FINANCIAL MODELLING

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 COURSE DESIGN COMMITTEE

Content Reviewer TOC Reviewer

Dr. Ritesh Kumar Dubey Dr. Ritesh Kumar Dubey
Visiting Faculty, NMIMS Global Visiting Faculty, NMIMS Global
Access - School for Continuing Education Access - School for Continuing Education
Specialization: Finance Specialization: Finance

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Author: Vikas Gupta
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Reviewed By: Dr. Ritesh Kumar Dubey, Ph. D.

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Copyright:
2023 Publisher
ISBN:
978-93-91540-04-3
Address:
4435/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
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 C O N T E N T S

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Financial Modelling: An Overview 1

2 Corporate Valuation 51

3 Comparable Company Analysis 83

Case Studies
107
1 to 3

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4 Discounted Cash Flow (DCF) Analysis 115

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Weighted Average Cost of Capital (WACC) 143

6 Building an Integrated Cash Flow Model 189

Case Studies
219
4 to 6
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7 Pro Forma for Financial Statement Modelling 225

8 Portfolio Management 259

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9 Integrated Risk Modelling 297

Case Studies
321
7 to 9

10 Analysing and Concluding the Model 333

11 Variance-Covariance Matrix 365

12 Recruiting, Interviewing and Selection 393

Case Studies
427
10 to 12

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F I N A N CIAL MO DE LLIN G

C U R R I C U L U M

Financial Modelling: An Overview: Meaning of Modelling, Introduction to Excel, Understanding

Advanced Features of Excel, Functions in Excel, Trace Dependents and Trace Precedents, Micro-
soft Excel as the Modeller’s Tool, Uses of Financial Models, Role of Financial Modeller, Creating
Charts in Excel, Exploring Types of Charts, Creating a Chart, Resizing a Chart, Moving a Chart,
Copying and Pasting a Chart. Converting a Chart Type into Another Chart Type, Printing a Chart,
Understanding Finance Functions Present in Excel, Creating Dynamic Modelling, Steps in Dynam-
ic Modelling, Data Validation

Corporate Valuation: Meaning of Valuation, mportance of Valuation, Understanding Enterprise

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Value and Equity Value, Present Value and Net Present Value, The Internal Rate of Return (IRR)
and Loan Tables, Multiple Internal Rates of Return, Flat Payment Schedules, Future Values and
Applications, A Pension Problem—Complicating the Future Value Problem, Continuous Com-
pounding
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Comparable Company Analysis: Introduction to Comparable Company Analysis, Selecting Com-
parable Companies, Spreading Comparable Companies, Analysing the Valuation Multiples, Con-
cluding and Understanding Value, Introduction to Precedent Transactions Analysis, Selecting
Comparable Transactions, Spreading Comparable Transactions, Concluding Value, Four Methods
to Compute Enterprise Value (EV), Using Accounting Book Values to Value a Company, The Firm’s
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Accounting Enterprise Value, The Efficient Markets Approach to Corporate Valuation, Enterprise
Value (EV) as the Present Value of the Free Cash Flows

Discounted Cash Flow (DCF) Analysis: Discounted Cash Flow (DCF) Analysis, Understanding
Unlevered Free Cash Flow, Forecasting Free Cash Flow, Forecasting Terminal Value, Present Value
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and Discounting, Understanding Stub Periods, Analysis of bonds and swaps, Performing Sensitivity
Analysis, Cash Flows: DCF “Top Down” Valuation, Consolidated Statement of Cash Flows (CSCF),
Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF), Free Cash Flows Based
on Pro Forma Financial Statements

Weighted Average Cost of Capital (WACC): Weighted Average Cost of Capital (WACC), Using the
CAPM to Estimate the Cost of Equity, Estimating the Cost of Debt, Understanding and Analysing
WACC, Concluding Valuation, Computing the Value of the Firm’s Equity, E, Computing the Value
of the Firm’s Debt, D, Computing the Firm’s Tax Rate, TC, Computing the Firm’s Cost of Debt, rD,
Two Approaches to Computing the Firm’s Cost of Equity, rE, Implementing the Gordon Model for
rE, The CAPM: Computing the Beta, Using the Security Market Line (SML) to Calculate Merck’s,
Cost of Equity, Ke/Ri. Computing the WACC, Three Cases, Computing the WACC for Merck (MRK),
Computing the WACC for Whole Foods (WFM), Computing the WACC for Caterpillar (CAT)

Building An Integrated Cash Flow Model: Building an Integrated Cash Flow Model, Use Automa-
tion to Improve Your Forecasting Model’s Reliability, Summary: How to Create a Cash Flow Fore-

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 v

cast in Excel, Understanding Circularity, An alternative approach to solving circular interest, Using
algebra to solve circular interest, Setting up and Formatting the Model, A Consistent Colour Scheme,
Exact Figures in Financial Model Formatting, Text with Custom Formatting, Financial Model Format-
ting Matters, Selecting Model Drivers and Assumptions, Model Tab: Detailed Calculations and Oper-
ating Build-up, Creating the Debt and Interest Schedule, Free Cash Flow (FCF): Measuring the Cash
Produced by the Business, Merck: Reverse Engineering the Market Value

Pro Forma for Financial Statement Modelling: Meaning of Financial Statement Modelling, Modelling
and Projecting the Financial Statem, Projecting the Income Statement, Projecting the Balance Sheet,
Projecting the Cash Flow Statement, Drafting Cash Flow Projection, How Financial Models Work, Pro-
jecting Next Year’ s Balance Sheet and Income Statement, Alternative Modelling of Fixed Assets, Gross
Fixed Assets as a Function of Sales, Constant Net Fixed Assets, Sensitivity Analysis, Debt as a Plug, In-
corporating a Target Debt/Equity Ratio into a Pro Forma, Project Finance: Debt Repayment Schedules,

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Calculating the Return on Equity, The ROE in Our First Full Model, Tax Loss Carry Forwards

Portfolio Management: Turning Your Goals into a Strategy, Risk-reward Ratio, Investment Risk Pyr-
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amid, Portfolio Strategies, Building an Investment Portfolio, Risk Reduction in the Stock Portion of a
Portfolio, Value Investing, Growth Investing

Integrated Risk Modelling: Meaning of Risk Modelling, The Model, General Risk, Credit Risk, Oper-
ational Risk, Market Risk, Implementation, Simulation Procedure, Simulation Variability, Empirical
Results
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Analysing And Concluding The Model: Revolver Modelling, How does a revolver work in a 3-state-
ment model? Revolvers are secured by accounts receivable and inventory, Analysing the Output, Stress
Testing the Model, Error Checking, Types of Stress Testing, Fixing Modelling Errors, The Model Re-
view Process, Seven Types of Errors, Advanced Modelling Techniques, Using the Model to Create a
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Discounted Cash Flow (DCF) Analysis, DCF Model Basics: Present Value Formula, How to Build a DCF
Model: 6 Step Framework

Variance-Covariance Matrix: Sample Variance-Covariance Matrix, Fixed-Weight Historical, Expo-

nential Smoothing, Multivariate GARCH, The Correlation Matrix, Computing the Global Minimum
Variance Portfolio (GMVP), Alternatives to the Sample Variance-Covariance, The Single-Index Model
(SIM), Constant Correlation, Shrinkage Methods, Using Option Information to Compute the Variance
Matrix

Recruiting, Interviewing and Selection: Recruiting and Interviewing, Financial Institutions and In-
vestment Banks, Process of Interviewing, General Interviewing Overview, Qualitative/fit Questions,
Technical Questions, Post Interview, Following up, Selecting a Firm, Selecting a Group, Investment
Banking, Selection, How to Hire Financial Advisors?

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 C H A
1 P T E R

FINANCIAL MODELLING: AN OVERVIEW

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CONTENTS

1.1 Introduction
1.2 Meaning of Modelling
IMSelf Assessment Questions
Activity
1.3 Introduction to Excel
1.3.1 Understanding Advanced Features of Excel
1.3.2 Functions in Excel
1.3.3 Trace Dependents and Trace Precedents
Self Assessment Questions
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Activity
1.4 Microsoft Excel as the Modeller’s Tool
1.4.1 Uses of Financial Models
1.4.2 Role of Financial Modeller
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Self Assessment Questions

Activity
1.5 Creating Charts in Excel
1.5.1 Exploring Types of Charts
1.5.2 Creating a Chart
1.5.3 Resizing a Chart
1.5.4 Moving a Chart
1.5.5 Copying and Pasting a Chart
1.5.6 Converting a Chart Type into Another Chart Type
1.5.7 Printing a Chart
Self Assessment Questions
Activity
1.6 Understanding Finance Functions Present in Excel
Self Assessment Questions
Activity
1.7 Creating Dynamic Modelling
1.7.1 Steps in Dynamic Modelling

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CONTENTS

1.7.2 Data Validation

Self Assessment Questions
Activity
1.8 Summary
1.9 Multiple Choice Questions
1.10 Descriptive Questions
1.11 Higher Order Thinking Skills (HOTS) Questions
1.12 Answers and Hints
1.13 Suggested Readings & References

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 FINANCIAL MODELLING: AN OVERVIEW 3

INTRODUCTORY CASELET

FINANCIAL MODELLING

Based on a company’s previous performance and predictions of

future income, costs and other factors, financial modelling is a Case Objective
technique for projecting likely financial outcomes. Financial mod- This caselet explains
elling, which mimics a forecast’s assumptions using a company’s the overview of financial
financial statements to show how those statements may seem in modelling.
the future, is built on financial projections. Since they are con-
structed using financial data, models usually offer results for a
month, quarter or year.

The bulk of financial models are made on Excel spreadsheets and

need human data entry. One of the simplest variants, known as
the three-statement model, just requires an income statement,

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balance sheet, cash flow statement and any associated schedules.
Due to the vast range of uses for them, some versions are far more
advanced than others. Models are routinely modified by busi-
nesses to meet their demands.
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There is software that helps users to optimise forecasting esti-
mates with the help of a thorough, already-built statistical model-
ling engine. The model can provide predictions for future finan-
cial results and enable users to integrate them immediately into
their plan or projection using an industry-accepted statistical
model. You may edit data on your own by combining this tool with
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spreadsheet apps such as Excel. Without your assistance, it can

also automatically analyse your historical data using pre-built
algorithms to provide financial estimates.
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4 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Explain the meaning of modelling
>> Discuss the introduction to Excel
>> Describe the advanced features of Excel
>> Summarise the Microsoft excel as the modeller’s tool
>> Classify the financial functions present in Excel

1.1 INTRODUCTION
Building spreadsheet models to quantitatively depict a company’s

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Know More expected financial outcomes is known as financial modelling. The act
The technique of evaluating of creating a financial representation of all or partial features of a com-
the financial performance of pany or specific securities is known as financial modelling. The model
a project or corporation using is often known for doing computations and giving advice based on
all pertinent variables, growth
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such data. The model may also serve as a summary for specific events
and risk assumptions, and for the user, such as the Sortino ratio or investment management
analysing their effects is known
as financial modeling. It makes
returns, or it may be used to predict market direction, such as the Fed
it possible for the user to quickly model. A mathematical depiction of a company’s financial activities
get knowledgeable about all and financial statements is called a financial model. Making pertinent
the factors involved in financial assumptions about the company’s performance in the upcoming fiscal
forecasting. years is used to anticipate the company’s future financial success.
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It may be used as a risk management tool to analyse different financial

and economic situations and offer asset assessments. These models
do computations, analyse the results and then offer suggestions based
on the data acquired. In financial models, financial statements such
as the income statement, balance sheet and cash flow statement are
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projected using schedules such as depreciation schedules, amortisa-

tion schedules, working capital management and debt schedules. It
includes all corporate rules and constraints imposed by lenders that
could affect the financial situation.

In this chapter, you will study the meaning of modelling, introduction

to Excel, understand the advanced features of Excel, Microsoft Excel
as the modeller’s tool, create charts using forms and control toolbox,
understand finance functions present in Excel, create dynamic mod-
elling, steps in dynamic modelling, etc., in detail.

1.2 MEANING OF MODELLING

The method through which a company creates a financial representa-
tion of some, all or neither of its characteristics or a particular security
is modelling. The model is often known for making computations and
giving advice based on the results. The model may also give guidance
for potential actions or alternatives and describe specific occurrences
for the end user.

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 FINANCIAL MODELLING: AN OVERVIEW 5

Financial modelling is the process of compiling a spreadsheet-based

overview of a company’s costs and profits that may be used to estimate NOTE
the effects of a potential event or choice. Building a model from scratch
or updating an existing model
For business leaders, a financial model has various applications. It with newly accessible data are
the two options for financial
is most frequently used by financial analysts to assess and forecast modeling. As you can see,
the potential effects of upcoming events or management choices on a all of the financial scenarios
company’s stock performance. mentioned above are intricate
and unstable. It aids the
Financial modelling is the process of using numbers to describe the user in fully comprehending
every element of the intricate
activities of a business in the past, present and anticipated future. circumstance.
These models are designed to be instruments for making decisions.
They could be used by company leaders to predict the expenses and
profitability of a proposed new project.

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Using them, analysts can explain or forecast how events, such as
changes in strategy or business model and economic policy changes,
may affect a company’s stock price.
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Financial models are employed when attempting to value a com-
pany or when contrasting it with others in the same sector. They are
also employed in strategic planning to evaluate potential outcomes,
determine project costs, establish budgets and distribute resources
throughout the organisation.
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SELF ASSESSMENT QUESTIONS

1. Which of the following is the process of compiling a

spreadsheet-based overview of a company’s costs and profits?
a. Financial modelling
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b. Capital budgeting
c. Time value of money
d. None of these
2. Which of the following uses financial modelling to explain
or forecast how certain events, including internal ones and
external ones?
a. Financial accountants
b. Financial analysts
c. Financial models
d. All of these

ACTIVITY

Note the advantages of financial modelling.

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6 FINANCIAL MODELLING

1.3 INTRODUCTION TO EXCEL

MS Excel, developed by Microsoft, is a full-featured spreadsheet
? DID YOU KNOW
application that allows you to store, analyse, manipulate and visual-
Apart from MS Excel, some
other spreadsheet applications
ise data in different ways. The application is specifically designed to
available in the market are: organise data in tables and analyse the tabulated data. It allows you
yyOpenOffice Calc to present your data in a graphical format by using various elements
yyLibreOffice Calc such as shapes, charts, pictures and SmartArt graphics. Moreover, MS
yyGoogle Sheets Excel provides a wide variety of formulas and functions that you can
yyGnumeric use to perform the most complex calculations with ease. You can also
yyKingsoft Spreadsheets use MS Excel to work with textual data. All these features make MS
Excel one of the most popular spreadsheet applications available in
the market today.

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MS Excel 2021 is the latest version of the Excel application. In MS
Excel 2021, you can fill the data in a worksheet using the flash fill fea-
ture, save and share data online, insert online pictures in the work-
sheet, use new charts to visualise data, use new formulas and func-
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tions to perform calculations, etc.

Microsoft Office program includes MS-Excel. It is an electronic spread-

sheet with many rows and columns that is used for data organisation,
graphic data representation and other computations. A cell is made
up of a row and a column, which together make up one of its 10,48,576
rows and 16,384 columns. The address of each cell is determined by
the name of the column and the row, for example, A1, D2, etc. Another
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name for this is a cell reference.

Cell reference is the address or name of a cell or set of cells. It aids the
computer program in locating the cell from which the data or value is
to be taken for the formula. In cell referencing, naming of a cell and
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range may be also used. The cells of other spreadsheets and applica-
tions can be referred to:
‰‰ Referencing the cell of other worksheets is known as External ref-
erencing.
‰‰ Referencing the cell of other programs is known as Remote refer-
encing.

There are three types of cell references in Excel:

1. Relative reference
2. Absolute reference
3. Mixed reference

1.3.1 UNDERSTANDING ADVANCED FEATURES OF EXCEL

Excel is a tool that every financial analyst uses more frequently than
they would want to acknowledge.

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 FINANCIAL MODELLING: AN OVERVIEW 7

Following are some of the important MS Excel Functions/Features for

an Excel Modeller: NOTE
You can create a blank workbook
1. Graphical Features of Excel: Excel has several graphical tools by pressing the Ctrl + N keys
for representing data in graphs and images, including: from the keyboard.
 Charts: Richly detailed graphical representations of the data
may be created using charts.
 SmartArts: By graphically aligning data in imaginative ways,
we may use SmartArts to represent information.
 ClipArts:We may employ ready-to-use clip arts to present
our message visually.
 Shapes: We may represent data in infographics and shapes
using several shapes. The free-form characteristics allow us

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to draw any shape.
 Pictures: Any picture may be added to improve the items.
For instance, the backgrounds of charts, shapes and work-
sheets.
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2. Functional Features of Excel: Excel Tools and Functionality let
us carry out difficult computations and improve Excel’s features.
 Functions: More than 300 pre-built formulae (Text, Date,
Math, String, etc.) are accessible in Excel Cells and may be
utilised to perform a variety of calculations.
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 Hyperlinks: In Excel, we may quickly browse between the

various sections of the spreadsheet by using hyperlinks.
 Spell-check: Using the built-in spell check tool helps us elim-
inate grammatical and spelling problems in the data.
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 Add-ins:To further the functionality of the spreadsheet, we

may create VBA or .NET Excel Add-ins.
 VBA Macros: VBA programming is a feature of Excel’s VBA
macros. You may automate repetitive tasks using the macro
functionality.
 Protection: Workbook, Worksheet and VBA Protection op-
tions are offered in Excel for protection.
 Conditional Formating: We can format the data by the given
requirements. This makes it easier to see the important data
range.
3. Database Feature of Excel: Create databases and perform
several data processing tasks using Excel.
 PivotTables: You may use them to effectively generate cross
tables by summarising the data.
 Tables: Parent and child records can be used to organise the
rows and columns. It will be simpler to quickly carry out fur-
ther investigation as a result.

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8 FINANCIAL MODELLING

 Grouping: We can group the rows and columns of data that

NOTE have parent and child records.
While working with different
applications of Microsoft Office,  Sorting: The data may be sorted in Excel. The data may be
some users may see Search in sorted using one or more columns in either ascending or de-
place of Tell me what you want scending order.
to do in the Ribbon. Please note
that the working of both the  Filtering: Excel allows you to filter the data. We may estab-
Search option and the Tell me lish a variety of choices to filter with just the most important
what you want to do option is
alternatives. Excel has a feature called Advanced Filtering
same.
that enables us to run more intricate filters.
 Sparklines: Excel made it possible to put compact charts
into cells.
 Database: We can use Excel as a database to install 1 million

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records. We can import data into Excel by connecting to sev-
eral databases.
 Data Validations: We may limit the kinds of data that can be
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addition, we may offer a drop-down menu from which we can
select a predetermined set of choices.
 Slicers: Slicers were introduced in Excel 2010 and allow us to
link several pivot tables and filter data using buttons.

1.3.2 FUNCTIONS IN EXCEL

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In MS Excel, formulas and functions are important applications that

are used to perform complex mathematical calculations on large
amounts of data. A formula is an equation or an expression, designed
by a user, which is used to perform calculations on data, whereas, a
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function is a predefined calculation in Excel that takes a value and

performs a calculation on the value and returns a value as a result.

The values used in a function are called arguments and must appear
in a specific order. Functions are generally used for simplifying formu-
las, especially those formulas that are used for performing long and
complex calculations.

Let us discuss some different types of function categories available in

Excel.

MATHEMATICAL AND STATISTICAL FUNCTIONS

Mathematical functions in MS Excel are used to perform calculations

on either individual values or the values selected in a range of cells.
Statistical functions, on the other hand, are used to analyse values.
For example, you can use statistical functions to find out the greatest
or smallest value in a range. In MS Excel, you can access mathemat-
ical functions by clicking the Math & Trig button and the statistical

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 FINANCIAL MODELLING: AN OVERVIEW 9

functions by selecting the Statistical option from the drop-down list

that appears when you click the More Functions button.

