Chapter one

Introduction to Financial Modeling and Valuation

1.1. Introduction to financial modeling

Financial Modeling covers standard financial models in the areas of corporate finance, financial
statement simulation, portfolio problems, options, portfolio insurance, duration, and
immunization. The aim in each case has been to explain clearly and concisely the
implementation of the models using Excel.
Financial modeling is the construction of spreadsheet models that illustrate a company's likely
financial results in quantitative terms. Financial models can simulate the effect of specific
variables so that the company can plan a course of action should they occur. Financial modeling
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 summarize particular events
for the end user such as investment management returns or the Sorting 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.

1.2. 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 is called a cell. The address of a cell is given by the letter representing
the column and the number representing a row. Let's illustrate this using the following image.
We all deal with numbers in one way or the other. We all have daily expenses which we pay for
from the monthly income that we earn. For one to spend wisely, they will need to know their
income vs. expenditure. Microsoft Excel comes in handy when we want to record, analyze and
store such numeric data.
1.3. Basic Financial Calculations using excel

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.
n
CFt
The present value of a cash flow CF t anticipated to be received at time t is∑
i=1 ( 1+r ) t

The numerator of this expression is usually understood to be the expected time t cash flow , and
the discount rate r in the denominator is adjusted for the riskiness of this expected cash flow—
the higher the risk, the higher the discount rate. The basic concept in present value calculations is
the concept of opportunity cost.

Opportunity cost is the return which would be required of an investment to make it a viable
alternative to other, similar investments. In the financial literature there are many synonyms for
opportunity cost, among them: discount rate, cost of capital, and interest rate. When applied to
risky cash flows, we will sometimes call the opportunity cost the risk-adjusted discount rate
(RADR) or the weighted average cost of capital (WACC). It goes without saying that this
discount rate should be risk-adjusted, and much of the standard finance literature discusses how
to do this. As illustrated below, when we calculate the net present value, we use the investment’s
opportunity cost as a discount rate. When we calculate the internal rate of return, we compare the
calculated return to the investment’s opportunity cost to judge its value

1.3.1 Present Value and Net Present Value

Both of these concepts are related to the value today of a set of future anticipated cash flows. As
an example, suppose we are valuing an investment which promises $100 per year at the end of
this and the next 4 years. We suppose that these cash flows are risk free: There is no doubt that
this series of 5 payments of $100 each will actually be paid. If a bank pays an annual interest rate
of 10% on a 5-year deposit, then this 10% is the investment’s opportunity cost, the alternative
benchmark return to which we want to compare the investment. We can calculate the value of
the investment by discounting its cash flows using this opportunity cost as a discount rate:

A B C D
1 COMPUTING PRESENT VALUE
2 Discount rate 10%
3
4 year Cash flow PV
5 1 100 1909.09 B5/(1+$B$2)^A5
6 2 100 6446.28 B6/(1+$B$2)^A6
7 3 100 5131.57 B7/(1+$B$2)^A7
8 4 100 3103.86 B8/(1+$B$2)^A8
9 5 100 1290.26 B9/(1+$B$2)^A9
10 Net present value
11 Summing cells C5:C9 379.08 =sum(C5:C9)
12 NPV 379.08 =NPV(B2,B5:B9)
13 PV 379.08 =PV(B2,B5_100)
The present value, 379.08, is the value today of the investment. In a competitive market, the
present value should correspond to the market price of the cash flows. The spreadsheet illustrates
three ways of obtaining this value:

• Summing the individual present values in cells C5:C9. To simplify the copying, note the use of
“ ∧ ” to represent the power and the use of both the relative and absolute references; for example:
= B5/(1 + $B$2) ∧ A5 in cell C5.

• Using the Excel NPV function. As we show on the next page, Excel’s NPV function is
unfortunately misnamed—it actually computes the present value and not the net present value.

