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Financial Modeling_Chap-One

This document introduces financial modeling and valuation, focusing on key concepts such as present value (PV), net present value (NPV), and internal rate of return (IRR). It explains how financial modeling uses spreadsheet software, particularly Excel, to create mathematical representations of a company's financial operations and forecasts. The document also provides examples of calculating PV, NPV, and IRR, as well as applications of these concepts in real-world financial scenarios.

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mohammedaliyi551
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18 views

Financial Modeling_Chap-One

This document introduces financial modeling and valuation, focusing on key concepts such as present value (PV), net present value (NPV), and internal rate of return (IRR). It explains how financial modeling uses spreadsheet software, particularly Excel, to create mathematical representations of a company's financial operations and forecasts. The document also provides examples of calculating PV, NPV, and IRR, as well as applications of these concepts in real-world financial scenarios.

Uploaded by

mohammedaliyi551
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter One

Introduction to Financial Modeling and Valuation

Basics and Definition of Financial Modeling


This course 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.
This course covers:
• Present value and Net present value (NPV)
• Internal rate of return (IRR)
• Payment schedules and loan tables
• Future value
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.

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, the alternative benchmark return to which we want to
compare the investment.

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 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:

This formula can also be computed using Excel’s PV function and Excel’s NPV function
in valuing a finite annuity.

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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


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 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 in rows 2–10. 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:

Remember, the exact IRR makes NPV zero.

 We can determine that, at 22.16 percent the NPV becomes zero.

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3.2. Excel’s Rate Function
Excel’s Rate function computes the IRR of only a series of constant future
payments . In the following example, we pay $1,000 today for an annual payment of
$100 for the next 30 years. Rate shows that the IRR is 9.307 percent:

4. Flat Payment Schedules


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:

 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.

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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, as shown in the following spreadsheet, is
2,593.74. FV= PV

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

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