Both these buttons are located in the Function Library group under
the Formulas tab of the ribbon. You can also access these options from
the Insert Function dialogue box. This dialogue box appears when you
click the Insert Function button beside the Formula Bar.

Some mathematical and statistical functions are as follows:

‰‰ SUM(), SUMIF() and SUMIFS() functions: The SUM() function
is the most basic function in MS Excel and is used to add values NOTE
in a range of cells. The syntax of the SUM() function is as follows: You can also provide a range of
cells in the SUM function. For
=SUM(number1, number2, number 3,………,number N) example, if you write =SUM (A1:
A9), then the SUM() function

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In the preceding syntax, SUM is the name of the function and adds the numbers present in the
number1, number2, …., numberN is the arguments or values cells range from A1 to A9.
whose sum you want to find. For example, to find the sum of three
numbers, 100, 200 and 300 in Excel, you need to write the following:
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=SUM(100,200,300)
The output obtained after applying the preceding formula will be
600. The SUMIF() is also used in Excel for adding the values but on
some specific criteria. The syntax of using the SUMIF() function in
Excel is as follows:
=SUMIF(range, criteria, [sum_range])’
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In the preceding syntax, the ‘range’ parameter signifies the range

of cells which need to be evaluated by the ‘criteria’ parameter. The
‘criteria’ parameter signifies the condition that must lie in the
‘range’ parameter. You must enclose the non-numeric criteria in
double quotes, but numeric criteria do not require to be enclosed
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in double quotes except when used with operators, i.e., “>52”.

The ‘sum_range’ specifies the range of cells for criteria but its
specification is optional in the SUMIF() function. For example,
consider the following formula:
=SUMIF(D2:D25,”>25”)
The preceding formula will sum only the numbers which lie in the
range D2:D25 but are greater than 25.
The SUMIFS() function works similar to SUMIF() function with
the only difference that the SUMIF() function allows you to apply
it to find the sum of cells using single criteria while the SUMIFS()
function can be applied using multiple criteria to find the sum of
cells. The syntax of using the SUMIFS() function is as follows:
=SUMIFS(sum_range, criteria_range1, criteria1, [criteria_
range2, criteria2], …)
In the preceding syntax, the sum_range specifies the range
to be summed, criteria_range1 specifies the first range to be

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10 FINANCIAL MODELLING

evaluated,criteria1 signifies the criteria to be used on criteria_

range1, criteria_ range2, criteria2 are optional and signifies
MARK IT! additional ranges and their related criteria. Now, consider the
following formula:
Using the SUMIF() function
to match strings more than =SUMIFS(G6:G12,D5:D11,”Fruit”)
255 characters long will give
incorrect results. In the preceding formula, the sum of only those values will take
place which lies in the range G6 to G12 in column G when the
value in column D is “Fruit”. Now, consider another variation of
SUMIFS() function:
=SUMIFS(G6:G12,D5:D11,”Car”,D5:D11,”red”)
In the preceding formula, the SUMIFS() function is set to add
values lying in the cell range from G6 to G12 in column G only

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when the vehicle is “Car” and the colour is red.
‰‰ AVERAGE(), AVERAGEIF() and AVERAGEIFS() functions:
The AVERAGE() function calculates the average or means value
of the group of numbers. To calculate the average, the AVERAGE()
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function calculates the sum of the selected values and divides it by
the number of values. The syntax of the AVERAGE() function is as
follows:
=AVERAGE(number1, number2, number3,………)
In the preceding syntax, AVERAGE is the name of the function
and number1, number2, number3, …. are the arguments or values
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on which you want to apply the AVERAGE function.

The AVERAGEIF() function helps you in finding the average (or
arithmetic mean) for the cells based on a certain condition or
criteria specified in the function. The syntax for the AVERAGEIF()
function is as follows:
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=AVERAGEIF(range, criteria, average_range)

In the preceding syntax, the ‘range’ parameter signifies the range
of cells which need to be evaluated by the ‘criteria’ parameter. The
‘criteria’ parameter signifies the condition that must lie in the
‘range’ parameter. The ‘average_range’ specifies the range of cells
for criteria but its specification is optional in the AVERAGEIF()
function.
For example, consider the following formula:
=AVERAGEIF(D2:D25,”>25”)
The preceding formula will average only those numbers which lie
in the range D2:D25 but are greater than 25.
The AVERAGEIFS() function works similar to the AVERAGEIF()
function with the only difference that the AVERAGEIF() function
allows you to apply it to find the sum of cells using a single criterion
while the AVERAGEIFS() function can be applied using multiple
criteria to find the sum of cells.

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 FINANCIAL MODELLING: AN OVERVIEW 11

The syntax of using the AVERAGEIFS() function is as follows:

NOTE
=AVERAGEIFS(average_range, criteria_range1, criteria1,
You can use wildcard characters
[criteria_range2, criteria2], …) such as question mark (?) for
In the preceding syntax, the average_range specifies the range matching any single character
and an asterisk (*) for matching
to be summed, criteria_range1 specifies the first range to be any series of characters in the
evaluated, criteria1 signifies the criteria to be used on criteria_ SUMIF() and SUMIFS() functions.
range1, criteria_ range2, criteria2 are optional and signifies
additional ranges and their related criteria. Now, consider the
following formula:
=AVERAGEIFS(G6:G12,D5:D11,”Fruit”)
In the preceding formula, the average of only those values will take
place which lies in the range G6 to G12 in column G when the

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value in column D is “Fruit”. Now, consider another variation of
AVERAGEIFS() function:
=AVERAGEIFS(G6:G12,D5:D11,”Car”,D5:D11,”red”)
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In the preceding formula, the AVERAGEIFS() function is used for
finding the average of values that lie in the range G6 to G12 in
column G only when the vehicle is “Car” and the colour is red.
‰‰ COUNT(), COUNTIF() and COUNTIFS() functions: The
COUNT() function is used to count the number of cells that con-
tain numeric data in a selected range of cells.
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This function does not count the blank entries or text data in the
range. The syntax of the COUNT() function is as follows:
=COUNT(number1, number2, number3,………..)
In the preceding syntax, COUNT is the name of the function and
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number1, number2, number3, ….. are the arguments or values

that you want to count.
The COUNTIF() function is used for counting the number of cells
that lies within a range that meets the specified condition. The
syntax of using the COUNTIF() function is as follows:
=COUNTIF(range, criteria)
In the preceding syntax, the ‘range’ parameter signifies the range
of cells which need to be evaluated by the ‘criteria’ parameter.
The ‘criteria’ parameter signifies the condition that must lie in the
‘range’ parameter. For example, consider the following formula:
=COUNTIF(D2:D25,”>25”)
The preceding formula will count only those numbers which lie in
the range D2:D25 but are greater than 25.
The COUNTIFS() function works similar to the COUNTIF()
function with the only difference that the COUNTIF() function

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12 FINANCIAL MODELLING

allows you to apply it to find the sum of cells using single criteria
while the COUNTIFS() function can be applied using multiple
MARK IT! criteria to find the sum of cells. The syntax of using the COUNTIFS()
function is as follows:
In the SUMIFS() function, you
can enter up to 127 range/ =COUNTIFS(criteria_range1, criteria1, [criteria_range2, cri-
criteria pairs. teria2],…)
In the preceding syntax, criteria_range1 specifies the range
to be evaluated; criteria_range1 specifies the first range to be
evaluated; criteria1 signifies the criteria to be used on criteria_
range1; criteria_ range2 and criteria2 are optional and signify
additional ranges and their related criteria. Now, consider the
following formula:
=COUNTIFS(G6:G12,D5:D11,”Fruit”)

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In the preceding formula, the count of only those values will take
place which lies in the range G6 to G12 in column G when the
value in column D is “Fruit”. Now, consider another variation of
IM the COUNTIFS() function:
=COUNTIFS(G6:G12,D5:D11,”Car”,D5:D11,”red”)
In the preceding formula, the COUNTIFS() function is used for
finding the average of values lying in the range from G6 to G12 in
column G only when the vehicle is “Car” and the colour is red.
‰‰ MIN() and MAX() functions: The MIN() function returns the
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smallest value among the set of values.

The syntax of using MIN() function is as follows:
=MIN(number1, number2,….)
On the other hand, the MAX() function returns the largest value
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among the set of values.

The syntax of using the MAX() function is as follows:
=MAX(number1, number2,….)
The MIN() and MAX() ignore logical values and text. For example,
consider the following formula:
=MIN(1000,2000,3000)
The preceding formula will give 1000. Now, consider the following
TURN TO THE formula:
WEB
= MAX(1000,2000,3000)
You can learn more about
formulas and functions using the The preceding formula will give 3000.
following link:
‰‰ MEDIAN() function: The MEDIAN() function allows you to find
https://support.microsoft. the median (or middle number) from a group of numbers. The syn-
com/en-us/office/formulas-
tax of using the MEDIAN() function is as follows:
andfunctions-294d9486-b332-
48edb489-abe7d0f9eda9?ui=en- =MEDIAN (number1, [number2], ...)
US&rs=en-US&ad=US

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 FINANCIAL MODELLING: AN OVERVIEW 13

In the preceding syntax, number1, number2 signify a number or

cell reference containing numeric values. For example, consider
the following formula:
=MEDIAN(10,20,30,40,50) returns 30.
‰‰ STDEVA() function: The STDEVA() function allows you to deter-
mine the standard deviation based on a given sample. The syntax
of using the STDEVA() function is as follows:
=STDEVA(value1, [value2], ...)
In the preceding syntax, value1, value2, ... represent numeric
values. You can also provide a single array or a reference to an
array in the function instead of using comma-separated values.

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‰‰ SEQUENCE function: A list of consecutive numbers is generated
in an array by the SEQUENCE function. The rows and columns
inputs determine whether the array is one or two dimensions. You
can use SEQUENCE by itself to generate a collection of sequen-
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tial numbers that spills onto the worksheet. Additionally, it can be
used to create a numeric array inside of another formula, which
is a necessity that frequently appears in more complex formulas.
Rows, columns, start and step are the first four arguments for the
SEQUENCE function. By default, every number is 1. The number
of rows and columns that should be generated in the output is
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controlled by the rows and columns arguments.

For example, the formulas below generate numbers between 1 and
5 in rows and columns:
=SEQUENCE(5,1) // returns {1;2;3;4;5} in 5 rows
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=SEQUENCE(1,5) // returns {1,2,3,4,5} in 5 columns

Note the output from SEQUENCE is an array of values that will
spill into adjacent cells.
The syntax for SEQUENCE indicates that rows is required, but
either rows or columns can be omitted:
=SEQUENCE(5) // returns {1;2;3;4;5} in 5 rows
=SEQUENCE(5) // returns {1,2,3,4,5} in 5 columns
The start argument is the starting point in the numeric sequence
and step controls the increment between each value.
Both formulas below use a start value of 10 and a step value of 5:
=SEQUENCE(3,1,10,5) // returns {10;15;20} in 3 rows
=SEQUENCE(1,3,10,5) // returns {10,15,20} in 3 columns

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14 FINANCIAL MODELLING

Examples
In the example blow in figure 1.1, the formula in B4 is:
=SEQUENCE(10,5,0,3)

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Figure 1.1: SEQUENCE function
With this configuration, SEQUENCE returns an array of sequential
numbers, 10 rows by 5 columns, starting at zero and incremented
by 3. The result is 50 numbers starting at 0 and ending at 147, as
shown in the screen.
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SEQUENCE can work with both positive and negative values.

To count from -10 to zero in increments of 2 in rows, set rows to 6,
columns to 1, start to -10, and step to 2:
=SEQUENCE(6,1,-10,2) // returns {-10;-8;-6;-4;-2;0}
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To count down between 10 and zero:

=SEQUENCE(11,1,10,-1) // returns {10;9;8;7;6;5;4;3;2;1;0}
Because Excel dates are serial numbers, you can easily use
SEQUENCE to generate sequential dates. For example, to
generate a list of 10 days starting today in columns, you can use
SEQUENCE with the TODAY function.
=SEQUENCE(1,10,TODAY(),1)

TEXT FUNCTIONS

Most people think of MS Excel as an application that is only used to

handle numeric data. While it is true that MS Excel provides several
features that make working with numbers easy, the application is also
found to be equally helpful for manipulating textual data. To work
with text, MS Excel provides a special set of functions known as text
functions. These functions can be used to control the way text appears
on a worksheet. These text functions can be easily accessed from the

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 FINANCIAL MODELLING: AN OVERVIEW 15

Function Library group under the Formulas tab. Following are the
commonly used text functions:
‰‰ CONCATENATE() function: The CONCATENATE() function is
used to join two or more text strings into a single text string. The
items to be joined can be text strings, numbers or single-cell refer-
ences. The syntax for the
CONCATENATE() function is as follows:
=CONCATENATE(text1, text2, ……)
In the preceding syntax, CONCATENATE is the name of the
function and text1, text2, …. are the text strings that can be joined
to a single text string. You can join up to 255 text strings to a single
text string.

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‰‰ LEN() function: The LEN() function returns the length (that is,
number of characters) of a text string. This function also considers NOTE
the space between words and characters in the text string as a The standard deviation is a way
character. The syntax of the LEN() function is as follows: of finding out how widely values
IM are distributed from the average
=LEN(text) value (or mean).
In the preceding syntax, LEN is the name of the function and text
is the text string whose length you want to find.
‰‰ RIGHT() function: The RIGHT() function extracts a specified
number of characters from the end of a text string.
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The syntax of the RIGHT() function is as follows:

=RIGHT(text, num_chars)
In the preceding syntax, RIGHT is the name of the function,
the text is the text string containing the characters you want to
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extract, and num_char is the number of characters that you want

to extract from the string.
‰‰ LEFT() function: The LEFT() function extracts a specified num-
ber of characters from the beginning of a text string. The syntax of
the LEFT() function is as follows:
=LEFT(text, num_chars)
In the preceding syntax, LEFT is the name of the function, the text
is the text string that contains the characters you want to extract,
and num_chars is the number of characters you want to extract
from the text string.
‰‰ MID() function: The MID() function extracts a specified number
of characters from the middle of a text string. The syntax of the
MID() function is as follows:
=MID(text, start_num, num_chars)
In the preceding syntax, MID is the name of the function, the text
is the text string from which you extract the middle characters,

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16 FINANCIAL MODELLING

start_num is the position from where you extract the characters

in the text string, and num_chars is the number of characters that
MARK IT! you want to extract from the text string.
You can draw a trend line by ‰‰ PROPER() function: The PROPER() function is used to convert
using the line chart. a text string to a title case. In the title case, the first letter of each
word is in uppercase and all other letters are converted to lower-
case. The syntax of the PROPER() function is as follows:
=PROPER(text)
In the preceding syntax, PROPER is the name of the function and
text is the text string you want to convert to the title case.
‰‰ UPPER() function: The UPPER() function is used to convert a
text string to uppercase.

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The syntax of the UPPER() function is as follows:
=UPPER(text)
In the preceding syntax, UPPER is the name of the function and
IM text is the text string you want to convert to uppercase.
‰‰ LOWER() function: The LOWER() function is used to convert a
text string to lowercase.
The syntax of the LOWER() function is as follows:
=LOWER(text)
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In the preceding syntax, LOWER is the name of the function and

text is the text string you want to convert to lowercase.

LOGICAL FUNCTIONS

Logical functions in MS Excel can be used to introduce decision-mak-

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ing into a worksheet. In other words, these functions enable us to test a

condition for logical TRUE or FALSE. They are usually used in doing
comparisons and finding out whether the specified values in a formula
are equal to each other or not, or which value is higher or lower and
return TRUE or FALSE based on the evaluation of the formula.

Some logical functions are as follows:

‰‰ AND() function: The AND() function returns TRUE if all the argu-
ments used in the function are true; otherwise, it returns FALSE.
The syntax of the AND() function is as follows:
=AND (logical1, [logical2] ,…)
In the preceding syntax, AND is the name of the function and
logical1 is the first condition that you want to test, which can
either be TRUE or FALSE logical2 and others. … are additional
conditions that you want to test, which can be evaluated to either
TRUE or FALSE. These are optional arguments.

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 FINANCIAL MODELLING: AN OVERVIEW 17

‰‰ OR() function: The OR() function returns TRUE if any condition

is TRUE and returns FALSE if all arguments are FALSE. The syn- NOTE
tax of the OR function is as follows: If array1 and array2 contain
different number of data points,
=OR (logical1, [logical2],…) the CORREL() function returns
the #N/A error.
In the preceding syntax, OR is the name of the function and
logical1 is the first condition that you want to test, which can
either be TRUE or FALSE logical2 and others. … are additional
conditions that you want to test, which can be evaluated to either
TRUE or FALSE. These are optional arguments.
The main difference between the OR() and AND() functions is
that the OR function returns TRUE if any one of the specified
conditions in it is satisfied and the AND function returns TRUE
only when all the specified conditions are satisfied; otherwise,

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both functions return FALSE.
‰‰ XOR() function: The XOR() function is introduced with Excel 2013
and it returns a logical ‘Exclusive OR’ of all arguments. The result
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of the XOR() function is TRUE when the number of TRUE inputs
is odd and FALSE when the number of TRUE inputs is even. The
syntax of the XOR() function is as follows:
=XOR (logical1, [logical2], …)
In the preceding syntax, XOR is the name of the function and
logical1 is the first condition that you want to test, which can either
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be TRUE or FALSE. logical2, and others…. are the additional

conditions that you want to test, which can either be evaluated to
TRUE or FALSE. These are optional arguments.
‰‰ IF()function: The IF() function checks to see whether a certain
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condition is true or false. The function returns one value if the

condition evaluates to TRUE and another value if it evaluates to
FALSE. The syntax of the IF() function is as follows:
=IF(logical_test, [value_if_true], [value_if_false])
In the preceding syntax, IF is the name of the function; logical_
test is the condition you want to test; if the condition will be
satisfied, the value you specified in value_if_true is returned,
and if the condition will not be satisfied, the value you specified
in value_if_false is returned. value_if_true and value_if_false are
the optional arguments.

FORMULATEXT FUNCTION

The FORMULATEXT function extracts a formula from a cell refer-

ence and returns it as a text string. A formula can be extracted as text
from a cell reference using the FORMULATEXT function. When a
cell with a formula is chosen, the text that appears in the formula bar
is identical to the text that FORMULATEXT returns. Once text has

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18 FINANCIAL MODELLING

been retrieved using FORMULA text, it can be used in another for-

mula as text.

FORMULATEXT takes just one argument, reference, which is nor-

mally a cell reference like A1. If you use FORMULATEXT on a cell
that doesn’t contain a formula, it returns #N/A. FORMULATEXT will
handle formulas up to 8192 characters.

SYNTAX
FORMULATEXT(reference)
The FORMULATEXT function syntax has the following arguments.
‰‰ Reference Required. A reference to a cell or range of cells.

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Remarks
‰‰ The FORMULATEXT function returns what is displayed in the
formula bar if you select the referenced cell.
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‰‰ The Reference argument can be to another worksheet or work-
book.
‰‰ If the Reference argument is to another workbook that is not open,
FORMULATEXT returns the #N/A error value.
‰‰ If the Reference argument is to an entire row or column, or to a
range or defined name containing more than one cell, FORMU-
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LATEXT returns the value in the upper leftmost cell of the row,
column, or range.
‰‰ In the following cases, FORMULATEXT returns the #N/A error
value:
 The cell used as the Reference argument does not contain a
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formula.
 The formula in the cell is longer than 8192 characters.
 The formula can’t be displayed in the worksheet; for example,
due to worksheet protection.
 An external workbook that contains the formula is not open in
Excel.
‰‰ Invalid data types used as inputs will produce a #VALUE! error
value.
‰‰ Entering a reference to the cell in which you are entering the func-
tion as the argument won’t result in a circular reference warning.
FORMULATEXT will successfully return the formula as text in
the cell.
Example:

Copy the example data in the following table, and paste it in cell A1
of a new Excel worksheet. For formulas to show results, select them,

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 FINANCIAL MODELLING: AN OVERVIEW 19

press F2, and then press Enter. If you need to, you can adjust the col-
umn widths to see all the data.

