Financial Modeling

AcFn 3044

Chapter I

Introduction to Financial Modeling and Valuation

 Outlines
 Introduction to financial modeling
 Overview of excel functions for modeling
 Basic Financial Calculations using excel
 Present Value and Net Present Value
 The IRR and Loan Tables
 Future values and Applications
 What is a financial modeling?
• Financial modeling is a representation in numbers of a company's
operations in the past, present, and the forecasted future.
• “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.”
• A financial model is simply a tool that’s built-in spreadsheet software such as
Ms Excel to forecast a business’ financial performance into the future.
What is a financial model................
• A financial modeling a tool that can be used to forecast the company’s
future financial performance.
• It is forecast based on expected condition and project based of hypothetical
assumption.
• Company executives might use them to estimate the costs and project the
profits of a proposed new project
• The forecast is typically based on the company’s historical performance, and
assumptions about the future, and requires preparing an income statement,
balance sheet, cash flow statement, and supporting schedules (known as a 3
statement model).
 Objective and Use of financial model
Objective To combine accounting, finance, and business metrics to
create an abstract representation of a company in excel, forecasted into
the future.
Uses
• Making business decisions at a company
• Making investments in a private/public company
• Pricing securities
• Undergoing a corporate transaction such as merger and acquisition,
divestitures, and capital raising.
 Steps for financial Modeling
1. Historical data (at least 3 years of input)
2. Ratios and metrics (such as margin, growth rate, and asset turnover)
3. Assumptions (build ratios and metrics into the future by making
assumptions about margin, growth rate etc.)
4. Forecast (forecast the three financial statements into the future by
using assumptions)
5. Valuations (value the company by using the DCF or other methods)
6. Additional analysis (sensitivity, scenario, charts, graph, etc.)
 TYPES OF FINANCIAL MODEL

• There are various kinds of financial models that are used according to
the purpose and need of doing it. Different financial models solve
different problems.
• While majority of the financial models concentrate on valuation,
some are created to calculate and predict risk, performance of
portfolio, or economic trends within an industry or a region.
• The following are the different types of financial models:
1. DISCOUNTED CASH FLOW MODEL:
• Among different types of Financial model, DCF Model is the most
important. It is based upon the theory that “the value of a business is
the sum of its expected future free cash flows, discounted at an
appropriate rate”.
• In simple words this is a valuation method uses projected free cash
flow and discounts them to arrive at a present value which helps in
evaluating the potential of an investment. Investors particularly use
this method in order to estimate the absolute value of a company.
• These models help predict future cash flow and estimate the present
value of those cash flows.
2. COMPARATIVE COMPANY ANALYSIS MODEL:

• Also referred to as the “Comparable” or “Comps”, it is the one of the

major company valuation analyses that is used in the investment banking
industry.
• In this method we undertake a peer group analysis under which we
compare the financial metrics of a company against similar firms in
industry.
• It is based on an assumption that similar companies would have similar
valuations multiples, such as EV/EBITDA.
• The process would involve selecting the peer group of companies,
compiling statistics on the company under review, calculation of
valuation multiples and then comparing them with the peer group.
3. Sum-of-the-parts Model: It is also referred to as the break-up
analysis. This modeling involves valuation of a company by
determining the value of its divisions if they were broken down and
spun off or they were acquired by another company.

4. Three Statement Models: These model combines income

statement , balance sheet, and cash flow statement to evaluate the
performance of a company.

5. Sensitivity Analysis Models These models are used to

assess the impact of changing assumptions on a company’s financial
performance or metrics.
6. Leveraged buyout (LBO) model:
• An LBO model is a financial tool typically built in Excel to evaluate a
leveraged buyout (LBO) transaction, which is the acquisition of a
company that is funded using a significant amount of debt. Both the
assets of a company being acquired and those of the acquiring company
are used as collateral for the financing.
• Hence it helps in determining if the sponsor can afford to shell out the
huge chunk of money and still get back an adequate return on its
investment.
• Model are used to evaluate the potential for a leveraged buyout by
analyzing the potential return to investors and the impact of debt
financing on a company’s capital structure.
7. MERGER & ACQUISITION (M&A) MODEL:

• Merger & Acquisitions type of financial Model includes the accretion

and dilution analysis. The entire objective of merger modeling is to
show clients the impact of an acquisition to the acquirer’s EPS and
how the new EPS compares with the status quo. In simple words we
could say that in the scenario of the new EPS being higher, the
transaction will be called “accretive” while the opposite would be
called “dilutive.”
• To evaluate potential mergers and acquisitions, including estimating
the value of the target company and the potential impact on the
acquiring company’s finances.
8. OPTION PRICING MODEL:
• On, to buy or sell the underlying instrument at a specified price on or
before a specified future date”. Option traders tend to utilize different
option price models to set a current theoretical value.
• Option Price Models use certain fixed knowns in the present (factors
such as underlying price, strike and days till expiration) and also
forecasts (or assumptions) for factors like implied volatility, to compute
the theoretical value for a specific option at a certain point in time.
• Variables will fluctuate over the life of the option, and the option
position’s theoretical value will adapt to reflect these changes.
Introduction to Excel in Financial 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.
 Basic financial Calculations

1. Present Value (PV)

• PV is the value right now of some amount of money in the future.
• PV is a financial calculation that measures the worth of a future
amount of money or stream of payments in today's dollars adjusted for
interest and inflation or risk.
• PV compares the buying power of one future dollar to purchasing
power of one today dollar.
• Example, suppose we are valuing an investment that promises $100 per year at the end
of this and the next 4 years.
• 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

PV= 100 100 100 100 100 .

