphabetical letters are usually assigned to columns
and numbers are usually assigned to rows. The point where a column and a row meet are called a cell.
The address of a cell is given by the letter representing the column and the number representing a row.
Microsoft Excel is the ideal tool for the kind of modelling. Its immense popularity throughout the
business world today for processing quantitative data and developing analytical solutions is widely
acknowledged. One could argue that, it is one of the most powerful and most important software
applications of all time. It would not be an exaggeration to claim that if civilization were about to vanish
and somebody could pass future generations a single wonder of our time. Excel is everywhere you look in
the business world – especially in areas where people are handling numbers, such as marketing, business
development, sales, and finance. In a 2011 study, Weiser Mazars found that Excel was the favorite tool of
insurance finance and accounting. Teams relied heavily on Excel to compensate for shortcomings in the
information flow. Most leaders they questioned did not have plans to change this process. Moreover, they
found that 87% of companies rely on Excel in their planning, budgeting, and other performance
management processes. In a different survey performed by gtnews during 2014 in relation to the
technology that Financial Planning and Analysis (FP&A) professionals are using, almost three-quarters
(73%) of those surveyed indicated that Excel is still the primary tool they use in more than half of all their
analytical work, even if they also have a standalone system. But, while Excel is reasonably robust, the
spreadsheets that people create with Excel are incredibly fragile. For starters, there is no way to trace
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where your data came from, there is no audit trail (so you can overtype numbers and not realize it), and
there is no easy way to test spreadsheets. The biggest problem is that anyone can create Excel
spreadsheets – badly. Because it’s so easy to use, the creation of even important spreadsheets is not
restricted to people who understand programming and do it in a methodical, well-documented way. That
is why one should be aware of Excel’s limitations. Tim Worst all, a Forbes contributor, proclaimed
recently in a Forbes article that “Microsoft’s Excel Might Be the Most Dangerous Software on the Planet”
after JP Morgan’s loss of several billion dollars due to a spreadsheet error. Moreover, a [Link] article
states that the error rates in spreadsheets are huge; Excel will dutifully average the wrong data right down
the line and there’s no protection against that. Finally, an article entitled “Beware of the Spreadsheet”
appeared in the international edition of Accounting and Business, in which David Parmenter argued that
the use of large spreadsheets for reporting, forecasting, and planning should be abandoned because of
their susceptibility to errors.
1.1.1. Components of Microsoft excel
Active Cell: A cell which is currently selected. It will be highlighted by a rectangular box and its address
will be shown in the address bar. You can activate a cell by clicking on it or by using your arrow buttons.
To edit a cell, you double-click on it or use F2 to as well.
Columns: A column is a vertical set of cells. A single worksheet contains 16384 total columns. Every
column has its own alphabet for identity, from A to XFD. You can select a column clicking on its header.
Rows: A row is a horizontal set of cells. A single worksheet contains 1048576 total rows. Every row has
its own number for identity, starting from 1 to 1048576. You can select a row clicking on the row
number marked on the left side of the window.
Fill Handle: It’s a small dot present on the lower right corner of the active cell. It helps you to fill
numeric values, text series, insert ranges, insert serial numbers, etc.
Address Bar: It shows the address of the active cell. If you have selected more than one cell, then it will
show the address of the first cell in the range.
Formula Bar: The formula bar is an input bar, below the ribbon. It shows the content of the active cell
and you can also use it to enter a formula in a cell.
Title Bar: The title bar will show the name of your workbook, followed by the application name
(“Microsoft Excel”).
File Menu: The file menu is a simple menu like all other applications. It contains options like (Save,
Save As, Open, New, Print, Excel Options, Share, etc.).
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Quick Access Toolbar: A toolbar to quickly access the options which you frequently use. You can add
your favorite options by adding new options to quick access toolbar.
Ribbon Tab: Starting from the Microsoft Excel 2007, all the options menus are replaced with the
ribbons. Ribbon tabs are the bunch of specific option group which further contains the option.
Worksheet Tab: This tab shows all the worksheets which are present in the workbook. By default, you
will see, three worksheets in your new workbook with the name of Sheet1, Sheet2, Sheet3 respectively.
Status Bar: It is a thin bar at the bottom of the Excel window. It will give you an instant help once you
start working in Excel.