Formula Description Result

=TODAY() The formula in C2 returns the formula =FORMULA-
it finds in cell A2 as a text string so that TEXT(A2)
you can easily inspect its structure. The
formula entered in A2 is =TODAY(), and
will return the current day in A2. The
formula =TODAY() should appear as text
in C2.

1.3.3 TRACE DEPENDENTS AND TRACE PRECEDENTS

To find the cells that contain the formula in Excel, utilise trace prec-

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edents and trace dependents. The cells that influence the value of
the active cell are shown in Trace Precedents, while the cells that are
impacted by the active cell are shown in Trace Dependents. Tracer
arrows can be used to spot trace predecessors and trace dependents.
IM
Example: In this case, there are two tables as shown in figure 1.2.
Employee ID and sales are contained in one table, while Employee ID
and tax are contained in the other table. We have calculated the total
of each table item’s corresponding value in cells C9 and C16. Then,
C5:C8 are examples of C9, and C12:C15 are examples of C16.Let’s see
how will we trace precedents here. The steps for performing trace
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precedent are as follows:

1. Select the cell that contains the formula whose precedents you
want to trace, as shown in Figure 1.2:
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Figure 1.2: Selecting the Cell

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20 FINANCIAL MODELLING

2. Click the Trace Precedents button under the Formula Auditing

group in the Formulas tab, as shown in Figure 1.3:

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Figure 1.3: Clicking the Trace Precedents button

Once you click Trace Precedents, the tracer arrows will show the
cells that affect the active cell’s value as shown Figure 1.4:
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Figure 1.4: Trace Precedents Cells

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 FINANCIAL MODELLING: AN OVERVIEW 21

3. Repeat steps 1 and 2 to show that C12:C15 are precedents of C16

as shown in Figure 1.5:

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Figure 1.5: Trace Precedents

Example: In this case, there are two tables. Employee ID and sales
are contained in one table, while Employee ID and tax are contained NOTE
in the other table. We have calculated the total of each table item’s The cell at one end of the line is
corresponding value in cells C9 and C17. We have deducted C17 from activated by double-clicking a
C9 in cell F11. In that instance, cells C9 and C17 are necessary for F11. tracer arrow.
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Let’s see how will we trace dependents here. The steps for performing
trace dependents are as follows:
1. Select the cell that contains the formula whose dependent cells
you want to trace, as shown in Figure 1.6:
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Figure 1.6: Selecting the Cell

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22 FINANCIAL MODELLING

2. Click the Trace Dependents button under the Formula Auditing

group in the Formulas tab, as shown in Figure 1.7:

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Figure 1.7: Clicking the Trace Dependents button
Once you click Trace Dependents, the tracer arrows will
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show the cells that are affected by the active cell as shown in
Figure 1.8:
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Figure 1.8: Affected Cells in Trace Dependents

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 FINANCIAL MODELLING: AN OVERVIEW 23

3. Repeat steps 1 and 2 to show that cell F11 is dependent on the

cell C9 and also with C17 as shown in Figure 1.9:

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Figure 1.9: Trace Dependents
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SELF ASSESSMENT QUESTIONS

NOTE
Choose the Remove Arrows
3. The _________ function allows you to predict exponential button, which is located just
growth based on a given set of data. below the Trace Dependents
button, if you wish to remove the
a. MEDIAN
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arrows.

b. STDEVA
c. GROWTH
d. AVERAGE
4. Which of the following functions is used to count the number
of cells within a range that meet the given condition?
a. COUNT
b. COUNTIF
c. COUNTIFS
d. None of these

ACTIVITY

Find some more features of MS Excel.

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24 FINANCIAL MODELLING

MICROSOFT EXCEL AS THE

1.4
MODELLER’S TOOL
One of the most sought-after yet poorly understood abilities in finance
? DID YOU KNOW is financial modelling. The goal is to combine accounting, finance and
Instead of working on a blank business variables to make a predicted, abstract Excel depiction of a
template, you can use sample
templates provided by MS Excel.
corporation.

It may be quite difficult to predict a company’s activities in the future.

Every company is different and needs a highly specialised set of calcu-
lations and assumptions.

Excel is employed since it is the tool that can be customised and is the
most adaptable. Software, on the other hand, might be overly restric-

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tive and hinder your ability to comprehend each line of the business
the way Excel does.

One of the most versatile and in-demand financial abilities in today’s

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environment is Excel. Most important company choices need the use
of financial models.

Typically, a financial model has been created anytime a firm plans to

grow, evaluates a specific project (also known as project finance mod-
elling), merges with or acquires a certain (target) company or fore-
casts future financials.
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The creation of a financial model is crucial for new businesses and

large enterprises for future business planning. Long-term planning,
expansion, development, cost planning, etc., all benefit from financial
modelling in Excel. Excel spreadsheets are frequently used to build
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financial models.

Let’s examine what financial modelling in Excel means.

QUICK TIP
In case, you do not find a Financial modelling may be defined as the methodical forecasting of
template matching to your a company’s financials. Financial analysts, investment bankers, stock
requirements, you can search
for more templates on the
research analysts and other finance experts put together a financial
Microsoft website. model.

You must comprehend the fundamental terms used in Excel financial

modelling:
‰‰ Forecasting: Forecasting refers to the company’s anticipated
future financial status.
‰‰ Assumptions: To create a financial model, some hypothetical
assumptions must be made. What does it mean now? Assumptions
are used to depict a state that is compatible with the projection’s
goal but is not always predicted to occur.

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 FINANCIAL MODELLING: AN OVERVIEW 25

‰‰ Financial statement analysis: Financial analysis refers to the

use of numerous tools to analyse financial statements, such as the
income statement, balance sheet and cash flow statement.
Figure 1.10 shows the Cash flow Statement:

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Figure 1.10: Cash Flow Statement

The following are the steps for analysing financial statement:

1. Historical data: Past financial information for the business
dating back at least three years should be included.
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2. Ratios and metrics: Establish historical ratios and KPIs for the
company, such as margins, growth rates, asset turnover and
inventory swings.
3. Assumptions: Continue to develop the ratios and metrics by
estimating what the future margins, growth rates, asset turnover
and inventory changes will be.
4. Forecast: You may anticipate the future income statement,
balance sheet and cash flow statement by reversing all of the ? DID YOU KNOW
calculations you performed to arrive at the historical ratios and The File tab is located below the
metrics. In other words, use the predetermined assumptions to Quick Access Toolbar.
complete the financial accounts.
5. Valuation: After the prediction has been made, the company
may be valued using the Discounted Cash Flow (DCF) analysis
method.

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26 FINANCIAL MODELLING

Figure 1.11 shows the Discounted Cash Flow Statement:

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Figure 1.11: Discounted Cash Flow Statement

1.4.1 USES OF FINANCIAL MODELS

Multi-purpose financial modelling is ready. It is used to analyse

finances, make decisions and comprehend the performance and sta-
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tus of the company’s finances. The following situations illustrate the

usage of financial models:
‰‰ Projecting future financial performance, i.e., budgeting and finan-
cial planning.
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‰‰ Examining the company’s performance concerning its objectives

and aims.
‰‰ An evaluation of the company.
‰‰ Making comparisons between the company’s performance and
that of its peers and industry rivals.
‰‰ Examining the ratios and financial accounts.
‰‰ Management accounting and MIS preparation.
‰‰ Calculating new projects’ financial indicators.
‰‰ Resource allocation for the business.
‰‰ Making strategic plans and decisions.
‰‰ Capital budgeting and investment planning.
‰‰ Business/asset divestments and mergers/acquisitions.
‰‰ Analysing the capital structure (Debt/ Equity)

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1.4.2 ROLE OF FINANCIAL MODELLER

The technique of utilising numbers to represent a business’s past,

current and predicted future actions is known as financial model- NOTE
ling. These models are intended to be tools for decision making. They Here is a list of the 10 most
might be used by business owners to forecast the costs and revenue common types of financial
models:
of a new project that is being considered. The following is the role of yyThree Statement Model
a financial modeller: yyDiscounted Cash Flow (DCF)
Model
‰‰ Financial modelling’s importance in the finance sector is rising
yyMerger Model (M&A)
quickly.
yyInitial Public Offering (IPO)
‰‰ Financial modelling serves as a crucial instrument that enables Model
cost-effective estimation of company concepts and risks. yyLeveraged Buyout (LBO)
Model
‰‰ Financial modelling is the process of producing a visually appeal-

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yySum of the Parts Model
ing depiction of a company’s financial status. yyConsolidation Model
‰‰ Financial models are mathematical expressions used to depict the yyBudget Model
financial performance of an organisation. yyForecasting Model
IM yyOption Pricing Model
SELF ASSESSMENT QUESTIONS

5. Which of the following refers to the company’s anticipated

future financial status?
a. Assumptions
b. Financial statement analysis
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c. Forecasting
d. Planning
6. Which of the following is to create a financial model, some
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hypothetical assumptions must be made?

a. Assumptions
b. Planning
c. Financial statement analysis
d. Forecasting

ACTIVITY

Describe some more tools that can be used for financial modelling.

1.5 CREATING CHARTS IN EXCEL

In MS Excel, charts are used for the visual representations of data
contained in a worksheet. Representing numeric data visually makes
it easy for users to understand the information, especially if it is long.
Charts are a great way of comparing data or showing the relationship

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28 FINANCIAL MODELLING

between given quantities. Microsoft Excel provides various types of

charts, such as line charts, column charts and pie charts. Each type of
chart presents data in a different way or style and you can select one
that best suits your requirements. MS Excel 2019 also provides the
Recommended Charts feature that recommends the most appropriate
charts for representing your data.

1.5.1 EXPLORING TYPES OF CHARTS

A chart is one of the best ways to present and analyse data visually.
Charts make it easy for users to understand numerical data. Excel
MARK IT! provides you with various types of charts that you can use to represent
A chart is one of the ways to
your data. You can also create a wide range of customisable charts,
represent and analyse data such as column charts, pie charts, surface charts and area charts. A

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visually. chart is ideal for representing numbers and their relationship with
one another. In addition, Excel provides various options that you can
use to change the appearance of a chart by adding elements such as
a chart title, an axis title and a legend. You can also select a suitable
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chart type depending on the data you want to represent. For this, you
first need to select the data and then select the type of chart that you
want to use to represent your data.
‰‰ Column chart: Column charts display each data point (individual
data values) as a vertical column, where the height of a column
corresponds to the value represented by it. The column chart is
ideal to use when you want to compare data.
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‰‰ Bar chart: A bar chart represents data in the form of horizontal

bars. The length of the bars corresponds to the value of data they
represent.
‰‰ Line chart: Line charts are used to plot continuous data in the
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? DID YOU KNOW form of lines. Therefore, each point on a line chart corresponds to
In a column chart, the vertical a value. The line chart can use any number of data series and you
axis represents a value can distinguish the lines by using different colours or line styles.
scale and the horizontal axis
represents various categories ‰‰ Pie chart: A pie chart is used to show the proportions or contribu-
that are measured against the tions of different sections relative to a whole. These proportions or
value scale.
contributions are contributed by each value in a single data series.
Various sectors or blocks in a pie chart represent data as a propor-
tion of the whole. Pie charts are most effective while representing
small amounts of data.
‰‰ Area chart: Similar to a line chart, an area chart also displays a
series as a set of points connected by a line. However, the differ-
ence is that in the area chart, the area below the line is filled with
the colour of the line. Area charts help draw attention to the total
values across a given data.
‰‰ Surface chart: This chart displays a three-dimensional surface
that joins a group of data points. This chart is beneficial if you need

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 FINANCIAL MODELLING: AN OVERVIEW 29

to identify the ideal combinations between the data of two groups

or sets. Similar to a topographic map, the surface chart indicates
the areas that contain the same range of values in the form of the
same colours and patterns.
‰‰ Radar chart: This chart, also known as a star chart, plots the val-
ues of each data set on a different axis that is started from the
middle point of the chart and is completed on the outer ring of the
chart.
‰‰ XY (Scatter) chart: This chart is used to show the relationship
between the numerical values in two data series. This type of chart
represents one data series on the X-axis and the other data series
on the Y-axis.

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‰‰ Map chart: This chart is used to compare the data value and show
the comparison with the help of geographical regions.
‰‰ Stock chart: This chart is used to show the fluctuations in stock
prices. However, this chart can also be used to represent scientific
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data. It is important to organise the data of the stock chart very
carefully.
‰‰ Treemap: This chart is used to show the data in the hierarchical
form. This chart gives the facility to compare data of different lev-
els by different colours and proximities. It can be plotted when any
blank cell is available in the hierarchical structure. It is the best
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possible way to compare large amounts of data.

‰‰ Sunburst: This chart acts as a Treemap chart for the ones who pre-
fers pie charts. It is extremely similar to a Treemap chart, except
for the fact that the data is represented using concentric rings or
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circles. The central circle represents the top level of the hierarchy.
‰‰ Histogram: This chart is used to show data in the form of fre-
quency within a distribution. Each column in a Histogram chart is
known as a Bin. It makes it easy to analyse the data defined within
various data ranges.
‰‰ Box and Whisker: This chart is appropriate to represent statisti-
cal data sets related to each other without using any formula. This
chart produces answers from the raw data.
‰‰ Waterfall: This chart is used to represent the financial data, which
encounters changes, such as addition and subtraction. It helps
to study how the initial value of data is affected relatively by this
change. There is a colour code set for the columns in the chart.
‰‰ Funnel: This chart is used to represent the change in values
during the multiple stages of a process. In a typical Funnel chart,
the values cascade gradually, which gives a Funnel-type shape to
the chart.

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30 FINANCIAL MODELLING

‰‰ Combo chart: This chart represents the data by using the com-
bination of two or more charts. MS Excel provides several types
of charts to represent worksheet data graphically. It also provides
various tools that allow you to perform various actions on a chart,
for example, you can resize, move and copy your chart. Apart from
this, you can add or delete charts as per your requirements. In
addition, you can convert a chart from one type to another type.

1.5.2 CREATING A CHART

MS Excel provides 17 types of charts to represent the data in your

worksheet. Each of these chart types contains several subtypes.

You can create any type of chart according to the data you want to

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represent. The idea is to select the correct chart to ensure the best
visualisation of your data. You can create a chart by performing the
following steps:
IM1. Open a new or an existing workbook whose data you want to
represent in a chart.
2. Select the data that you want to represent in a chart. In our case,
we have selected the cell range A1:D7 (Figure 1.3).
3. Select the desired chart type under the Charts group of the
Insert Tab. In our case, we have selected the Column chart type.
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A drop-down list appears.

4. Select the desired chart from the drop-down list. In our case, we
have selected the 3-D 100% Stacked Column chart under the
3-D Column section, as shown in Figure 1.12:
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Figure 1.12: Selecting the 3-D 100% Stacked Column Chart

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 FINANCIAL MODELLING: AN OVERVIEW 31

The selected chart is created on the worksheet, as shown in

Figure 1.13:

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Figure 1.13: Displaying the 3-D 100% Stacked Column Chart

1.5.3 RESIZING A CHART

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If you want to change the size of your chart, you can do so by simply
selecting the chart. On selecting the chart, eight handles appear on
the border of the chart. Now, place the mouse pointer on any of these
handles and drag it to resize the chart. You can resize a chart by per-
forming the following steps:
1. Open a new or an existing workbook that contains the chart you
want to resize.
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2. Click anywhere on the chart. Eight handles appear on the border

of the chart.
3. Move the mouse pointer over any of these handles. In our case,
we have moved the mouse pointer over the middle handle at the
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bottom of the chart.

4. Drag the mouse pointer to set the chart as per the desired size, as
shown in Figure 1.14:

Figure 1.14: Resizing the Chart

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32 FINANCIAL MODELLING

5. Release the mouse button. The chart is resized, as shown in

Know More Figure 1.15:
When you select a chart, the
Chart Tools contextual tab
appears on the Ribbon with
Design and Format tabs.

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Figure 1.15: Displaying the Resized Chart

EXHIBIT

Formatting Paint Brush

Formatting pain brush is one of the most underused features

of Excel. The Format Painter copies formatting from one place and
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applies it to another.
1. Select cell B2, as shown in Figure A:
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Figure A: Selecting the Cell B2

2. Click the Format Painter button under the Clipboard group
in the Home tab. A moving dashed border appears around cell
B2 and the mouse pointer changes to a plus and a paintbrush,
as shown in Figure B:

Figure B: Displaying the Paintbrush

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 FINANCIAL MODELLING: AN OVERVIEW 33

3. Select the cell D2 to apply formatting, as shown in Figure C: NOTE

The Format Painter applies the
Currency format, background
colour and borders of cell B2 to
cell D2. That saves time! Instead
of selecting cell D2, you can also
select a range of cells to apply
the format of cell B2 to a range
Figure C: Selecting the Cell D2 of cells.

4. Double click the Format Painter button to apply the same

formatting to cells multiple times.

1.5.4 MOVING A CHART

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When you create a chart in MS Excel, it appears in the middle of your
workbook by default. Sometimes, the chart hides the data in the work- NOTE
sheet. Click the Format Painter button
IM again (or press Esc) to exit
Therefore, to ensure that both the data and the chart are visible in Format Painter mode.
the worksheet, you need to correctly align the chart with the data. For
this, you need to move the chart to a new location within the same
worksheet. Perform the following steps to move a chart:
1. Open a new or an existing workbook that contains the chart you
want to move.
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2. Click anywhere on the chart to display the borders around it.

3. Click and drag the border to move the chart to the desired
location in the worksheet.
4. Release the mouse button. The chart is moved to the new location.
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1.5.5 COPYING AND PASTING A CHART

Sometimes, you may need a copy of a chart within the same work-
sheet or a different worksheet. In such a case, instead of making the
same chart from scratch again, you can copy that chart and paste it to
the desired location on the worksheet.

You can copy and paste a chart by performing the following steps:
1. Select the chart that you want to copy.
2. Click the Copy button under the Clipboard group of the Home
tab.
3. Select the location where you want to paste the chart.
4. Click the Paste button under the Clipboard group of the Home
tab.

The copied chart is pasted at the selected location.

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34 FINANCIAL MODELLING

1.5.6 CONVERTING A CHART TYPE INTO ANOTHER CHART

TYPE

Suppose you find that your data does not suit the chart that you have
created. In such cases, MS Excel provides you with the facility to
switch to another chart type that suits your data.

You can convert a chart type into another chart type by performing
the following steps:
1. Select the chart that you want to convert.
2. Click the Change Chart Type button under the Type group of the
Design tab in the Chart Tools contextual tab. The Change Chart
Type dialogue box appears with the All Charts tab selected by
default.