(1+10%)^1) (1+10%)^2) (1+10%)^3) (1+10%)^4) (1+10%)^5)

PV = 379.08
PV In excel
 2. Net Present Value
• Net present value (NPV) is a financial metric that seeks to capture the
total value of a potential investment opportunity.
• The idea behind NPV is to project all of the future cash inflows and
outflows associated with an investment, discount all those future cash
flows to the present day, and then add them together.
 Example on NPV
• Suppose that the above investment is sold for $400. Clearly, it would not be worth
its purchase price, since—given the alternative return (discount rate) of 10%.
• NPV=(400) + 379.08 = (20.08)
• Suppose, for example, that the series of 5 cash flows of $100 is sold for $250.

NPV = (400) + 100 100 100 100 100 .

(1+10%)^1 (1+10%)^2 (1+10%)^3 (1+10%)^4 (1+10%)^5

NPV = (250) + 90.9091 + 82.6446 + 75.1315 + 68.3013 + 62.0921

NPV = (250) + 379.08

NPV = 129.08
NPV In Excel
 The Present Value of an Annuity
• An annuity is a security that pays a constant sum in each period in the future.
• Payment of Annuity may be made at the beginning (annuity due) or end
(ordinary annuity) of the period.
• 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.
 Example of Annuity
•
Present Value of an Annuity in excel
 The Present Value of a Growing Annuity
• A growing annuity pays out a sum C, which grows at a periodic
growth rate “g”. If the annuity is finite, its value today is given by.
 If the annuity is infinite
• Taking this formula and letting n  , we can compute the
value of the infinite growing annuity.
 Example of Growing Annuity
•
PV of infinite growing annuity in excel
 The Gordon Formula
• The Gordon formula values a stock by discounting its future
anticipated dividends at the cost of equity rE. Letting P0 be the
current stock price, Div0 the current dividend, and g the growth
rate of future dividends, then:
 Internal Rate of Return (IRR) and Loan Tables
• The internal rate of return is the discount rate which equates the present value the expected cash
flows with the initial investment outlays
• The internal rate of return (IRR) is defined as the compound rate of return ‘r’ which makes the
NPV equal to zero:
• This shouldn't be confused with the return on investment (ROI). Return on investment ignores
the time value of money, essentially making it a nominal number rather than a real number. The
ROI might tell an investor the actual growth rate from start to finish, but it takes the IRR to show
the return necessary to take out all cash flows and receive all of the value back from the
investment.

where:
• R1 ​& R2​=randomly selected discount rates
• NPV1​=higher net present value
• NPV2​=lower net present value​
 Example of IRR
• Assume a project costing 800 in year zero returns a variable series of cash
flows at the end of year one up to year five as follows. What is the IRR of the
project under trial and error?
Years 0 1 2 3 4 5
(Investment) cashflows (800) 200 250 300 350 400
Internal Rate of Return (IRR) in Excel
 Class work on IRR
• Assume a project that has an initial investment of 40,000 Birr and the
following net cash inflows: Year 1, 15,000 Birr; year 2, 10,000 Birr; Year
3, 10,000 Birr; year 3, 15,000 Birr; and year 5, 15,000Birr.
Required: What is the IRR of this project?
 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
Example
Solution of excel
Direct calculation of IRR for uneven cash flow
 Excel’s Rate Function
• Excel’s Rate function computes the IRR of a series of constant future
payments. In the example below, we pay $1,000 today for an annual
payment of $100 for the next 30 years. Rate shows that the IRR is
9.307%.
 Future Values and Applications
• Future Values is the amount of money after a specified amount of time
and discount rate.
• Suppose you deposit 1,000 in an account today, leaving it there for 10
years. Suppose annual compound interest rate of 10%.

• How much money will you have at the end of 10 years?

Fv = Pv (1+r)^n
Fv = 1000 (1+10%)^10 years
Fv = 2593.74
Future Values In excel
 Example two on future value
•
Example two on future value in excel
 Class work on future value
• Again, you intend to open a savings account. Your initial deposit
end of year one Br. 1,000 will be followed by a similar deposit at
the end of years 2, 3, …, and 10. If the account earns 10% per
year, how much will you have in the account at the end of year
10?
 A Pension Problem—Complicating the
Future Value Problem
• Assume You are currently 55 years old and intend to retire at age 60. To make
your retirement easier, you intend to start a retirement account. At the
beginning of each of years 1, 2, 3, 4 (that is, starting today and at the beginning
of each of the next four years), you intend to make a deposit into the retirement
account. You think that the account will earn 8% per year. After retirement at
age 60, you anticipate living 8 more years. 5 At the beginning of each of these
years you want to withdraw $30,000 from your retirement account. Your
account balances will continue to earn 8%.
• How much should you deposit annually in the account?

Do it !! Assignment??????????
 End of Chapter One

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