1.2. Basic Financial Calculations using excel
In order to understand the performance and conditions of the given business in corporate finance by
developing financial model by using excel is as follows:
1. Present value
2. Future Value
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Time-dated cash flows (Excel functions XNPV and XIRR)
6. Payment schedules and loan tables
7. Pension and accumulation problems
8. Continuously compounded interest
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Almost all financial problems are centered on finding the value today of a series of cash receipts over
time. The cash receipts (or cash flows, as we will call them) may be certain or uncertain.
1. Present Values
PV is the current worth of a future sum of money or stream of cash flows given a specified rate of return.
Present value is the concept that states an amount of money today is worth more than that same amount in
the future. In other words, money received in the future is not worth as much as an equal amount received
today. Example, receiving $1,000 today is worth more than $1,000 five years from now.
n
The present value formula is PV=FV/(1+i) , where you divide the future value FV by a factor of 1 + i
for each period between present and future dates.
• Input these numbers in the present value calculator for the PV calculation:
• The future value sum FV.
• Number of time periods (years) t, which is n in the formula.
• Present value takes into account any interest rates an investment might earn.
For example, if an investor receives $1,000 today and can earn a rate of return of 5% per year, the $1,000
today is certainly worth more than receiving $1,000 five years from now.
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1.1. The Present Value of an Annuity—Some Useful Formulas
An annuity is a security which pays a constant sum in each period in the future. Annuities may have a
finite or infinite series of payments. If the annuity is finite, and the appropriate discount rate is r, then the
value today of the annuity is its present value:
If the annuity promises an infinite series of constant future payments, then this formula reduces to:
Both of these formulas can be computed with Excel. Below we compute the value of a finite annuity in
three ways: using the formula (cell B6), using Excel ’s PV function (cell B7), and using Excel’ s NPV
function:
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Examples of infinite Annuity
2. Future Values
Future value (FV) is the value of a current asset at a future date based on an assumed rate of
growth. The future value is important to investors and financial planners, as they use it to estimate how
much an investment made today will be worth in the future.
n
The future value formula is FV=PV(1+i) , where the present value PV increases for each period into the
future by a factor of 1 + i.
• The future value calculator uses multiple variables in the FV calculation:
• The present value sum. Number of time periods, typically years.
• Future value is what a sum of money invested today will become over time, at a rate of
interest.
For example, if you invest $1,000 in a savings account today at a 2% annual interest rate, it will be worth
$1,020 at the end of one year. Therefore, its future value is $1,020.
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Thus, the answer is that we will have $17,531.17 in the account at the end of year 10. This same
answer can be represented as a formula that sums the future values of each deposit:
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An Excel Function Note from cell B18 that Excel has a function FV that gives this sum. The
dialog box brought up by FV is the following:
• We note three things about this function:
1. For positive deposits FV returns a negative number (look back at footnote 2). This is an irritating
property of this function that it shares with PV and PMT. To avoid negative numbers, we have put
the Pmt in as −1,000.
2. The line Pv in the dialog box refers to a situation where the account has some initial value other
than 0 when the series of deposits is made. In this example, this space has been left blank,
indicating that the initial account value is zero.
3. As noted in the picture, “Type” (either 1 or 0) refers to whether the deposit is made at the
beginning or the end of each period (in our example the former is the case).
3. Net present value (NPV)
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and investment
planning to analyze the profitability of a projected investment or project. NPV is the result of calculations
used to find today’s value of a future stream of payments.
Net present value, or NPV, is used to calculate the current total value of a future stream of payments. If
the NPV of a project or investment is positive, it means that the discounted present value of all future cash
flows related to that project or investment will be positive, and therefore attractive. Net present value
(NPV) is a financial metric that seeks to capture the total value of a potential investment opportunity.
N
CFt
• NPV =CF 0 + ∑
t =1 (1+ r)t
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NPV is used in capital budgeting and investment planning to analyze the profitability of a projected
investment or project. It is the result of calculations used to find today's value of a future stream of
payments.
4. Internal rate of return (IRR)
The internal rate of return (IRR) is very similar to NPV except that the discount rate is the rate that
reduces the NPV of an investment to zero. This method is used to compare projects with different
lifespans or amounts of required capital. The internal rate of return (IRR) is a rate of return used in capital
budgeting to measure and compare the profitability of investments. It is also called the discounted cash
flow rate of return (DCFROR) or the rate of return (ROR).