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3. Select a chart category from the list of chart category names
displayed on the left side of the dialogue box. In our case, we
have selected the Bar category.
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4. Select a chart type from the list of available chart types. In our
case, we have selected the Clustered Bar chart type.
5. Click the OK button, as shown in Figure 1.16:
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Figure 1.16: Selecting the Chart Type

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 FINANCIAL MODELLING: AN OVERVIEW 35

The chart type of the selected chart converts to the Clustered Bar
chart type, as shown in Figure 1.17:

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Figure 1.17: Displaying the Chart

When you click the Chart Elements (+) button on the chart you will
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access the various chart options. Some of them are described as fol-
lows:
‰‰ X-axis:Refers to a horizontal axis, which is also known as the cat-
egory axis
‰‰ Y-axis: Refers to a vertical axis also known as value axis
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‰‰ Data Series: Refer to a set of data that you want to display in a

chart
‰‰ Chart Area: Refers to the total space that is enclosed by a chart
‰‰ Chart Title: Denotes the type of data plotted in a chart
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‰‰ Axes Titles: Mention the name or title for X, Y and Z axes

‰‰ Legend: In a chart showing different data series, a unique colour
or pattern is assigned to each data series
‰‰ Gridlines: These are the horizontal and vertical lines within the
plot area in a chart
‰‰ Data Label: Provides additional information about a value, that is
coming from a worksheet cell

1.5.7 PRINTING A CHART

Before printing a chart, you can adjust its position in a worksheet as

per your requirements. The procedure of printing a chart is similar to
the procedure of printing a worksheet. If you want to print the chart
without worksheet data, you need to select the chart and MS Excel
resizes the chart to fit the page of the worksheet. You can print a chart ? DID YOU KNOW
by performing the following steps: By default, the legend is
displayed at the bottom side of
1. Select the chart that you want to print. the chart.

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36 FINANCIAL MODELLING

2. Select the File tab. The Backstage View appears.

3. Select the Print option on the Backstage View.
4. Type the desired value in the Copies spin box. In our case, we
have typed the value as 1.
5. Click the Print button to print the chart, as shown in Figure 1.18:

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Figure 1.18: Setting the Print Options
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SELF ASSESSMENT QUESTIONS

7. Which of the following charts is used to show data in the form

of frequency within a distribution?
a. Histogram
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b. Funnel
c. Waterfall
d. Treemap

ACTIVITY

Find some more advanced features of MS Excel.

UNDERSTANDING FINANCE FUNCTIONS

1.6
PRESENT IN EXCEL
The financial functions provided in MS Excel help you to perform
financial calculations, such as calculating the monthly payment of a
loan or an investment, the interest earned on security and the future
value of an investment or a loan. Financial functions are primarily
used by accountants, financial institutions and insurance companies.
In MS Excel, you can access the financial functions by clicking the

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 FINANCIAL MODELLING: AN OVERVIEW 37

Financial button under the Function Library group located in the

Formulas tab. Some financial functions present in Excel are as fol-
lows:
‰‰ PV() Function: The PV() function calculates the total value of an
investment or a loan over some time with a fixed rate of annual
interest. The syntax of the PV function is as follows:
=PV(rate, nper, pmt, [fv], [type])
In the preceding syntax, PV is the name of the function and vari-
ous arguments used in the syntax can be briefly described as fol-
lows:
 rate: Refers to the rate of interest per period (measured month-
ly, half-yearly or yearly).

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 nper: Refers to the total number of payment periods in an an-
nuity (set amount of time measured monthly or yearly).
 pmt: Denotes an amount paid at fixed intervals of time (mea-
IM
sured monthly or yearly). It includes the principal amount and
rate of interest. The pmt argument is optional.
 fv: Refers to the future value that you want to achieve after the
last payment is made. It is an optional argument.
 type: Specifies the number 0 or 1 and indicates when payments
are due. If the number is 0 or omitted, it means that the pay-
ments are due at the end of the period. If the number is 1, it
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means that the payments are due at the beginning of the peri-
od. It is an optional argument.
‰‰ FV() Function: The FV() function returns the future value of an
investment or a loan based on a fixed interest rate and a fixed pay-
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ment. The syntax of the FV() function is as follows:

=FV(rate, nper, pmt, [pv], [type])
In the preceding syntax, FV is the name of the function and the
various arguments used in the syntax can be briefly described as MARK IT!
follows:
The rate of interest is divided
 rate: Refers to the rate of interest per period. by 12 to get the monthly rate of
 nper: Refers to the total number of payment periods in an an- interest and the annual amount
is multiplied by 12 to get the total
nuity. payment to be made.
 pmt: Refers to the payments made in each period. It includes
the principal amount and rate of interest. This is an optional
argument.
 pv: Refers to the present value of the investment or loan. If pv
is left blank, the present value of the investment is considered
to be zero. It is an optional argument.
 type: Specifies the number 0 or 1 and indicates when payments
are due. If the number is 0 or omitted, it means that the pay-

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38 FINANCIAL MODELLING

ments are due at the end of the period. If the number is 1, it

means that the payments are due at the beginning of the peri-
od. It is an optional argument.
‰‰ PMT() Function: The PMT() function is used to calculate the pay-
ment of a loan or investment on a fixed number of payments and
at a fixed rate of interest. The syntax of the PMT() function is as
follows:
=PMT(rate, nper, pv, [fv], [type])
In the preceding syntax, PMT is the name of the function and var-
ious arguments used in the syntax can be briefly described as fol-
lows:
 rate: Refers to the rate of interest for a loan or investment.

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 nper: Refers to the total number of payments.
 pv: Refers to the present value investment or loan.
 fv: Refers to the future value that you want to achieve, after
IM paying the last payment. If fv is left blank, then the future value
of the investment or the loan is considered to be zero. It is an
optional argument.
 type: Specifies the number 0 or 1 and indicates when payments
are due. If the number is 0, it means that the payments are due
at the end of the period. If the number is 1, it means that the
payments are due at the beginning of the period. It is an op-
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tional argument.
‰‰ NPER() Function: The NPER() function is used to calculate the
number of payment periods for an investment or loan based on a
fixed rate of interest and fixed payments that you make at the end
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of every month.
The syntax of the NPER() function is as follows:
=NPER(rate, pmt, pv, [fv], [type])
In the preceding syntax, NPER is the name of the function and the
various arguments used in the syntax can be briefly described as
follows:
 rate: Refers to the rate of interest for the loan or investment.
 pmt: Refers to the payments made in each period. It includes
the principal amount and the rate of interest.
 pv: Refers to the present value of the investment or loan. If pv
is left blank, the present value of the investment is considered
to be zero.
 fv: Refers to the future value or cash balance that you want to
attain after the last payment is made. If fv is left blank, the fu-
ture value of the investment or a loan is considered to be zero.
This is an optional argument.

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 FINANCIAL MODELLING: AN OVERVIEW 39

 type: Specifies the number 0 or 1 and indicates when payments

are due. If the number is 0 or omitted, it means that the pay-
ments are due at the end of the period. If the number is 1, it
means that the payments are due at the beginning of the peri-
od. This is an optional argument.
‰‰ RATE() Function: The RATE() function returns the rate of inter-
est per period of an annuity. The syntax for the RATE() function is
as follows:
=RATE(nper, pmt, pv, [fv], [type], [guess])
In the preceding syntax, RATE is the name of the function and the
various arguments used in the syntax can be briefly described as
follows:

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 nper: Refers to the total number of payment periods in an an-
nuity.
 pmt: Refers to the payments made in each period. It includes
IM
the principal amount and the rate of interest.
 pv: Refers to the present value of the investment or loan. If pv
is left blank, the present value of the investment or loan is con-
sidered to be zero.
 fv: Refers to the future value that you want to achieve, after
paying the last payment. If fv is left blank, then the future value
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of the investment or the loan is considered to be zero. It is an

optional argument.
 type: Specifies the number 0 or 1 and indicates when payments
are due. If the number is 0 or omitted, it means that the pay-
ments are due at the end of the period. If the number is 1, it
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means that the payments are due at the beginning of the peri-
od. It is an optional argument.
 guess: Refers to the estimation of interest rate. If you omit to
guess, it is assumed to be 10% (or 0.1). The RATE function is
usually computed if the guess argument is between 0 and 1. It
is an optional argument.

SELF ASSESSMENT QUESTIONS

8. Which of the following functions returns the rate of interest

per period of an annuity?
a. PV
b. RATE
c. FV
d. PMT

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40 FINANCIAL MODELLING

9. The ______________ function calculates the total value of an

investment or a loan over some time with a fixed rate of annual
interest.
a. PV
b. PMT
c. NPER
d. FV

ACTIVITY

How can we use Excel in financial modelling?

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1.7 CREATING DYNAMIC MODELLING
Dynamic modelling captures the control factors that allow the
NOTE
IM
behaviour of objects to be understood throughout time and depicts the
UML stands for Unified temporal features of a system. Events that signal changes, sequences
Modelling Language used to of events and the organisation of events and states are all character-
specify, visualise, construct, istics of a system that the dynamic model represents. The operations’
and document the artefacts of
software systems. goals, platforms and implementation methods are not taken into
account by the dynamic model.

A collection of State Diagrams serves as a visual representation of the

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Dynamic Model (called State Charts in UML). It is feasible to think of

each State Diagram (and its sub-diagrams) as a behavioural model for
the class it is modelled for since they represent every potential state
and event sequence allowed for a given class of objects in response
to external and internal events. Only objects with a clear lifespan or
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those that have noteworthy behaviour need to be modelled. A state

diagram displays the many conditions and state transitions that an
item experiences throughout its existence, as well as how those condi-
tions are affected by outside factors.

Use ACS for C and C++ to produce the code necessary to implement
the State Diagrams you’ve created.

State Diagrams offer a robust vocabulary for dynamic modelling,

allowing you to represent things such as:
‰‰ States: Comprising Atomic States, Sequential States, Concurrent
States and Submachine States—represent the state or circum-
stance of an item at a certain moment in its lifetime, when it meets
a condition, does an action or waits for a specific event.
‰‰ Transitions: Symbolise a relationship between two states, indicat-
ing that when a particular event occurs, a thing in the first state
will go to the second and do certain actions.

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 FINANCIAL MODELLING: AN OVERVIEW 41

‰‰ Events: Represents an event of importance that might cause a

change in the state. Event Action Blocks are used to model events.
‰‰ Actions: Define reactions to events and relate to functions from the
functional model. Event Action Blocks are used to model actions.
‰‰ Guard Conditions: When a transition event triggers, a guard con-
dition, a Boolean condition, decides whether the transfer takes
place. Event Action Blocks are used to mimic guard conditions.
‰‰ Pseudo states: These states include the initial, final, history, junc-
tion, entry, exit, fork and join states. Compound transitions are
built up using pseudo-states.
‰‰ Activities: Operations, Activities or Activities in the Class Model
relate to Activities in the Activities category, which describes con-

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tinuous state behaviour.

1.7.1 STEPS IN DYNAMIC MODELLING

IM
The general principles for creating a dynamic model are as follows.
The procedure is iterative because simulation findings may be used to
refine modelling suppositions or fix mistakes in the equations govern-
ing the dynamic balance.
1. Identify the objective for the simulation
2. Draw a schematic diagram, labelling process variables
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3. List all assumptions

4. Determine spatial dependence
 yes = Partial Differential Equation (PDE)
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 no = Ordinary Differential Equation (ODE)

5. Write dynamic balances (mass, species, energy)
6. Other relations (thermo, reactions, geometry, etc.)
7. Degrees of freedom, does several equations = the number of
unknowns?
8. Classify inputs as
 Fixed values
 Disturbances

 Manipulated variables
9. Classify outputs as
 States

 Controlled variables
10. Simplify balance equations based on assumptions

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42 FINANCIAL MODELLING

11. Simulate steady-state conditions (if possible)

12. Simulate the output with an input step

1.7.2 DATA VALIDATION

In most worksheets, you can enter and change data freely without
restrictions. However, in some cases, you may want to enter only the
data in the worksheet that meets your requirements. You can validate
data in Microsoft Excel by simply restricting what is entered in a cell
by using predefined criteria. Data validation helps you to control the
kind of information that is entered in a worksheet. For example, you
may want to restrict data entry to a certain range of dates or make
sure that only positive whole numbers are entered. Microsoft Excel
validates the entries of each user against the set criteria to ensure that

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only those values that meet the criteria are accepted. You can also pro-
vide messages to define the type of input you expect for the cell, and
instructions to help users correct any errors. When data is entered
that does not meet your requirements, Microsoft Excel displays an
IM
error message box with instructions you provide.

The error message box contains three buttons: Retry, Cancel and
Help. Clicking the Retry button allows you to edit the data you enter;
the Cancel button removes the invalid or incorrect data from the par-
ticular cell; and the Help button opens the Excel Help window that
provides general information about data validation.
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Microsoft Excel allows data validation on the following types of data:

‰‰ Any value: Allows you to validate any type of data
‰‰ Whole number: Specifies data validation in which users can only
enter whole numbers within a limit
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‰‰ Decimal: Specifies data validation in which users can only enter

decimal numbers within a limit
‰‰ List: Specifies data validation in which users can only select the
data from a list
‰‰ Date: Specifies data validation in which users can only enter a
date within a specified time frame
‰‰ Time: Specifies data validation in which users can only enter a
time within a specified time frame
‰‰ Text length: Specifies data validation in which users can only
enter some text within a specified text length
‰‰ Custom: Specifies data validation based on formulas or values that
check the validity of the entered data

The steps to perform the data validation are as follows:

1. Open a new workbook.

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 FINANCIAL MODELLING: AN OVERVIEW 43

2. Select the cell or cell range where you want to apply data
validation.
3. Click the Data Validation button under the Data Tools group in
the Data tab.
The Data Validation dialog box appears, with the Settings tab
activated by default.
4. Click the down arrow button of the Allow drop-down list.
A drop-down list appears.
5. Select an option from the drop-down list to specify the type of
data validation you want to apply. In our case, we have selected
the Whole number option

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6. Click the down arrow button of the Data drop-down list.
A drop-down list appears.
7. Select an option from the drop-down list to specify the criteria
IM
for data validation. In our case, we have selected the less than
option.
When you select the less than option in the Data drop-down list,
the Maximum text box appears in the Data Validation dialog
box.
8. Enter a value in the Maximum text box to specify the highest
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whole number that you want to set for the selected criteria.
9. Click on the Input Message tab.
10. Type a title in the Title text box to specify the title for the input
message box that appears when you enter data in the required
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cell.
11. Type the message in the Input message text area, which is
displayed in the input message box to guide the user to enter
correct data.
12. Click on the Error Alert tab
13. Type a title in the Title text box to specify the title for error
message box.
14. Type the error message that you want to display when a user
makes an invalid entry, in the Error message text area.
15. Click the OK button to save the settings.
16. Enter a value in the area you selected for validation in the
worksheet.
17. Press the ENTER key to check whether the value you entered is
valid or not.

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44 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

10. Which of the following represents a relationship between two

states, indicating that when a specific event occurs, an item
in the first state will move into the second state and carry out
specific activities?
a. Events
b. Transitions
c. Actions
d. Guard Conditions
11. Which of the following defines reactions to events and relate
to functions from the functional model?

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a. Guard Conditions
b. Events
IM c. Actions
d. Activities

ACTIVITY

Find out some features of Dynamic Modelling.

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S 1.8 SUMMARY
‰‰ The act of creating a financial representation of all or partial fea-
tures of a company or specific securities is known as financial
modelling. The model is often known for doing computations and
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giving advice based on such data.

‰‰ A mathematical depiction of a company’s financial activities and
financial statements is called a financial model. Making pertinent
assumptions about the company’s performance in the upcoming
fiscal years, is used to anticipate the company’s future financial
success.
‰‰ The method through which a company creates a financial repre-
sentation of some, all or neither of its characteristics or particu-
lar security. The model is often known for making computations
and giving advice based on the results. The model may also give
guidance for potential actions or alternatives and describe specific
occurrences for the end user.
‰‰ For business leaders, a financial model has various applications. It
is most frequently used by financial analysts to assess and forecast
the potential effects of upcoming events or management choices
on a company’s stock performance.
‰‰ Financial modelling is the process of using numbers to describe
the activities of a business in the past, present and anticipated

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 FINANCIAL MODELLING: AN OVERVIEW 45

future. These models are designed to be instruments for making

decisions. They could be used by company leaders to predict the
expenses and profitability of a proposed new project.
‰‰ Microsoft Office program includes MS-EXCEL. It is an electronic
spreadsheet with many rows and columns that is used for data
organisation, graphic data representation and other computations.
A cell is made up of a row and a column, which together make up
one of its 10,48,576 rows and 16,384 columns.
‰‰ Excel is a tool that every financial analyst uses more frequently
than they would want to acknowledge. We have selected the most
significant and complex Excel formulae that any top-tier financial
analyst needs to be familiar with based on our extensive expertise.
‰‰ One of the most sought-after yet poorly understood abilities in

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finance is financial modelling. The goal is to combine accounting,
finance and business variables to make a predicted, abstract Excel
depiction of a corporation.
‰‰ Financial modelling is the process of using numbers to describe
IM
the activities of a business in the past, present and anticipated
future. These models are designed to be instruments for making
decisions. They could be used by company leaders to predict the
expenses and profitability of a proposed new project.
‰‰ Microsoft Excel is the most important tool for investment bankers
and financial analysts. More than 70% of the time, they produced
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Excel models and performed computations, graphs, calculations

and other calculations.

KEY WORDS

‰‰ Computations: The act or action of computing

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‰‰ Fed model: A market timing tool built on a formula comparing

the yields on Treasury bonds and profits
‰‰ Finance: A term for matters regarding the management, cre-
ation and study of money and investments
‰‰ Financial modelling: The process of compiling a spread-
sheet-based overview of a company’s costs and profits that may
be used to estimate the effects of a potential event or choice
‰‰ Risk management: The procedure for recognising, evaluating
and controlling risks to a company’s resources and profits

1.9 MULTIPLE CHOICE QUESTIONS

1. Which of the following allows for the insertion of tables, pivot MCQ
tables, photos, clip art, charts, links, etc.?
a. Formulas b. Page layout
c. Insert Tab d. Home Tab

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46 FINANCIAL MODELLING

2. Which of the following offers thesaurus functionality, spelling

checks, text translation and tools for sharing and protecting
worksheets and workbooks?
a. Review b. View
c. Page layout d. None of these
3. The user may utilise a variety of built-in formulas and functions
by simply selecting a cell or cell range as the source of the value.
Which of the following option is correct regarding the above
statement?
a. Data b. Formulas
c. View d. Review
4. Which of the following is called a potent collection of Excel

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formulae that will advance your financial analysis and financial
modelling?
a. Index match b. IF combined with AND/OR
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c. XNPV and XIRR d. SUMIF and COUNTIF
5. These two complex equations are excellent examples of
conditional functions in practice. All cells that satisfy specified
requirements are added by SUMIF, and all such cells are counted
by COUNTIF. Which of the following option is correct regarding
the above statement?
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a. IF combined with AND/OR

b. XNPV and XIRR
c. Index match
d. SUMIF and COUNTIF
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6. Which of the following formula uses the terms rate, number of

periods and present value?
a. PMT b. IPMT
c. EFFECT d. RATE
7. Which of the following refers to the use of numerous tools to
analyse financial statements, such as the income statement,
balance sheet and cash flow statement?
a. Assumptions
b. Planning
c. Financial statement analysis
d. Forecasting
8. The firm may be appraised utilising the Discounted Cash Flow
(DCF) analysis technique after the forecast has been created.

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 FINANCIAL MODELLING: AN OVERVIEW 47

Which of the following option is correct regarding the above

statement?
a. Forecast
b. Ratios & Metrics
c. Historical data
d. Valuation
9. Identify the role of the financial modeller.
a. Financial modelling’s importance in the finance sector is ris-
ing quickly.
b. Financial models are mathematical expressions used to de-
pict the financial performance of an organisation.

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c. Both a. and b.
d. Making strategic plans and decisions.
10. Which of the following captures the control factors that allow
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the behaviour of objects to be understood throughout time and
depicts the temporal features of a system?
a. Financial modelling
b. Dynamic modelling
c. Financial analysis
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d. None of these

1.10 DESCRIPTIVE QUESTIONS

1. Discuss the meaning of modelling.
?
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2. Explain the brief introduction to Excel.