Using the Excel PV function. This function computes the present value of a series of constant
payments. PV (B2, 5,-100) is the present value of 5 payments of 100 each at the discount rate in
cell B2. The PV function returns a negative value for positive cash flows; to prevent this
unfortunate occurrence, we have made the cash flows negative. 2

1.3.2 The Internal Rate of Return (IRR) and Loan Tables

The internal rat e of return (IRR) is defined as the compound rate of return r which makes the
n
CFt
NPV equal to zero: CF 0+ ∑ =0
i=1 ( 1+r ) t

To illustrate, consider the example given in rows 2–10 below: A project costing 800 in year zero
returns a variable series of cash flows at the end of years 1–5. The IRR of the project (cell B10)
is 22.16%:

A B C
1 INTERNAL RATE OF RETURN
2 YEAR CASH FLOW
3 0 -800
4 1 200
5 2 250
6 3 300
7 4 350
8 5 400
9 INTERNAL RATE OF RETURN 22.16% =IRR (B3:B8)
10
By playing with the discount rate or by using Excel ’ s Goal Seek , we can determine that at
22.16% the NPV in cell B12 is zero

1.3.3 Loan Tables and the Internal Rate of Return

The IRR is the compound rate of return paid by the investment. To understand this 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. 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%:

A B C D
1 IRR Calculation
2 Year
3 0 -1,000
4 1 300
5 2 200
6 3 150
7 4 600
8 5 900
9
10 IRR 24.44% =IRR(B3:B8)
1.3.4 Future Values and Applications

We start with a triviality. Suppose you deposit 1,000 in an account today, leaving it there for 10
years. Suppose the account draws annual interest of 10%. How much will you have at the end of
10 years? The answer, as shown in the following spreadsheet, is 2,593.74:

A B C D E
1 Simple Future
2 Interest 10%
3 Year Beginning Interest Total ending
Balance earned during balance
the year
4 1 1000.00 100.00 1,100.00 =C5+B5
5 2 1100.00 110.00 1,210.00 =C6+B6
6 3 1210.00 121.00 1,331.00
7 4 1,331.00 133.10 1,464.10
8 5 1,464.10 146.41 1,610.51
9 6 1,610.51 161.05 1,771.56 =$B$2*B5
10 7 1,771.56 177.16 1,948.72
11 8 1,948.72 194.87 2,143.59
12 9 2,143.59 214.36 2,357.95
13 10 2,357.95 235.79 2,593.74
14 11 2,593.74 D5
15
16 A simpler way 2,593.74 <-- =B5*(1+B2)^10↖

1.4 Introduction to valuation and valuation standards

Valuations are widely used and relied upon in financial and other markets, whether for inclusion
in financial statements, for regulatory compliance or to support secured lending and transactional
activity. The International Valuation Standards (IVS) are standards for undertaking valuation
assignments using generally recognized concepts and principles that promote transparency and
consistency in valuation practice. The IVSC also promotes leading practice approaches for the
conduct and competency of professional valuers. The IVSC Standards Board is the body
responsible for setting the IVS. The Board has autonomy in the development of its agenda and
approval of its publications. In developing the IVS, the Board:

• follows established due process in the development of any new standard, including consultation
with stakeholders (valuers, users of valuation services, regulators, valuation professional
organisations, etc) and public exposure of all new standards or material alterations to existing
standards,

• liaises with other bodies that have a standard-setting function in the financial markets, •
conducts outreach activities including round-table discussions with invited constituents and
targeted discussions with specific users or user groups. The objective of the IVS is to increase
the confidence and trust of users of valuation services by establishing transparent and consistent
valuation practices. A standard will do one or more of the following:

• identify or develop globally accepted principles and definitions,

• identify and promulgate considerations for the undertaking of valuation assignments and the
reporting of valuations, • identify specific matters that require consideration and methods
commonly used for valuing different types of assets or liabilities.

A scope of work (sometimes referred to as terms of engagement) describes the fundamental

terms of a valuation engagement, such as the asset(s) being valued, the purpose of the valuation
and the responsibilities of parties involved in the valuation. This standard is intended to apply to
a wide spectrum of valuation assignments, including:

(a) Valuations performed by valuers for their own employers (“in-house valuations”),

(b) Valuations performed by valuers for clients other than their employers (“third-party
valuations”), and

(c) Valuation reviews where the reviewer may not be required to provide their own opinion of
value