The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the
interest rate or inflation). IRR is useful when comparing multiple projects against each other or in
situations where it is difficult to determine a discount rate. Broken down, each period's after-tax cash flow
at time t is discounted by some rate, r.
The sum of all these discounted cash flows is then offset by the initial investment, which equals the
current NPV. To find the IRR, you would need to "reverse engineer" what r is required so that the NPV
equals zero.
• How do you calculate IRR quickly?
So, the rule of thumb is that, for “double your money” scenarios, you take 100%, divide by
the # of years, and then estimate the IRR as about 75-80% of that value. For example, if
you double your money in 3 years, 100% / 3 = 33%. 75% of 33% is about 25%, which is the
approximate IRR in this case.
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Example Of Determining the IRR by Trial and Error
There is no simple formula to compute the IRR. Excel’s IRR function uses trial and error, which
can be simulated by using trial and error in a spreadsheet as illustrated below:
By playing with the discount rate or by using Excel’s Goal Seek (found under Data|What-if
analysis, see Chapter 31), we can determine that at 22.16% the NPV in cell B12 is zero:
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4.1. Loan Tables and the Internal Rate of Return
The IRR is the compound rate of return paid by the investment. To understand this, point fully, it helps to
make a loan table, which shows the division of the investment’s cash flows between investment income
and the return of the investment principal:
The loan table divides each of the cash flows of the asset into an income component and a return-of-
principal component. The income component at the end of each year is IRR times the principal balance at
the beginning of that year. Notice that the principal at the beginning of the last year (327.44 in the
example) exactly equals the return of principal at the end of that year.
• We can use the loan table to find the internal rate of return.
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Consider an investment costing 1,000 today that pays off the cash flows indicated below at the end of
years 1, 2, … 5. At a rate of 15% (cell B2), the principal at the beginning of year 6 is negative, indicating
that too little has been paid out in income. Thus, the IRR must be larger than 15%:
If the interest rate in cell B3 is indeed the IRR, then cell B11 should be 0. We can use Excel’ s
Goal Seek (found under Data |What-if analysis) to calculate the IRR.
As shown below, the IRR is 24.44%:
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The loan table is an effective illustration that the IRR is the interest rate that pays off an investment over
its term. Of course, we could have simplified life by just using the IRR function:
5. Time-dated cash flows (Excel functions XNPV and XIRR)
5.1. XNPV
The Excel XNPV function is a financial function that calculates the net present value (NPV) of an
investment using a discount rate and a series of cash flows that occur at irregular intervals. Calculate net
present value for irregular cash flows. Net present value. =XNPV (rate, values, dates).
NPV assumes that payments to be made in the future will be made on a regular basis, with equal time
intervals. XNPV, on the other hand, assumes that payments are not made on a regular basis. Computing
for the NPV and XNPV yields different results even if the same input values are used.
Example of XNPV
Computing mutually exclussive project by using XNPV
Discount rate 10%
Date Cash Flow Cash Flow
Project-A Project-B
15-Oct-20 $ (10,000.0) -10,000
15-Oct-21 $ 2,000.00 3,000
15-Oct-22 $ 3,000.00 2,000
15-Oct-24 $ 5,000.00 5,500
15-Oct-25 $ 5,500.00 5,000
15-Oct-27 $ 7,000.00 7,000
XNPV $ 4,717.04 $ 4,830.72
5.2. XIRR
The Excel XIRR ----
The XIRR function uses iteration to arrive at a result. XIRR (values, dates, [guess]) The key difference
between IRR and XIRR is the way each formula handles cash flows. IRR doesn't take into account when
the actual cash flow takes place, so it rolls them up into annual periods. By contrast, the XIRR formula
considers the dates when the cash flow actually happens.
Example of XIRR
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Computing mutually exclussive project by using xirr
Discunted rate 10%
Date Cash Flow Cash Flow
Project-A Project-B
15-Oct-20 $ (10,000) -10,000
15-Oct-21 $ 2,000.0 3,000
15-Oct-22 $ 3,000.0 2,000
15-Oct-24 $ 5,000.0 5,500
15-Oct-25 $ 5,500.0 5,000
15-Oct-27 $ 7,000.0 7,000
XIRR 21% 22%
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