3. Describe Microsoft Excel as the modeller’s tool.
4. Explain the role of the financial modeller.

HIGHER ORDER THINKING SKILLS

1.11
(HOTS) QUESTIONS
1. You are thinking about investing in a start-up business with an
original, creative idea. How will you begin?
a. Determine if the investment will bring in enough money to be
profitable.
b. Consider the company’s sources and expenditures of cash.
c. Determine how much debt is incurred in the investing pro-
cess.
d. Inspect the company’s balance sheet and goodwill.

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48 FINANCIAL MODELLING

2. Naman is an accountant in a firm that provides financial services.

The manager asks Naman to calculate the estimated future value
of the investment based on the fixed interest rate and a fixed
payment. Which function of MS Excel helps Naman to do this
task?
a. PV() function
b. FV() function
c. NPER() function
d. RATE() function
3. What does a toggle mean as it relates to an Excel financial model?
a. It is a cell that tests sensitivity by switching inputs for out-
puts.

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b. It is a formula that, depending on presumptions, generates a
yes or no decision.
c. In Excel, it’s a simple way to switch between several cell val-
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ues.
d. It is a simple approach to altering the model’s underlying sce-
nario as a whole.

1.12 ANSWERS AND HINTS

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ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Meaning of Modelling 1. a. Financial modelling
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2. b. Financial analysts
Introduction to Excel 3. c. GROWTH
4. c. COUNTIF
Microsoft Excel as the modeller’s tool 5. b. Forecasting
6. a. Assumptions
Creating Charts Using Forms and 7. a. Histogram
Control Toolbox
Understanding Finance Functions 8. b. RATE
Present in Excel
9. d. FV
Creating Dynamic Modelling 10. b. Transitions
11. c. Actions

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. c. Insert Tab

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 FINANCIAL MODELLING: AN OVERVIEW 49

Q. No. Answer
2. a. Review
3. b. Formulas
4. a. Index match
5. d. SUMIF and COUNTIF
6. a. PMT
7. c. Financial statement analysis
8. d. Valuation
9. c. Both a. and b.
10. b. Dynamic modelling

ANSWERS FOR DESCRIPTIVE QUESTIONS

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1. The method through which a company creates a financial
representation of some, all or neither of its characteristics or
a particular security. The model is often known for making
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computations and giving advice based on the results. The model
may also give guidance for potential actions or alternatives and
describe specific occurrences for the end user.
Financial modelling is the process of compiling a spreadsheet-
based overview of a company’s costs and profits that may be
used to estimate the effects of a potential event or choice. Refer
to Section 1.2 Meaning of Modelling
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2. Microsoft Office program includes MS-EXCEL. It is an

electronic spreadsheet with many rows and columns that is used
for data organisation, graphic data representation and other
computations. A cell is made up of a row and a column, which
together make up one of its 1048576 rows and 16,384 columns.
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The address of each cell is determined by the name of the column

and the row, for example, A1, D2, etc. Another name for this is a
cell reference. Refer to Section 1.3 Introduction to Excel
3. One of the most sought-after yet poorly understood abilities in
finance is financial modelling. The objective is to incorporate
accounting, finance and business elements to create an
Excel forecast that represents an organisation in an abstract,
projected way. It may be quite difficult to predict a company’s
activities in the future. Every company is different and needs a
highly specialised set of calculations and assumptions. Excel is
employed since it is the tool that can be customised and is the
most adaptable. Software, on the other hand, might be overly
restrictive and hinder your ability to comprehend each line of
the business the way Excel does. Refer to Section 1.4 Microsoft
Excel as the Modeller’s Tool
4. The technique of utilising numbers to represent a business’s
past, current and predicted future actions is known as financial

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50 FINANCIAL MODELLING

modelling. These models are intended to be tools for decision-

making. They could be used by company leaders to predict the
expenses and profitability of a proposed new project. Refer to
Section 1.4 Microsoft Excel as the Modeller’s Tool

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. b. Consider the company’s sources and expenditures of cash
2. b. FV() function
3. d. It’s a simple approach to alter the model’s underlying
scenario as a whole

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1.13 SUGGESTED READINGS & REFERENCES
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SUGGESTED READINGS
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
Bloss, M. and Dirnberger, M., n.d. Financial Modelling.
‰‰ Pfaff, P., 1990. Financial modelling. Needham Heights, Mass.: Allyn
and Bacon.
‰‰ Zivot, E. and Wang, J., 2003. Modelling financial time series with
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S-Plus. New York: Springer.

E-REFERENCES
‰‰ Corporate Finance Institute. 2022. What is Financial Modelling.
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[online] Available at: <https://corporatefinanceinstitute.com/

resources/knowledge/modelling/what-is-financial-modelling/>
[Accessed 24 August 2022].
‰‰ Dheeraj Vaidya, F., 2022. Financial Modelling. [online] WallStreet-
Mojo. Available at: <https://www.wallstreetmojo.com/finan-
cial-modelling/> [Accessed 24 August 2022].
‰‰ CFA Institute. 2022. Financial Modelling - Building a 3 Statement
Model. [online] Available at: <https://www.cfainstitute.org/en/
events/professional-learning/financial-modelling> [Accessed 24
August 2022].
‰‰ Varsity by Zerodha. 2022. Introduction to Financial Modelling –
Varsity by Zerodha. [online] Available at: <https://zerodha.com/
varsity/chapter/introduction-to-financial-modelling/> [Accessed
24 August 2022].

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 C H A
2 P T E R

CORPORATE VALUATION

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CONTENTS

2.1 Introduction
2.2 Meaning of Valuation
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2.2.1 Importance of Valuation
Self Assessment Questions
Activity
2.3 Understanding Enterprise Value and Equity Value
Self Assessment Questions
Activity
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2.4 Present Value and Net Present Value

Self Assessment Questions
Activity
2.5 The Internal Rate of Return (IRR) and Loan Tables
Self Assessment Questions
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Activity
2.6 Multiple Internal Rates of Return
Self Assessment Questions
Activity
2.7 Flat Payment Schedules
Self Assessment Questions
Activity
2.8 Future Values and Applications
Self Assessment Questions
Activity
2.9 A Pension Problem—Complicating the Future Value Problem
Self Assessment Questions
Activity
2.10 Continuous Compounding
Self Assessment Questions
Activity

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52 FINANCIAL MODELLING

CONTENTS

2.11 Summary
2.12 Multiple Choice Questions
2.13 Descriptive Questions
2.14 Higher Order Thinking Skills (HOTS) Questions
2.15 Answers and Hints
2.16 Suggested Readings & References

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INTRODUCTORY CASELET

BUSINESS VALUATION CASE STUDY: CASH FLOW IS KING

The significance of cash flow available to an investor or business

buyer has been emphasised in a number of my earlier writings Case Objective
on business valuation. I think the main factor used to determine
value in the majority of business appraisals should be this metric This caselet highlights the
valuation of business based
of cash flow. I was hired a few years ago to assist in figuring out
on cash flows.
the worth of a sole proprietorship’s 100% ownership stake for use
in marital breakdown proceedings. The worth of the company for
the purposes of asset dissolution had to be determined by the val-
uators for both parties. The court procedures and a comparison of
the valuation techniques employed by the two parties provide a
compelling illustration of the significance of cash flow in estimat-

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ing a company’s worth.

CASE BACKGROUND
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The company in question was a one-person operation that offered
“sales, repair, and installation” services to residences and com-
mercial establishments. The company was housed in a 2,500
square foot store in the owner’s home. The company paid a tiny
compensation to the owner’s spouse but did not pay rent for the
use of the premises or a salary for the owner’s services. Although
the company maintained a steady stream of customers, its profit-
ability changed from year to year.
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APPROACHES USED

In order to assess the worth of the company, the opposing val-

uation expert (Expert A) only used the Privately Traded Guide-
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line Company Method. In order to look for deals involving busi-

nesses thought to be comparable to the subject business, Expert
A searched the Pratt’s Stats –— Private Company Merger and
Acquisition database. Expert A discovered 38 transactions involv-
ing businesses thought to be comparable to the subject firm using
search parameters, including similar NAICS codes, a comparable
range of revenue, and a timeframe of the prior 10 years to the effec-
tive date of the valuation. Expert A calculated the mean (average)
sales multiple as 0.73 using these 38 transactions. The projected
enterprise value of the company was then calculated by Expert A,
who multiplied this sales multiple by the average of the preceding
three years’ sales to arrive at a figure of almost $432,000.

I used the same historical data as Expert A’s valuation and the pri-
vately traded guideline company method, but I also made normal-
isation adjustments to the income statements to account for the
shop’s market rate rent expense, the owner’s estimated market

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54 FINANCIAL MODELLING

INTRODUCTORY CASELET

level compensation based on services rendered, and any compen-

sation paid to the spouse that would not be necessary for the busi-
ness’ operation. Along with other search parameters, I also used
the Pratt’s Stats database. I found 40 transactions in my search,
including the 38 transactions that Expert A utilised. Additionally,
I selected the sales multiple and the Seller’s Discretionary Earn-
ings (SDE) multiple as the two multiples to employ in my valua-
tion. SDE is defined as Operating Profit (Earnings Before Interest
and Taxes) plus Owners Compensation plus Depreciation/Amor-
tisation in Pratt’s Stats FAQ. The most pertinent multiple, in my
opinion, is SDE since it closely mirrors the earnings stream that a
buyer of the company would have access to.

I determined the subject firm’s normalised SDE (taking into

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account the normalisation changes previously described) before
determining the SDE as a percentage of sales for the subject com-
pany. The SDE as a percentage of sales for the transactions in
my search was then contrasted with this proportion. The findings
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showed that the normalised SDE as a percentage of sales for the
subject firm was close to the SDE as a percentage of sales in the
21st percentile of the transactions in my search. The transactions’
related 21st percentile SDE multiple was 1.93 times SDE. I also
estimated the 21st percentile’s sales multiple, which came out to
be 0.41 times revenue. The outcome of calculating the estimated
enterprise value of the company using these two multiples was
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about $145,000.

ANALYSIS

My strategy took into account the bottom-line cash flow that a

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prospective buyer of the firm would have access to and utilised

multiples matching to deal with comparable levels of cash flow.
In my study, I made the point that top-line profitability indicators
such as revenue should be accompanied with an analysis demon-
strating how they relate to cash flow indicators at the bottom-line.
Simply put, the bottom-line cash flow that a business buyer would
have access to should be close to the “mean” cash flow of the data
set if the “mean” multiple for revenue is to be applied. It didn’t in
these transactions, and I thought a different multiple ought to be
used.

FINDINGS

The judge in the case heard arguments from both parties and
requested that a third independent valuation expert analyse
both reports and inform the court which strategy they thought
was more credible because of the discrepancy in the outcomes.

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 Corporate Valuation  55

INTRODUCTORY CASELET

According to the third expert’s testimony, they would have eval-

uated the firm using a bottom-line cash flow strategy that took
normalisation adjustments into account, similar to what I per-
formed in my analysis. When questioned if they would have used
the “mean” revenue multiple, they said that they would only have
done so if the bottom-line cash flow for the transactions under
consideration was close to the “mean” of the data set. The judge
accepted the conclusions in my appraisal assessment.

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56 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Explain the meaning of valuation
>> Recognise an understanding of enterprise value and equity
value
>> Express Present Value and Net Present Value
>> Describe the Internal Rate of Return (IRR) and Loan Tables
>> Discuss Flat Payment Schedules
>> Summarise Future Values and Applications

2.1 INTRODUCTION

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Quick Revision In the previous chapter, you studied the financial modelling. Build-
ing spreadsheet models to quantitatively depict a company’s expected
financial outcomes is known as financial modelling. The act of creat-
IM
ing a financial representation of all or partial features of a company or
specific securities is known as financial modelling. The model is often
known for doing computations and giving advice based on such data.

A company valuation provides management with information on

a variety of facts and numbers pertaining to the organisation’s true
worth or value in terms of market competition, asset values and rev-
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enue values. Some of the salient advantages and benefits of business

valuation are a significant insight into the company assets, fathoming
of the organisation’s resale value, in-depth knowledge during mergers
and acquisitions; getting a real company value and access to a range
of investors.
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Values have taken on a more prominent role as a result of the rise in

commercial activity. It doesn’t matter if it’s a multinational corporation
or a start-up company organisation; appraisals are common. Valuation
is regarded as a crucial factor for many related business operations,
from the establishment or genesis of the company entity to its mergers
and acquisitions, for receiving long-term financial help from banks or
financial institutions, winding up the organisation.

International Valuation Standards, Guidance to Valuation, Methods

employed in Valuation, Valuation of Tangibles and Intangibles, Valua-
tion during Mergers and Acquisitions, etc. are just a few of the many
important aspects of valuation. A professional must have a thorough
understanding of the aforementioned valuation-related topics in order
to approach valuation from all angles and resolve valuation-related
issues. Simply knowing the subject theoretically won’t cut it because
valuation isn’t an applied field of study where every component has a
practical application. Additionally, multiple valuation methodologies
should be utilised based on the size, scope and nature of the organi-
sation.

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 Corporate Valuation  57

In this chapter, you will get to know the meaning of and importance of
valuation. You will also get an understanding of enterprise value and
equity value along with present value and net present value. Further
on, you will be apprised of the Internal Rate of Return (IRR) and Loan
Tables, Multiple Internal Rates of Return and flat payment schedules.
The chapter will shed light on future values and applications. In the
end, you will gain knowledge about pension problems and continuous
compounding.

2.2 MEANING OF VALUATION

Valuation has gained significant recognition in business parlance.
Valuation has taken centre stage with the growth of various business NOTE
organisation forms, particularly the company form of business organ-
Tax reporting requires Valuation

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isation and various activities revolve around it. As a result, valuation as well. The Internal Revenue
has become ubiquitous, whether during the beginning of an entity, Service (IRS) mandates that a
expansion, merger and acquisition or winding-up. company be valued at its fair
market value. Some tax-related
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Although valuation is sometimes thought of as a science, the factors in events, such as the sale,
purchase, or gifting of remaining
value sometimes need natural subjectivity. In another sense, valuation stock, will be taxed based on
is not a precise science since it may be fraught with market imperfec- Valuation.
tions. Company valuers nowadays should possess erudite knowledge
to ensure that business valuation theory and processes are well pre-
sented and understood. Therefore, business valuation has to be more
of a science than an exercise in perception and guesswork.
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Even in the exceptional case where the appraiser has a complete

understanding of the market, the market may not provide an accu-
rate understanding of worth as well as the technique and process of
assessment. There may not always be a clear-cut valuation approach
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or a clear-cut value conclusion, but every valuation depends only on

its own conditions. A rational, methodical approach and careful appli-
cation of the fundamental concepts are required for correct appraisal.
This implies that there might not be a set structure or preferred
approach that can be used in every situation.

A business valuation is a technique for determining the overall eco-

nomic importance of a company or other business entity. Business val-
uation can be utilised to fathom a company’s fair value for a myriad
of reasons, including sale value, partner ownership, taxation and even
settlement. Business owners quite frequently seek objective estimates
of the value of their businesses from professional business evaluators.

A business valuation typically entails scrutinising the top business,

capital structure, future income prospects or asset market value. Eval-
uators, businesses and industries all harness various tools for valua-
tion. The various tools may be a review of financial data, discounting
cash flow models, company comparisons, etc.

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58 FINANCIAL MODELLING

Study Laying down various estimates of values with the minimum most
Hint possible range between the highest and lowest values computed at
various methods serve as a prerequisite for higher credibility of the
The accounting valuation of
the company’s assets less valuation process. A better valuation exercise has the subsequent
all claims senior to common characteristics:
equity (such as the company’s
liabilities) is known as book ‰‰ Realistic and acceptable value conclusion
value. The term “book value”
‰‰ Application of convincing methods to arrive at the value conclu-
comes from the accounting
practice of recording asset sion
value in the books at the
‰‰ Transparency of the valuation process
original historical cost.
‰‰ Realistic consideration of factors responsible for valuation
‰‰ Ensuring fair considerations and curtailing cutting corners

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In light of the recent privatisation of state-owned businesses, valua-
tion has recently been a topic of political and economic discussion.
Many business owners and managers are circumspect about issues,
such as: How much is our business worth? And how much is theirs?
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The valuation of a business is crucial in these situations; thus, a busi-
ness owner or person may need to be aware of the value of a firm. The
accurate and exact market value standard includes an independent
buyer and seller who are both in possession of the necessary infor-
mation and facts, are unaffected by outside pressures or influences,
and have access to all the data necessary to make well-informed judg-
ments.
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2.2.1 IMPORTANCE OF VALUATION

A valuation is helpful for many business processes, including mergers

and acquisitions, business sales, raising capital and taxation. It will
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be quite difficult for the key managerial professionals to fulfil their

professional obligations unless and until they have a thorough under-
standing of the valuation procedures involved in the aforementioned
business occurrences. Additionally, different company roles necessi-
tate distinct valuation strategies.

To serve the purpose valuation assists in canvassing the key concepts

whose understanding is required to perform the tasks about merg-
ers and acquisitions, convincing banks and financial institutions seek
financing to meet their short- and long-term capital needs, deal with
tax-related issues, satisfy numerous statutory obligations, etc.

Valuation of business plays a very critical role, thus, an entrepreneur

or individual should be well aware of the value of a business. The fair
market value standard consists of an independent buyer and seller
having the necessary knowledge and facts, not under any undue influ-
ence or stressors and having access to all of the information to make
an informed decision.

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 Corporate Valuation  59

A trained valuation professional with extensive credentials should do

a business valuation because it is a complex financial examination.
Owners of small businesses that choose for inexpensive company
valuation usually overlook significant advantages of a full valuation
investigation and report produced by a certified valuation profes-
sional. The possible benefits might provide business owners more
control over strategic decisions like the sale of their company, reduce
their financial risk in a legal case, reduce the amount of gift or estate
tax they would have to pay and act as a buffer in an audit situation.

The importance of valuation arises for statutory as well as commercial

reasons, which are explained as follows:
‰‰ Assessment under Wealth Tax Act, Gift Tax Act
‰‰ Formulation of scheme for amalgamation

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‰‰ Purchase and sale of shares of private companies
‰‰ Raising loans on the security of shares
‰‰ For paying court fees
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‰‰ Conversion of shares

SELF ASSESSMENT QUESTIONS

1. Business owners who opt for __________ business valuation

tend to considerably miss out on the key benefits received
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from a comprehensive valuation analysis and valuation report

done by a certified valuation expert
a. Low-cost b. High-cost
c. Medium-cost d. Medium and high cost
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ACTIVITY

Find out the current valuation of a small enterprise.

UNDERSTANDING ENTERPRISE VALUE

2.3
AND EQUITY VALUE
As an investor, one does not have to be apprehensive about the nature NOTE
of the product or service as long as the company is earning profits and Enterprise Value (EV) exhibits the
the stock price is soaring. However, organisations have to weigh both value of an organisation’s overall
operations to all stakeholders,
factors and how best to succeed in their business and provide valuable encompassing common
returns to their investors. shareholders, preferred equity
holders and lenders of debt
From a technical point of view, the concepts of serving clients and financing.
ensuring high returns for investors are deemed separate as they
both have their characteristics and processes. The former is known

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60 FINANCIAL MODELLING

as enterprise value and the latter is known as Equity Value. Custom-

ers and investors frequently misunderstand how enterprise value and
stock value differ from one another. It is important to define every-
thing to compare company and stock values ​​to help one make well-in-
formed investment decisions.

The enterprise value of a company is inferred as the entire financial

NOTE worth of all of the assets of the company, even entailing cash. The
Enterprise Value demonstrates enterprise value exhibits the worth of an organisation if it is to be
the value of the cardinal
operations of an organisation acquired by another company in the current market. Due to the fact
irrespective of how it raises that a company’s capital structure has no bearing on its overall worth,
finance and thus offers a precise enterprise value is a useful tool for investors and other organisations
comparison between companies
to discern between businesses with various capital structures.
owing to being independent of
their different capital structures.

