Chapter One: Introduction to Financial Modeling and Valuation

Basics and Definition of Financial Modeling

This chapter aims to give you some finance basics and their Excel implementation. If you
have had a good introductory course in finance, this course is likely to be at best a
refresher.

Financial modeling is a representation in numbers of a company's operations in the past,

present, and the forecasted future. Financial modeling refers to the creation of a
mathematical representation or summary or model of the financial and operational
characteristics of a business. Applications involving financial modeling include business
valuation, management decision making, capital budgeting, financial statement analysis,
and determining the firm’s cost of capital. It is a task of building an abstract
representation of real world financial situations.
In general, financial modeling is the application of spreadsheet software (best example of
this is application of Excel) to define simple arithmetic relationships among variables
within the firm's income, balance sheet, and cash-flow statements, and to define the
interrelationships among the various financial statements. The primary objective in
applying financial modeling techniques is to create a computer-based model, which
facilitates the acquirer's understanding of the effect of changes in certain operating
variables on the firm's overall performance and valuation. ―The models require a
mixture of finance, accounting, and Excel.‖

This chapter covers:

Present value (PV)
Net present value (NPV)
Internal rate of return (IRR)
Debt /loan Payment schedules
Future value (FV)
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.

The numerator of this expression is usually understood to be the expected time (n) cash
flow (CF), 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).

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 Present Value and Net Present Value
Both concepts, present value and net present value, are related to the value today of a
set of future anticipated cash flows.

1. The Present Value, PV

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, used as a discount rate.

 The present value, 379.08, is the value today of the investment.

1.2. Present Value of an Annuity—Some Useful Formulas

An annuity is a security that 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:

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If the annuity promises an infinite series of constant future payments, then this formula
reduces to:

2. The Net Present Value, NPV

The net present value is the present value of future cash inflows from an asset (the cash
flow at time beyond year one) minus the cost of acquiring the asset (the cash flow at
time zero, Initial investment donated by CF0). Suppose, for example, that the series of 5
cash flows of $100 is sold for $250. Then, as shown below, the NPV = 129.08. Denoting
by r the discount rate applicable to the investment, the NPV is calculated as follows:

 The NPV represents the wealth increment of the purchaser of the cash flows. If
you buy the series of five cash flows of 100 for 250, then you have gained 129.08 in
wealth today, which is an NPV.

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3. Internal Rate of Return (IRR)
The internal rate of return (IRR) is defined as the compound rate of return paid by the
investment, r that makes the NPV equal to zero:

There is no simple formula to compute the IRR. But, it is possible just by playing with
the discount rate (trial and error), which is tiresome or by using Excel’s IRR function
and Excel’s Rate function, which are simplified.

3.1. Excel’s IRR function (Direct calculation of IRR):-It used to determine both a
variable and constant series of cash flows. To illustrate, consider the following example
given. A project costing 800 in year zero returns a variable series of cash flows at the
end of years 1–5; this can be simulated as shown in the following spreadsheet:

 We can determine that, at 28.65 percent (the exact IRR), the NPV becomes zero.

4. Flat Payment Schedules

Another common problem is to compute a ―flat‖ repayment for a loan. For example,
you take a loan for $10,000 at an interest rate of 7 percent per year. The bank wants
you to make a series equal of payments that will pay off the loan and the interest over
six years. We can use Excel’s PMT function to determine how much each annual
payment should be:

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  The zero in cell C15 indicates that the loan is fully repaid over its term of 6
years. You can easily confirm that the present value of the payments over the 6
years is the initial principal of 10,000.Thus, the answer of $2,097.96 is correct
by creating a loan table.

5. 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 is shown in the following spreadsheet.

As cell C17 shows, you don’t need all these complicated calculations: The future value of 1,000 in
10 years at 10% per year is given by: FV = 1,000* (1+ 10)10 = 2,593. 74.