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A business expands and goes through several processes, one of which
can be mergers and acquisitions. A company can commence a merger
with various companies to forge a new business entity or acquire a dif-
ferent company to further grow. In both instances, the company takes
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the enterprise value of the other company into consideration before
finalising the acquisition.

Along with the target firm’s outstanding debt, the purchasing com-
pany also takes cash into account while making an acquisition. Enter-
prise value is a crucial consideration for both organisations because
debt also drives up acquisition costs while company cash lowers them.
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The formula that can be used to evaluate the value of any stabilised
asset or company is:

Company’s Value = Cash Flow/(Discount Rate – Cash Flow Growth

Rate), where Cash Flow Growth Rate < Discount Rate.
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Equity value is defined as the total value of the company’s share and all
loans provided to the company by the company’s shareholders. This
is the value that remains for the benefit of the company’s sharehold-
ers after all debts have been settled. Investors must consider equity
value when assessing a company and its shares. This enables them
to understand the worth of your business both now and in the future.

The essence behind equity value is to determine how much the value
of a company affects its stock. Investors evaluate the company’s offer-
ings and its equity model. In the equity value calculation, enterprise
value is added to non-operating assets, then liabilities are subtracted
from available cash. However, the total value of shares can be better
understood by considering the number of shares outstanding (both
common and preferred) and the sum of borrowings from sharehold-
ers. Stock prices are volatile and may rise or decline based on our
share price in the stock market.

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The formula to calculate the equity value of a company:

Equity Value = Enterprise Value – (Total Debt + Cash)
Or
Equity Value = Number of Shares × Share Price

When we draw a comparison between enterprise value and equity

value, we will get an understanding that the enterprise value is used
more pervasively than the equity value. It is so because the enterprise
value enables analysts to ameliorate the capital structure from the val-
uation process. Nonetheless, enterprise value is cardinally utilised by
investment banks who seek to find the value of the entire organisation
before advising their clients on the merger or acquisition process.

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Though analysts prefer recoursing to the enterprise value technique
more than the equity value, it is still an essential technique used in
equity research by investors. As investors seek to buy individual shares
of the company and not the whole business, they harness equity value
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and its current company value and foresee its future value by relying
on whether the share price has the potential to offer a good return.

The enterprise value exhibits how much finance an organisation will

get if it was to sell the entire stakes to anyone in the market. It is a
crucial measure for companies that are underway to finalise the pro-
Study
cess of mergers and acquisitions. Through the use of enterprise value,
Hint
companies assure that they do not overspend more than what the
M

acquiree company is valued at. Equity value underscores

an organisation’s worth by
On the contrary, equity value is a part of enterprise value that relates computing shareholder’s
equity. In other way, it is
to the equity aspect of the company and showcases how much value the total price at par to all
the company can generate if one is to purchase the shares of the com- shareholders’ equity.
N

pany.

SELF ASSESSMENT QUESTIONS

2. Equity value can be computed by multiplying

a. Share price and number of authorised shares
b. Share price and number of subscribed shares
c. Share price and number of outstanding shares
d. Share price and number of unsubscribed shares
3. The _____________ exhibits how much finance an organisation
will get if it was to sell the entire stakes to anyone in the
market.
a. Market value b. Book value
c. Enterprise value d. Realisable value

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62 FINANCIAL MODELLING

ACTIVITY

Get in touch with a budding entrepreneur and identify the business

firm’s enterprise value.

PRESENT VALUE AND NET PRESENT

2.4
VALUE
One of the key tasks of financial analysis is determining the monetary
value of assets. In part, this value is determined by the income gener-
ated during the life of the asset. Funds may be paid, making it difficult
to compare the value of different assets at another time. Lets’ start
NOTE with a simple case. Would you rather have assets to pay back `1,000

S
By making use of present value today, or is he the one who paid him `1,000 in a year? I found out that
one can swiftly assess the value
of an investment today. Utilising
the money was paid today Better than the money paid in the future.
Excel, investors can obtain a This idea is called time Value for money. The time value of money is
prelude to of whether investing
IM
at the heart of many financial Calculations, especially value-related.
money today on a certain asset If you had the choice of `1,000 or `1,100 a year from now? The second
is worthy considering a specific
rate of return. option will pay you more (which is a good thing), but it pays off in the
future (which is bad).

The present value is the existing value that one or more assets or
investments would have in the future discounted at the market rate.
M

The present value of future cash flows will always be less than the
same amount of future cash flows because cash received today can be
invested for a higher return than cash promised in the future.

An essential aspect of the present value calculation is the interest rate

used for discounting. The market rate is the theoretically correct rate,
N

but it can also be adjusted up or down to reflect the perceived risk of

the underlying cash flows. For example, if cash flow is considered very
problematic, a higher discount rate may be justified, reducing present
value.

Numerous financial decisions, including how to value pension liabili-

ties, whether to invest in fixed assets, and which sort of investment to
choose all depend on the idea of present value. In the latter scenario,
present value provides a standard foundation for differentiating dis-
tinct investment kinds. In hyperinflationary economies, when future
cash flows look to be worthless and become zero due to the rapid
decline in the value of money, the concept of present value is partic-
ularly crucial. This effect is made clearer by the use of current value.

Net Present Value (NPV) is the product of the difference between an

investment and the future cash flows from that investment over some
time. This allows companies and investors to decide whether to invest
based on the present value of future returns.

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 Corporate Valuation  63

Net present value is the current/present value of all future cash

flows generated by an asset. In other words, it is the value that can
be obtained by using the asset. Or the discount amount based on the
discount rate. Banks, financial institutions, investment bankers and
venture capitalists are also often consulted to value assets and compa-
nies. NPV considers the time value of money. This demonstrated that
the money one has now will be worth more than the same amount in NOTE
the future. Future declines in the value of money are primarily due to NPV is a sort of valuation and
inflation, interest rates and lost investment opportunities. is pervasively utilised across
finance and accounting for
NPV is inferred as the current value of all future cash flows from a identifying the value of a
business, investment security,
project. The value of a project is not simply the sum of all future cash capital project, new venture,
flows, as the time value of money indicates that it is worth more in cost reduction program and
the present than in the future. These future cash flows need to be dis- whatever entailing cash flow.
counted because the value of money one will reap in the future will be

S
less than it is at present. To compute NPV, each future cash flow must
be discounted to obtain the present value of each cash flow. Then sum
these present values associated with each period.
IM
One can think of NPV in several manners, but one of the straightfor-
ward ways is to infer it is as the total sum of the current value of all
cash inflows, i.e., the cash you earn from the project, minus the pres-
ent value of all cash outflows, i.e., cash disbursed on the project. This
manner of considering NPV bifurcates into two parts, but the formula
takes into consideration both of these parts in tandem. Our discount
rate, r, which is the rate of return we might anticipate from alternative
M

ventures, is used to calculate the present value. For instance, you have
a pound sterling. If you don’t invest that pound sterling, you will still
have that same pound sterling bill in your pocket the subsequent year
as well. Nonetheless, if you invest it, you could have more than that
pound sterling one year from now. The alternative way is investing in
N

the pound sterling, and the rate of return for that alternative project is
the rate at that your pound sterling would grow over one year.

The NPV method identifies if a project/investment is worth undertak-

ing by distinguishing two things: initial investment and the total value
of future cash flows. NPV analysis deduces that a project or invest-
ment is worth undertaking when it determines the present value of
future cash flows higher than the initial investment and vice versa.
It brings the intricate array of cash flows into a simplified weighing
scale situation where one can easily decipher which is worthy. In the
NPV context, we have to see which one is greater, the present value of
future cash flows or the initial investment.

NPV is the difference between the present value of an investment and

the cost resulting from an investment.

The points given here define the role of NPV accurately:

‰‰ A positive NPV showcases that the investor’s monetary position
will be enhanced by taking up a project.

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64 FINANCIAL MODELLING

‰‰ A negative NPV points out the monetary loss of an investor.

‰‰ Nil or nought NPV depicts that the present value of all the benefits
over useful time is at par with the prevailing value.

SELF ASSESSMENT QUESTIONS

4. ___________ is the difference between the present value of an

investment and the cost resulting from an investment.
a. NPV
b. IRR
c. ARR
d. APR

S
5. The project is accepted in the case of _________ NPV.
a. Negative
b. Zero
IM
c. Positive
d. May be negative or positive

ACTIVITY

In a case where the NPV is negative, what does it indicate?

M

THE INTERNAL RATE OF RETURN (IRR)

2.5
AND LOAN TABLES
N

The discount rate that yields a Net Present Value (NPV) of zero is
NOTE known as the Internal Rate of Return (IRR). It’s a well-known metric
Market value can differ radically
for determining investment efficiency. In normal circumstances when
over a certain period of time a negative cash flow occurs at the start of the project, followed by all
and is largely influenced by the positive cash flows, the IRR technique will provide the same outcome
business cycle. Market values as the NPV method for non-mutually exclusive ventures in an uncon-
are categorised under bear
strained environment. However, in the case of mutually incompatible
markets that precede recessions
and augment during up-trends projects, the often employed choice criterion of selecting the project
that precede economic with the highest IRR may result in the selection of a project with a
expansion packs. lower NPV.

IRR can be defined as the discount rate at which the present value of
all future cash flows (hypothetical profits monetised) equals the initial
investment, in another way the rate at which investment is recovered.
It can be utilised to gauge and compare the profitability of invest-
ments.

In general, the higher the IRR of an investment, the more desirable it

is to perpetuate investing. IRR can thus be used to rank several pos-
sible investment options that an organisation is considering. Assum-

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 Corporate Valuation  65

ing all other factors are equal for the various investments, we recom-
mend prioritising the security investment with the highest IRR. IRR
is sometimes called the economic rate of return.

In theory, an organisation should make all available security invest-

ments with an IRR that exceeds the minimum acceptable return spec-
ified by the organisation. Of course, investments may be limited by the Study
availability of company funds. Because IRR is an interest rate, it is a Hint
measure of investment efficiency, quality or rate of return. This is in A company’s market value
contrast to NPV, which is a measure of the value or size of an invest- may vary markedly from its
ment. book value or shareholders’
equity. A stock is commonly
The IRR of an investment is the interest rate at which the NPV of considered undervalued if its
costs (negative cash flows) of the investment is at par with the NPV of value is significantly lower
than its book value, implying
the benefits (positive cash flows) of the investment.

S
that the stock trades at a
significant discount to book
IRRs are generally used to identify the feasibility of investments or value per share
projects. The greater a project’s IRR, the more likely it is viable to take
up the project. The project with the highest IRR could be chosen first,
IM
assuming that all other parameters are equal across all projects.

A loan table infers an amortisation table that lists all of the scheduled
payments on a loan as enshrined by a loan amortisation calculator.
The table computes the extent of payment towards the principal and
interest as per the total loan amount, interest rate and loan term. One
can create one’s amortisation table, but the easiest way to amortise
M

a loan is, to begin with, a template that automates all of the relevant
calculations.

The loan table bifurcates a loan balance into a schedule of equal pay-
ments as per predefined loan amount, loan term and interest rate. NOTE
This loan amortisation schedule enables borrowers to evaluate how A positive IRR infers that
N

much interest and principal they will shell out as part of each monthly a project or investment is
payment—along with the unpaid payment after each payment. Loan anticipated to return value to the
company, while a negative IRR,
tables typically include some of the following: points out to a more intricate
‰‰ Loan details: Loan table computations are based on the entire cash flow stream that may make
the metric less useful.
loan amount, loan period and interest rate. If one makes use of an
amortisation calculator or table, there will be a field to feed in the
information.
‰‰ Payment frequency: Typically, the first column in the loan table
lists how frequently the debtor will make a payment, with monthly
being the most frequently used period.
‰‰ Total payment: This column entails the debtor’s entire monthly
payment. If one uses a loan table template, this number will be
calculated. One also can calculate it manually or by using a per-
sonalised loan calculator.
‰‰ Extrapayment: The amortisation calculator will add any extra
payments to the principle and calculate future interest payments

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66 FINANCIAL MODELLING

based on the increased balance if the borrower wishes to make

more than the required minimum payment each month.
‰‰ Principal repayment: This section of the loan table exhibits how
much of each monthly payment goes toward repaying the loan
principal. This number rises over the life of the loan.
‰‰ Interest costs: Similarly, a loan table’s interest column shows how
much of each payment is applied to loan interest. Over the course
of an amortised loan, the monthly interest payments decline.

SELF ASSESSMENT QUESTIONS

6. ______________ of an investment is the interest rate at which

the NPV of costs of the investment is at par with the NPV of
the benefits of the investment.

S
a. ARR b. IRR
c. APR d. IPR
IM 7. One of the following is not included in loan tables.
a. Interest cost
b. Principal repayment
c. Loan details
d. Estimated expenditure
M

ACTIVITY

What does the principal repayment column depict in the loan table?
N

MULTIPLE INTERNAL RATES OF

2.6
RETURN
Study When a project has more than one internal rate of return, multiple
Hint IRRs frequently occur. The complexity becomes apparent when a
project has anomalous cash flow (non-conventional cash flow pattern).
Multiple internal rates of return
occurs when there is more One of the methods for capital planning that is most frequently used
than one rate of return from
the same project/investment
is IRR. By comparing the IRR of the project under consideration with
that makes the net present the hurdle rate, investment decisions are incorporated. When the IRR
value of the project equal to exceeds the hurdle rate, the project is deemed feasible, else it will be
nil. This situation occurs when rejected. In case, there are more than two IRRs, it will be a bit ambig-
the IRR method is utilised for uous which IRR to compare with the hurdle rate.
a project/investment in which
negative cash flows follow
Traditional cash flows (also called normal cash flows) is a cash flow
positive cash flows.
pattern in which cash flows alter sign once only, which states that all
net cash outflows happen at the commencement of the project, after
all, net cash inflows. In another way, there are perennial streams of
net cash inflows or net cash outflows. Non-conventional cash flows,

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 Corporate Valuation  67

also known as non-normal cash flows, are cash flows with intermittent
streams of net cash inflows and outflows, i.e., net cash outflows may
occur at the start of the project, followed by net cash inflows and then
net cash outflows may occur afterwards.

At times a series of cash flows have more than one IRR. In the next
example we can tell that the cash flows in cells B6:B11 have two IRRs
since the NPV graph crosses the x-axis twice as shown in Figure 2.1:

S
IM
M
N

Figure 2.1: Calculating Multiple Interest Rate of Return

Excel’s IRR function empowers us to add an extra argument which

will enable one to compute both IRRs. Rather than writing = IRR
(B6:B11), we will state = IRR(B6:B11,guess) . The argument guess is
a beginning point for the algorithm which Excel uses to calculate the
IRR, by adjusting the guess, we can evaluate both the IRRs.

SELF ASSESSMENT QUESTIONS

8. If the IRR is higher than the hurdle rate, the project is deemed
to be ___________.
a. Rejected
b. Accepted
c. Cannot be determined
d. May be accepted or rejected

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68 FINANCIAL MODELLING

ACTIVITY

Find out the instance in which multiple IRRs may occur.

2.7 FLAT PAYMENT SCHEDULES

Several loans are paid back by utilising a series of payments over a
certain period. These payments generally entail an interest amount
computed on the outstanding balance along with the loan plus a por-
tion of the unpaid balance of the loan. This payment of a portion of the
unpaid balance of the loan is called the payment of principal.

There are usually two sorts of loan repayment schedules – even prin-
cipal payments and even total payments.

S
Furthermore, flat interest rate mortgages and loans calculate interest
based on the amount of money a borrower receives at the beginning
of a loan. For example, You take out a loan for 10,000 at a 7% annual
IM
interest rate. The commercial bank wants to make a series of pay-
ments over a ten-year period to pay off the loan and interest. Figure
2.2 shows how we may calculate the required amount for each annual
payment using Excel’s PMT function:
M
N

Figure 2.2: Flat Payment Schedules

Source: https://www.ablebits.com/office-addins-blog/2019/05/08/create-loan-amortiza-
tion-schedule-excel/

Notice that we have put “PV”—Excel’s nomenclature for the starting

loan principal—with a minus sign. As discussed above, if we do not do
this, Excel turns out to be a negative payment (a minor irritant).

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 Corporate Valuation  69

Figure 2.3 showcases creating a loan table:

S
Figure 2.3: Creating a Flat Loan Table
IM
The zero in cell C15 points out that the loan is fully repaid over its
term of 6 years. One can easily state that the present value of the pay-
ments over the 6 years is the initial principal of `10,000.

SELF ASSESSMENT QUESTIONS

9. Which of the following payment is a portion of the unpaid

M

balance of the loan?

a. Payment penance b. Payment of price
c. Payment of loan d. Payment of principal
N

ACTIVITY

Using excel find out flat repayment for a loan of `20,000 at an inter-
est rate of 7% per year.

2.8 FUTURE VALUES AND APPLICATIONS

Future value is the amount of money that a starting investment will
turn out to be, over time, at a certain compounded rate of interest. NOTE
For instance, an investment of `2,000 today in an account paying 4 % One can compute the future
interest will be worth `2,433.31 in five years. That’s an example of the value through compound interest
time value of money. using this formula: future value
= present value x (1 + interest
Future Value (FV) is the prevailing value of an asset at a future date rate)n
based on its assumed growth rate. Future value is cardinal to investors
and financial planners. As one can anticipate that the investment one
can do today will be worth it in the future. By estimating future value
investors can make informed investment decisions based on their

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70 FINANCIAL MODELLING

anticipated needs. However, external economic factors, such as infla-

tion can affect the future value of assets by undermining their value.

Computing future value empowers investors to foretell the amount of

NOTE profit to be reaped from different investments with a varying magni-
To assess future value with tude of accuracy. The growth attained by holding a fixed amount of
simple interest, the formula is: cash may differ from investing the same amount in stocks. Thus, the
future value = present value x [1 future value equation is used to compare multiple options.
+ (interest rate x time)].
Evaluating the future value of an asset can be complex depending
on the type of asset. Future value calculations are also based on the
assumption of a continuous growth rate. When we put our money in
a savings account with guaranteed interest, it is simple to accurately
determine its future value. However, investing in the stock market or
other securities with more volatile returns can pose higher challenges.

S
Small business owners may overlook the time value of money as one
of those monotonous concepts, but it’s not as dull as it appears. Future
value and present value are key financial concepts that managers
make use of for day-to-day functioning, whether they know about it or
IM
not. The money one possesses presently is worth more than the money
one will receive in a few years. The difference is the impact of inflation
and the risk of not getting the money you expect in the future.

Suppose Raj deposit `1,000 in an account today, leaving it there for

10 years. Suppose the account draws an annual interest of 10%. How
much will you have at the end of 10 years? The answer is depicted in
M

the subsequent Figure 2.4:

N

Figure 2.4: Simple Future Value

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 Corporate Valuation  71

As cell C17 showcases, we do not require all these intricate calcula-

tions: 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

Now let’s suppose the following, slightly more intricate, problem:

Again, one can tend to open a savings account. The starting deposit
of 1,000 today will be followed by a similar deposit at the beginning
of years 1, 2, ... , 9. If the account reaps interest of 10% per year, how
much as an investor one will have in the account at the beginning
of year 10? This problem is can be solved in Excel, as depicted in
Figure 2.5:

S
IM
M
N

Figure 2.5: Future Value in Annual Deposit

We can deduce that we will have 17,531.17 in the account at the culmi-
nation of year 10.

This similar answer can be exhibited as a formula that sums the future
values of each deposit:

Total at beginning of year 10 = 1,000×(1+10%)10 + 1,000×(1+10%)9+

.....+ 1,000×(1+10%)1
10
= ∑ 1,000×(1+10%)
*
(1 + 10%) tt

t=1

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72 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

10. __________ is the prevailing value of an asset at a future date

based on its assumed growth rate.
a. Market value
b. Book value
c. Present value
d. Future value

ACTIVITY

Compute the future value of `15,000 for 8 years with draws the

S
annual interest of 10%.

A PENSION PROBLEM—COMPLICATING
2.9
IM THE FUTURE VALUE PROBLEM
The Indian pension system has been replete with myriad problems.
The gradual collapse of the ongoing pension system population high-
lights the need to strengthen formal pension channels. The immediate
and more pressing reasons for pension reform are also well known.
Informal employment is on the rise, while prevailing benefit systems
M

are distorted in favour of organised workers, and the biased treatment

of workers in the private sector and those in public institutions. The
need to boost domestic savings rates through the labour sector, an
underdeveloped private pension market and ultimately, higher con-
tract savings.
N

Supposedly Raja is 58 years old and would retire at age 60. To make
his retirement secure and comfortable, he postulates to start a retire-
ment account:

At the beginning of each of years 1, 2, 3, 4 (from today onwards and at

the start of each of the following four years), Raja intends to deposit
into the retirement account. Raja seeks to earn 8% interest per year.
Following retirement at age 60, for instance, Raja will live around 8
more years. At the onset of each of these years, Raja seeks to draw
`30,000 from his retirement account. Raja estimates that the account
balances will continue to earn 8%.

So based on the estimation how much should a deposit be made annu-

ally? The following figure bifurcates how easily Raja can go wrong
in this kind of problem—in this case, Raja calculated that to provide
`30,000 per year for 8 years, Raja requires to invest `2,40,000/5 =
`48,000 in each of the first 5 years. As the figure showcases, he will
end up with a significant amount of money at the end of 8 years.

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 Corporate Valuation  73

The problem is shown in Figure 2.6:

S
IM
Figure 2.6: Retirement Problem

There are varied ways to solve this problem. One such resolution
is through Excel Solver which can be located in the Data menu, as
M

shown in Figure 2.7:

N

Figure 2.7: Excel Solver

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74 FINANCIAL MODELLING

When we click on the solve box, we get the following result as shown
in Figure 2.8:

S
IM
Figure 2.8: Retirement Problem

SELF ASSESSMENT QUESTIONS

11. The need to boost ____________ through the labour sector,

an underdeveloped private pension market and ultimately,
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higher contract savings.

a. International savings rate
b. Domestic savings rate
N

c. Currency rate
d. Domestic recession

ACTIVITY

Find out in-depth about the pension problem using excel.

2.10 CONTINUOUS COMPOUNDING

When compound interest is calculated and reinvested into an account’s
balance across an essentially infinite number of periods, it is said to be
compounding continuously. While this is infeasible in virtue, the con-
cept of continuously compounded interest is crucial in the financial
aspect. Continuous compounding can be inferred as an extreme case
of compounding, as most interest is calculated on a monthly, quarterly
or semi-annual basis.

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 Corporate Valuation  75

Rather than scrutinising interest on a definite number of periods,

such as yearly or monthly, continuous compounding computes inter-
est by estimating continuous compounding over an infinite number of
periods. The formula for compound interest over finite periods takes
into consideration four variables, which are:
‰‰ PV = the present value of the investment
‰‰ I = the defined interest rate
‰‰ n = the number of compounding periods
‰‰ t = the time in years

The formula for continuous compounding is sourced from the formula

for the future value of an interest-reaping investment:

S
Future Value (FV) = PV × [1 + (i / n)](n × t)

Contrary to what the enormously varied periods in the perennial com-

pounding interest formula would have an individual believer, contin-
uous compounding does not yield a considerably higher return than a
IM
period of years, bi-annually or quarterly interest payments. For exam-
ple, while you would receive `3,000 as yearly interest on ab investment
of `20,000 at a 15% interest rate, using the continuous compounding
interest formula would give you about `16,180. A mere `1,180 extra.

Figure 2.9 showcases multiple compounding periods:

M
N

Figure 2.9: Multiple Compounding Periods

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76 FINANCIAL MODELLING

Another strong reason to utilise continuous compounding is the

ease of calculation. For instance, a person invested `1,000 which
amounted to `1,500 in 1 year and 9 months. Do we have to calcu-
late the annualised rate of return? The simplest and straightfor-
ward way to do this is to use the continuously compounded annual
return. Since 1 year and 9 months equals 1.75 years, this return leads
to:

× * 1  1,500 
1,000
1,000 exp[ r×*1.75]
exp[r 1.75] = 1,500 ⇒ r = In = 23.1694%
1.75  1,000 

SELF ASSESSMENT QUESTIONS

12. ____________ is referred to as a mathematical limit that

S
compound interest can amount to if it’s computed and
reinvested into an account’s balance over a theoretically
uncountable number of periods.
a. Simple compounding
IM
b. Continuous compounding
c. Simple derivative
d. Functional derivative

ACTIVITY
M

Using compounding interest find out the sum if one invested `10,000
for 2 years and 9 months at 5% per annum.

S 2.11 SUMMARY
N

‰‰ With the increase in commercial activities, valuations have become

the citadel and gained higher prominence.
‰‰ Irrespective of whether it be a budding business entity or a mul-
tinational business house, valuations are widespread. Right from
the foundation or genesis of the business entity, during its merger
and acquisitions, for securing long-term monetary aid from banks/
financial institutions, winding up the organisation, for several
associated business activities, valuation is deemed as a cardinal
aspect.
‰‰ There are a plethora of essential facets related to the valuation-In-
ternational Valuation Standards, Guidance to Valuation, Methods
utilised in Valuation, Valuation of Tangibles and Intangibles, Valu-
ation during Mergers and Acquisitions, etc.
‰‰ Just possessing theoretical knowledge on the subject will not
serve the purpose, as valuation is not an applied research wherein
every element of valuation has a feasible relevance. Furthermore,

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 Corporate Valuation  77

depending on the magnitude, nature and scale of the business dif-

ferent valuation approaches ought to be harnessed.
‰‰ Valuation may be deemed as science but, to a greater extent, valu-
ation variables demand innate subjectivity. In another way, valua-
tion is not accurately a science as it may be riddled with imperfec-
tion in the market.
‰‰ Nowadays business valuers ought to have erudite knowledge to
make business valuation theory and practices well explained and
properly defined.
‰‰ The act of business valuation, thus, needs to be more of a science
than perception and conjectures.
‰‰ Even in a rare situation, where the person valuing has a thorough

S
knowledge of the market, the market may not offer an accurate
knowledge of value as well as the valuation methodology and pro-
cess.
‰‰ Under some circumstances, there may not be a definitive valua-
IM
tion method or a definitive value conclusion, but every valuation is
hinged only on its instances.
‰‰ Correct valuation demands a logical and methodical approach and
thoughtful application of the fundamental principles. This infers
that there may not be a prescribed format or a preferred method-
ology, which is always applicable.
M

‰‰ The enterprise value of a company is inferred as the entire finan-

cial worth of all of the assets of the company, even entailing cash.
‰‰ The enterprise value exhibits the worth of an organisation if it is to
be acquired by another company in the current market.
N

‰‰ Due to the fact that a company’s capital structure has no bearing

on its overall worth, enterprise value is a useful tool for investors
and other organisations to discern between businesses with vari-
ous capital structures.
‰‰ Equity value is defined as the total value of the company’s share
and all loans provided to the company by the company’s share-
holders. This is the value that remains for the benefit of the com-
pany’s shareholders after all debts have been settled.
‰‰ When analysing a company’s shares and evaluating its perfor-
mance, investors must consider equity value. This enables them to
understand the worth of your business both now and in the future.
‰‰ The determination of whether to buy one form of investment over
another and the calculation of pension obligations are only a few
fiscal applications where the concept of present value is crucial.
‰‰ Inthe latter scenario, current value provides a standard frame-
work for identifying diverse investment kinds.

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78 FINANCIAL MODELLING

‰‰ In hyperinflationary economies, where the value of money is erod-

ing so quickly that future cash flows appear to have no worth at
all and become zero, the concept of present value is particularly
crucial. This effect is made clearer by the use of current value.

KEY WORDS

‰‰ Enterprise value: It exhibits how much finance an organisation

will get if it was to sell the entire stakes to anyone in the market
‰‰ Equity value: It is defined as the total value of the company’s
share and all loans provided to the company by the company’s
shareholders
‰‰ Net Present Value (NPV): It is the result of the disparity
between an investment and its potential future cash flows over

S
time
‰‰ Present value: It is the existing value that one or more assets or
investments would have in the future discounted at the market
IM rate
‰‰ Valuation: It is a method to identify the economic significance
of an entire company or business entity

2.12 MULTIPLE CHOICE QUESTIONS

1. Which of the following is a core principle of finance?
MCQ
M

a. Investment management
b. Rate of Return
c. Time value of money
d. Future value of money
N

2. Consider the following formula for calculating the time value of

money:
FV = PV × [1 + (i/n)(n × t)
What does ‘n’ denote in this formula?
a. Number of compounding periods per year
b. Total number of years
c. Number of years till maturity
d. Nought
3. Which concept denotes the current value of a future sum of
money which gives a specified rate of return?
a. Future value
b. Present value
c. Time value of money
d. Internal rate of return

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 Corporate Valuation  79

4. Which of the following shows the value of a current asset in a

future period based on an assumed rate of growth?
a. Future value
b. Present value
c. Time value
d. Coerce value
5. The Net Present Value (NPV) of a project is equal to the sum of
the ___________ of all the cash flows.
a. Present values
b. Future values
c. Time value

S
d. Expected value
6. A _____________ provides the management of the company with
several information and numbers pertaining to the organisation’s
IM
true worth or value.
a. Business vehemence
b. Business audit
c. Business virtue
d. Business valuation
M

7. The focal point of the corporate type of business organisation has

been __________, around which many operations are conducted.
a. Caricature
b. Valuation
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c. Vernacular
d. Veracity
8. Expand the term IRR.
a. Internal Rate of Return
b. Invested Rate of Return
c. Internal Rate of Repugnance
d. Internal Ratio of Return
9. The ______________of a company is inferred as the entire financial
worth of all of the assets of the company, even entailing cash.
a. Erudite value
b. Evanescence value
c. Enterprise value
d. Internal value

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80 FINANCIAL MODELLING

10. ____________ is defined as the total value of the company’s

share and all loans provided to the company by the company’s
shareholders.
a. Market value b. Stock value
c. Deemed value d. Equity value

2.13 DESCRIPTIVE QUESTIONS

? 1. State the meaning of valuation.
2. Explain the importance of valuation.
3. Discuss enterprise value.
4. Describe equity value.

S
HIGHER ORDER THINKING SKILLS
2.14
(HOTS) QUESTIONS
IM1. If you deposit `1000 today in a bank which pays 10% interest
compounded annually, then how much will the deposit grow to
after 8 years?
a. `20,100 b. `8.044
c. `1,142 d. `2,144
2. Suppose Golu is an investor who invests in bank security.
M

Golu disburses `1,00,000 and later on sells it for `1,08,000 after

a year. Find out the annual rate of return on the security on a
continuously compounded basis.
a. 7.7% b. 8.7%
N

c. 10.6% d. 11.1%

2.15 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Meaning of Valuation 1. a. Low-cost
Understanding enterprise value 2. c. Share price and num-
and equity value ber of outstanding
shares
3. c. Enterprise value
Present Value and Net Present 4. a. NPV
Value
5. c. Positive
The Internal Rate of Return (IRR) 6. b. IRR
and Loan Tables

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 Corporate Valuation  81

Topic Q. No. Answer

7. d. Estimated expenditure
Multiple Internal Rates of Return 8. b. Accepted
Flat Payment Schedules 9. d. Payment of principal
Future Values and Applications 10. d. Future value
A Pension Problem—Complicat- 11. b. Domestic savings rate
ing the Future Value Problem
Continuous Compounding 12. b. Continuous com-
pounding

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer

S
1. c. Time value of money
2. a. Number of compounding periods per year
3. b. Present value
IM
4. a. Future value
5. a. Present value
6. d. Business valuation
7. b. Valuation
8. a. Internal Rate of Return
9. c. Enterprise value
M

10. d. Equity value

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. Valuation has gained significant recognition in business parlance.
N

The term “valuation” has become widely used in business.

Valuation has taken centre stage with the growth of various
business organisation forms, particularly the company form of
business organisation and various activities revolve around it.
Refer to Section 2.2 Meaning of Valuation
2. Valuation is useful for several business functions, such as
mergers and acquisitions, sale of a business, procurement of
funds and taxation. Unless and until the important managerial
personnel are well knowledgeable about the valuation processes
involved in the aforementioned business events, it will be highly
intricate for them to fulfil their professional commitments. Refer
to Section 2.2 Meaning of Valuation
3. The enterprise value of a company is inferred as the entire
financial worth of all of the assets of the company, even entailing
cash. The enterprise value exhibits the worth of an organisation
if it is to be acquired by another company in the current market.
Refer to Section 2.3 Understanding Enterprise Value and
Equity Value

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82 FINANCIAL MODELLING

4. Equity value is defined as the total value of the company’s

share and all loans provided to the company by the company’s
shareholders. This is the value that remains for the benefit of
the company’s shareholders after all debts have been settled.
Investors must consider equity value when assessing a company
and its shares. Refer to Section 2.3 Understanding Enterprise
Value and Equity Value

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. d. 
`2,144
(The future value 8 years hence, will be:

S
`1000(1.10)8 = `1000 (2.144)= `2,144)
2. a. 7.7%
(Continuously compounded rate=ln (1,08,000/1,00,000)
=7.7%
IM
2.16 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
‰‰ Swan, J. (2018). Practical financial modelling. Burlington, MA:
M

CIMA Publishing.
‰‰ Rees, M. (2018). Principles of financial modelling.

E-REFERENCES
N

‰‰ https://www.cfainstitute.org/en/events/professional-learning/
financial-modeling
‰‰ https://zerodha.com/varsity/chapter/introduction-to-finan-
cial-modelling/
‰‰ https://www.wiley.com/en-us/Financial+Modeling+and+Valua-
tion:+A+Practical+Guide+to+Investment+Banking+and+Pri-
vate+Equity-p-9781118558768
‰‰ https://www.ablebits.com/office-addins-blog/2019/05/08/cre-
ate-loan-amortization-schedule-excel/

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 C H A
3 P T E R

COMPARABLE COMPANY ANALYSIS

S
CONTENTS

3.1 Introduction
3.2 Introduction to Comparable Company Analysis
IM
3.2.1 Selecting Comparable Companies
3.2.2 Spreading Comparable Companies
3.2.3 Analysing the Valuation Multiples
3.2.4 Concluding and Understanding Value
Self Assessment Questions
Activity
M

3.3 Introduction to Precedent Transactions Analysis

3.3.1 Selecting Comparable Transactions
3.3.2 Spreading Comparable Transactions
3.3.3 Concluding Value
Self Assessment Questions
N

Activity
3.4 Four Methods to Compute Enterprise Value (EV)
Self Assessment Questions
Activity
3.5 Using Accounting Book Values to Value a Company
Self Assessment Questions
Activity
3.6 The Firm’s Accounting Enterprise Value
Self Assessment Questions
Activity
3.7 The Efficient Markets Approach to Corporate Valuation
Self Assessment Questions
Activity
3.8 Enterprise Value (EV) as the Present Value of the Free Cash Flows
Self Assessment Questions
Activity

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84 FINANCIAL MODELLING

CONTENTS

3.9 Summary
3.10 Multiple Choice Questions
3.11 Descriptive Questions
3.12 Higher Order Thinking Skills (HOTS) Questions
3.13 Answers and Hints
3.14 Suggested Readings & References

S
IM
M
N

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 Comparable Company Analysis  85

INTRODUCTORY CASELET

COMPARABLE COMPANY ANALYSIS

Every professional banker begins their career by learning the dif-

ferent processes in the context of how to conduct a corporation’s Case Objective
analysis, also known as a comparable company analysis. An exam- This caselet discusses the
ination of comparable companies can be made in a pretty simple concept of Comparable
manner. The data in the report is used to arrive at an approxima- Company Analysis (CCA).
tion of the value of the company or the stock price.

Comparable company research is predicated on the idea that

similar businesses offer a useful point of comparison from which
to calculate an estimated valuation of the target business. The
inferred valuation derived from Trade Company is not intended
to be an exact measurement, rather, it is used to establish criteria

S
for the target firm based on the current market pricing of compa-
rable businesses.
Source:https://www.wallstreetprep.com/knowledge/comparable-company-analy-
IM
sis-comps/
M
N

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86 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Define the introduction to Comparable Company Analysis
(CCA)
>> Explain the introduction to precedent transactions analysis
>> Discuss the four methods to compute enterprise value
>> Describe using accounting book values to value a company
>> Classify the firm’s accounting enterprise value
>> Clarify the efficient markets approach to corporate valuation
>> Summarise the Enterprise Value (EV) as the Present Value
(PV)

S
3.1 INTRODUCTION
In the previous chapter, you studied the corporate valuation. A com-
Quick Revision
IM
pany valuation provides management with information on a variety
of facts and numbers pertaining to the organisation’s true worth or
value in terms of market competition, asset values and revenue val-
ues. Some of the salient advantages and benefits of business valua-
tion are a significant insight into the company assets, fathoming of
the organisation’s resale value, in-depth knowledge during mergers
and acquisitions; getting a real company value and access to a range
M

of investors.

Professionals such as financial analysts and many others perform cer-

tain activities to make certain analyses of the business corporation.
This analysis is a step-by-step approach and is usually done to finalise
N

the financial position of the economic entity and through which cer-
tain decisions can be taken.

The main agenda of the analysis is to provide satisfaction to different

stakeholders that the values occurring in the financials of the organi-
sation are true and fair and to know about the level of performance as
compared to earlier years of the business.

The choice of similar companies affects the trading comps study’s

accuracy. The trade comps valuation will often be more accurate the
stricter the screening procedure for comparable companies is.

The Comparable Company Analysis (CCA) is predicated on the idea

that businesses with comparable size, sector and stature will be eval-
uated similarly. The important thing to remember is that while this
method will provide an estimate that is close to the value, the valu-
ation in other circumstances may be very different from the actual
worth.

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 Comparable Company Analysis  87

In this chapter, you will study the comparable company analysis,

selecting comparable companies, spreading comparable companies,
analysing the valuation multiples, concluding and understanding
value, introduction to precedent transactions analysis, selecting com-
parable transactions, spreading comparable transactions, the efficient
markets approach to corporate valuation, Enterprise Value (EV) as
the present value of the free cash flows etc. in detail.

INTRODUCTION TO COMPARABLE
3.2
COMPANY ANALYSIS
Comparably by contrasting a firm’s valuation multiples with those of NOTE
its competitors, a relative valuation method known as “Comparable
Professionals perform
Company Analysis” or “Comps” can be used to determine the value of Comparable Company Analysis

S
a specific business entity or any company. There are various multiples to measure the performance of
used in the comparable analysis process that usually includes finan- the corporation.
cial ratios of particular valuation parameter. For instance, EV (Enter-
prise Value), equity market capitalisation, financial performance sta-
IM
tistics, such as earnings per share, EBITDA, sales and many others.

The multiples that are used in the same process are usually a ratio
of some valuation parameter, such as equity market capitalisation
or enterprise value, to some financial performance statistic, such as
Earnings Per Share (EPS), sales or EBITDA.

The fundamental notion is that, with all other factors being equal,
M

businesses with comparable traits should trade at comparable mul-

tiples.

Following are the certain steps used in the process of CCA:

‰‰ Choosing the correct form of comparable corporations or com-
N

panies: When completing a ratio analysis of public firms, this is the

first and most challenging (or arbitrary) stage. The first step for
an analyst should be to search for the company they are trying to
evaluate on Bloomberg or Cap IQ to gain a thorough description
and industry classification of the company.
‰‰ Collecting financial information: Depending on the industry and
stage of a company’s business lifecycle, different information will
be required. Metrics such as EBITDA and EPS are used to assess
mature enterprises, whereas Gross Profit or Revenue may be used
to assess early-stage businesses.
‰‰ Setting up the comps table: The next step is to construct a table in
Excel with all the pertinent data about the businesses you plan to
study. Some of the key details in a comparable company analysis
are: NOTE
Process of Comparable
 Stock price Company Analysis is a step-by-
 Total market value step approach.

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88 FINANCIAL MODELLING

 Corporate name
 Enterprise value net debt
‰‰ Performing the necessary calculations: It is now time to begin
calculating the various ratios that will be utilised to value the
aforementioned company using a combination of historical finan-
cial data and analyst projections that have been provided in the
comps table.

3.2.1 SELECTING COMPARABLE COMPANIES

The first and most crucial stage in selecting a comparable company

study is selecting a group of comparable businesses or a comparable
universe. The group of comparable businesses you choose at the out-

S
set of your study forms the basis for the remainder of your investiga-
tion and valuation.

It is crucial to make sure that you select the appropriate comparable

universe because if you don’t, you run the danger of having your val-
IM
uation and all the effort you put into creating your model be proven
can go in vain.

A specific criterion is followed while selecting or choosing the compa-

nies and some of them are as follows:
‰‰ Capital structure: When choosing comparable businesses to com-
TURN TO THE pare, a financial analyst should consider the capital structure of
M

WEB
the businesses. By doing this, the financial analyst can prevent the
Study and find out about the
criteria followed by today’s
comparable valuation from being incorrect as a result of differ-
corporations while choosing ent levels of leverage between the comparable companies and the
comparable companies. company they are seeking to value.
N

‰‰ Profitability analysis: As they are no longer using companies with

the same expectations of value, analysts run the danger of their
valuation being incorrect if they choose companies for their com-
parable universe that have vastly different margins. As a result,
when choosing comparable organisations, an analyst should pay
attention to the profitability aspect of the companies.
‰‰ Growth: When determining a company’s worth, investors take
into consideration growth expectations and growth rates. A com-
pany with a higher growth rate would naturally be valued higher if
the two businesses were entirely comparable except for their rates
of expansion.
‰‰ Geographical dimensions: The ability to compare businesses is
aided by their similarity in operations. In this regard, geography
is another factor to take into consideration while deciding on your
comparable universe. Consumer demographics, consumption hab-
its, regulatory limitations and product demand vary according to
region. If a company does not alter its offering or method of opera-

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 Comparable Company Analysis  89

tion, it may find that it is not successful in Asia. Therefore, a firm’s

comparability to other firms depends on its geographic region.
‰‰ Sizeof the companies: When evaluating businesses for your com-
parable universe, size is another aspect to take into consideration.
Similar size companies are preferred during the comparable com-
pany analysis.

3.2.2 SPREADING COMPARABLE COMPANIES

A corporation can be valued in a variety of ways. Based on cash flows

and relative performance in comparison to peers, the most popular
methodologies are used. Analysts can determine an intrinsic value
based on future cash flows with the aid of cash-based models such as
the Discounted Cash Flow (DCF) model.

S
The actual market value is then contrasted with this value. The stock
is undervalued if the intrinsic value is more than the market value.
The stock is overvalued if the intrinsic value is less than the market
IM
value.

The analyst can create an industry standard or average by comparing

cash flow valuation with relative comparisons in addition to intrinsic
valuation.

Financial ratios such as EV/S, price to sales, price to book and price to
M

earnings are usually used during the process of comparable company

analysis.

The company is overvalued if its valuation ratio is higher than the

average for its peer group. The company is undervalued if the valua-
tion ratio is lower than the average for its peers.
N

When combined, the intrinsic and relative valuation models offer a

rough estimate of value that analysts can use to determine the true
value of a company.

3.2.3 ANALYSING THE VALUATION MULTIPLES

There are many multiples that can be used in the process of CCA. But NOTE
some of them are main factors or multiple that are usually taken into Financial ratios play important
consideration by the analysts. role in the process of
Comparable Company Analysis.
Following are the different multiples used in the process of Compara-
ble Company Analysis (CCA):
‰‰ Enterprise value to sales ratio: This financial ratio calculates the
particular cost sacrificed by the company for the aim of purchas-
ing the company in the terms of sales revenue.

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90 FINANCIAL MODELLING

‰‰ Enterprise value to EBIT ratio: Dividing the enterprise value by

Earnings before Interest and Tax is another financial ratio used
in the process of CCA. This ratio is used to measure the earnings
yield of the business organisation.
‰‰ Price to earnings ratio: The market price per share is divided by
the company’s earnings per share to arrive at the P/E ratio. This
financial ratio depicts the financial health of the company in the
context of profit or income attributed to each share or common
stock.
‰‰ Price to book balue: This financial ratio depicts the entity’s book
value of common equity as per the terms of the market value of
their same common shares.

S
‰‰ Price to cash flow: A stock valuation indicator or multiple known
as the Price-to-Cash-Flow (P/CF) ratio assesses the value of stock
about its operating cash flow per share.
IM
3.2.4 CONCLUDING AND UNDERSTANDING VALUE

It is time to begin evaluating the data once the calculations are finished
and the comparisons table is complete. Finding organisations that are
overvalued or undervalued is one approach to using the data. Comps
can help you find the prospects, but as they do not take into account
any qualitative factors, the findings need to be carefully understood.
M

To fully examine the data in the comps table you have to understand
why numbers are what they are. Why does Company A trade with
Company B at a lower EV/EBITDA multiple? Is it a good time to buy
because it is undervalued?
N

Or is it because it requires greater capital expenditures and has a far

slower rate of growth? Company A can be “more expensive” than
Company B although trading at a lower multiple! Here is when the
skill of a skilled financial analyst is put to use.

SELF ASSESSMENT QUESTIONS

1. CCA stands for which of these?

a. Comparable Companies Analysis
b. Companies Comparable Analysis
c. Comparable Cost Analysis
d. Comparable Cashflow Analysis
2. Which of these factor is not used in Comparable Company
Analysis (CCA)?
a. Geography b. Growth
c. Size d. Name of the Business

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 Comparable Company Analysis  91

ACTIVITY

Find out the main objective of Comparable Company Analysis.

INTRODUCTION TO PRECEDENT
3.3 NOTE
TRANSACTIONS ANALYSIS
The understanding of the
Using specific financial data from previous Merger and Acquisition difference between merger
(M&A) deals and transactions, precedent transaction analysis is a and acquisition concepts is
technique for valuing businesses. mandatory for the precedent
transaction analysis.
This approach of valuation, often known as “precedents,” is fre-
quently created by analysts working in investment banking, private

S
equity and corporate development when attempting to value a whole
organisation as part of a merger or acquisition.

To provide a credible approximation of the multiples or premiums

IM
that others have paid for a publicly traded company, precedent trans-
action analysis uses information that is readily accessible to the gen-
eral public.

The analysis assesses whether the corporations making the purchases

are likely to make another acquisition soon and looks at the types of
investors who have previously bought comparable companies under
M

comparable circumstances.

3.3.1 SELECTING COMPARABLE TRANSACTIONS

The first step in the procedure is to hunt for similar transactions that
N

have taken place in the recent (preferably) past and are in the same
sector.

These kinds of standards must be established for the screening proce-

dure. An analyst must “clean” the transactions by carefully analysing
the business descriptions of the organisations on the list and deleting
any that aren’t a close enough fit before sorting and filtering them.

If the deal conditions weren’t made public, many transactions would

have missing or incomplete information. A press release, equity
research study or other sources that include deal metrics will be
sought after diligently by the analyst. If nothing is discovered, those
businesses will be crossed off the list.

The average, or chosen range, of valuation multiples, can be deter-

mined once a shortlist has been created (by doing processes 1 and 2).
EV/EBITDA and EV/Revenue are the most often used multiples for
antecedent transaction analysis.

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92 FINANCIAL MODELLING

Any extreme outliers, such as deals with EV/EBITDA multiples that

NOTE were significantly lower or higher than usual, may be excluded by an
Step-by-step process is followed analyst (assuming there is a good justification for doing so).
in the case of spreading
comparable transactions.
3.3.2 SPREADING COMPARABLE TRANSACTIONS

The comparable transaction is spread to find out the desired results.

Spreading comparable transactions requires a proper process of
interrelated steps.

The steps are as follows:

‰‰ Finding out the relevant event or transactions in the financials of
the company.
‰‰ After identification, properly analysing and refining are done in

S
the context of identified comparable transactions.
‰‰ After analysis, a proper range of multiples is determined. The aver-
age or chosen range, of valuation multiples, can be determined
IM once a shortlist has been created (by doing the above steps).
‰‰ After determining, a specific range of valuation multiples is applied
from the context of earlier or past transactions. A specific ratio is
used in the specific range of valuation.
‰‰ Lastly, it is crucial to graph the results once a valuation range has
been established for the company being assessed, therefore, they
M

can be clearly understood and contrasted with other approaches.

3.3.3 CONCLUDING VALUE

The following are some examples of diligence questions to bear in

N

mind when assembling a peer group for transaction comps:

‰‰ What was the state of the market when the agreement was final-
ised?
The buyer is more likely to pay a higher price if the credit markets
are strong (i.e., if borrowing money to partially finance the pur-
chase or share price is not too difficult to come by).
‰‰ Is the exchange hostile or cordial?
The purchase price typically rises during a hostile takeover
because neither party wants to lose.
‰‰ What was the justification for the transaction in the eyes of both
the buyer and the seller?
In M&A, overpaying is a frequent occurrence, hence the deal’s
outcome should be evaluated.
‰‰ Was the buyer a financial or a strategic one?
Because they can profit from synergies, strategic acquirers can
afford to pay a higher control premium than finance bidders.

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 Comparable Company Analysis  93

‰‰ How fiercely contested was the buying process?

The chance of a bigger premium increases with how competi-
tive the selling process is, or how many buyers are serious about
obtaining the target.
‰‰ Was the deal a negotiated sale or an auction process?
An auction-style sale will typically result in a higher purchasing
price.

SELF ASSESSMENT QUESTIONS

3. Precedent transaction analysis is a technique for valuing

___________.
a. Property

S
b. Business
c. Loan
d. Assets
IM
4. The first stage of spreading the transaction is
a. Finding out the relevant event or transactions
b. Analysing and refining
c. Determination of the range of multiples
d. None of these
M

ACTIVITY

Find out the main objective of Precedent transaction analysis.

N

FOUR METHODS TO COMPUTE

3.4
ENTERPRISE VALUE (EV)
The process of calculating a business’s financial value is known as NOTE
business valuation or computation of enterprise value. This valuation Enterprise value calculation is
is done because it provides useful data during legal proceedings and important because it attracts the
aids in creating your company’s exit strategy for buying and selling investors for the investment in
the case where value is good in
businesses, obtaining capital and strategic planning. terms of financial position.

There are various strategies and techniques used to estimate the

value of your company or enterprise or asset for financial reporting
are referred to as valuation methods.

There are four methods for computing the enterprise and the same
are as follows.
1. Brand Valuation Approach: The process of determining a
brand’s value or how much someone is prepared to pay for it is
referred to as brand valuation. A brand can determine the value

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94 FINANCIAL MODELLING

of both its tangible and intangible assets using the valuation

process known as brand valuation.
The projected worth of a brand derived from this valuation
process is based on factors such as customer perception, financial
performance, brand equity and comparable measures. The
worth of your brand determines your company’s market value.
Therefore, in the event of mergers and acquisitions, firms need
brand appraisals.
The return on brand investment for the company is determined
by brand valuation. For the creation of upcoming strategies, this
information is essential. Budget allocation decision-making is
aided by brand valuation.
2. Income Approach: One of the three primary strategies for valuing

S
a corporation is the income approach. By examining factors
including revenue, taxes and expenses, the income approach to
valuation determines the present value of future income that a
corporation will earn.
IM
The income method of valuation is founded on the idea that a
potential investor wants to know the financial returns on their
investment. The income method to business valuation evaluates
both the potential returns on investment and the associated
risks.
The income approach to business valuation uses a formula to
M

estimate future revenues, operational income, costs, net profit

and the amount of cash the company will eventually be able to
generate.
The discounted cash flow method, the price earning capacity
N

method, and the option pricing method are the three different
valuation approaches that fall under the umbrella of the income
approach to business valuation.
TURN TO THE 3. Market Approach: One of the most popular techniques for a
WEB business appraisal is the market approach.
Study and find out about the
easiest method for calculating This valuation method, as the name implies, estimates the worth
the EV. of the subject business, its intangible assets, securities and
business ownership interest using pertinent financial data from
similar or identical companies.
Using this approach of valuation, the size and activities of a
comparable business are compared to determine the worth of
the subject business.
This valuation technique determines appraisal value using
price-related factors such as sales. The relative value approach
is another name for this method of valuation.
The Market Price Method, Comparable Companies Method,
Comparable Transaction Method and EV to Revenue Multiples

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 Comparable Company Analysis  95

Method are the four different approaches that make up the

market approach to business valuation.
4. Cost Method: One of the popular methods of valuation is termed
a cost method. This method is based only on a single assumption.
The same assumption is that a particular buyer will not give or
pay more than the cost of the property in the case where the cost
of that particular property is almost equal to the cost incurred in
developing the same property.
When determining the value of a firm, the cost approach to
valuation estimates the values of the tangible and intangible
assets and liabilities that make up the business.
The cost approach to valuation is a practical method for established
businesses with substantial assets, holding corporations and

S
asset-intensive businesses even though it is not widely regarded
as a reliable indicator of the business value. This approach to real
estate valuation is suitable for valuing facilities with particular
uses, such as schools, hospitals and places of worship.
IM
It is also the preferred method of value for assessing new
buildings, insurance appraisals and commercial real estate.

SELF ASSESSMENT QUESTIONS

5. Which of these is not the method of calculating enterprise

value?
M

a. Cash approach b. Income approach

c. Market approach d. Expenditure approach
6. Examining factors including revenue, taxes and expenses is
an approach of the ___________ method.
N

a. Cash approach b. Income approach

c. Market approach d. Brand valuation method

ACTIVITY

Find out the easiest method for calculating the enterprise value.

USING ACCOUNTING BOOK VALUES TO

3.5
VALUE A COMPANY
Book value or accounting book value can be defined as the difference TURN TO THE
WEB
between all claims senior to common equity (such as the company’s
Search and find about the book
liabilities) and the accounting value of the company’s assets. The
value of stockholders’ equity for
accounting practice of documenting asset value at the original histori- Mahindra Company.
cal cost in the books is where the phrase “book value” originates.

Investors use a company’s book value to assess whether its shares are
overvalued or undervalued. The total of all line items included in the

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96 FINANCIAL MODELLING

stockholders’ equity section of a company’s most recent balance sheet

is referred to as book value. This would be the amount of cash left over
if all assets were liquidated at their book values and utilised to settle
the declared amount of liabilities.

The market value of a corporation, which is often higher, may differ

significantly from its book value. Because it may receive many more
benefits than just those listed on the balance sheet, a third party could
offer to pay significantly more for a corporation than book value.

Knowing where to look makes it simpler to determine a company’s

book value. On their balance sheets, which they publish regularly and
annually, businesses list their total assets and total liabilities. Addi-
tionally, it appears on the balance sheet as shareholders’ equity.

S
For doing the valuation of the company as per accounting book value
a simple formula is used that is:
TURN TO THE
WEB Book Value of Company = (Total Common Shareholders Equity – Pre-
Research and study about the
IM
ferred Stock) /Number of Outstanding Common Shares
difference between the common
stock and preferred stock. The book value per share (BVPS) is calculated by dividing book value
by the total number of outstanding shares. It enables us to compare
prices per share. All of the company’s stock that is now held by all of
its shareholders is considered to be outstanding. This covers restricted
shares and share blocks held by institutional investors. As a compa-
ny’s accounting value, book value has two main applications:
M

‰‰ It will function as the total amount of assets that would potentially

be distributed to investors if the firm or company was to be liqui-
dated.
‰‰ Equity analysts can use book value to determine if a stock is over-
N

priced or underpriced by comparing it to the company’s market

value or market price.

SELF ASSESSMENT QUESTIONS

7. _________ is not the attribute in the formula for calculating the

value of the company.
a. Total common shareholders’ equity
b. Preferred stock
c. Interest expense
d. Outstanding common shares
8. __________ can be defined as the difference between all claim’s
senior to common equity (such as the company’s liabilities)
and the accounting value of the company’s assets.
a. Market value b. Book value
c. Net realisable value d. Acquisition value

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 Comparable Company Analysis  97

ACTIVITY

Find out the book value of the Reliance Corporation.

THE FIRM’S ACCOUNTING ENTERPRISE

3.6
VALUE
Enterprise Value (EV) can be defined as a metric used to determine
a company’s overall worth. All ownership interests and asset claims
from both debt and equity are considered since it considers the total
market value rather than just the equity value.

EV can be compared to the theoretical value of a target firm or the

actual cost of purchasing a company (before a takeover premium is

S
considered). EV can be calculated by using majorly two different for-
mulas:
‰‰ Subtractingthe balance of cash and cash equivalents from the
IM
sum of market capitalisation and market value of debt.
‰‰ Subtracting the balance of cash and cash equivalents from the sum
of common shares, the market value of debt, the value of preferred
shares and minority interest.

Following are the major parts of EV:

1. Cash and cash equivalents: This is the financial statement’s
M

most liquid asset. Short-term investments, marketable securities, NOTE

commercial paper and money market funds are a few examples Cash and cash equivalents are
of cash equivalents. the most liquid for the asset and
hence get placed on the top of
We deduct this sum from EV since it will lower the target the heading of current assets.
N

company’s acquisition costs. It is anticipated that the acquirer

will utilise the cash to settle a portion of the fictitious takeover
price immediately. Specifically, it would be applied right away to
buy back debt or pay a dividend.
2. Minority interest: The percentage of a subsidiary that is not held
by the parent business (which holds more than 50% but less than
100% ownership in the subsidiary) is known as a non-controlling
interest.
The financial results of the parent company include the financial
statements of this subsidiary. Minority investment gets placed in
the EV calculation since the parent company has consolidated
financial statements with that minority interest, which means
that even though the parent does not own 100% of the company,
it includes 100% of the revenues, expenses and cash flow in its
figures. NOTE
3. Preferred stock: Preferred stocks are hybrid financial Value of total assets is equal to
the sum of value of total debt
instruments with aspects of both equity and debt. They have a and value of total stockholders’
greater priority in asset and earning claims than common stock equity.

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98 FINANCIAL MODELLING

and pay a predetermined sum of dividends. They are considered

as being in debt in this circumstance. Similar to debt, they usually
need repayment through a purchase.
4. Total debt: Banks and other creditors contribute to the total debt.
They consist of both short- and long-term debt and are interest-
bearing liabilities. Theoretically, when a company is purchased,
the buyer can use the target company’s cash to pay down some
of the assumed debt, as a result, the debt’s size is changed by
removing the cash. The book value can be used in cases where
information in the context of market value is not present.
5. Value of Equity: To calculate equity value, multiply the
outstanding fully diluted shares of the firm by the stock’s current
market price. Fully diluted indicates that in addition to just the
basic shares outstanding, it also includes warrants, convertible

S
securities and in-the-money options. A business that intends to
acquire another business must compensate the shareholders of
the target business with at least the market capitalisation value.
The EV equation shows that additional factors are added to this
IM
since it is believed that this alone is not a reliable indicator of a
company’s true value.

SELF ASSESSMENT QUESTIONS

9. __________ are hybrid financial instruments.

a. Preferred stock b. Common stock
M

c. Debt d. Bonds
10. __________ can be defined as a metric used to determine a
company’s overall worth.
N

a. Gross value b. Book value

c. Enterprise value d. Market value

ACTIVITY

Find out the advantages of using the enterprise value.

THE EFFICIENT MARKETS APPROACH

3.7
TO CORPORATE VALUATION
The Efficient Market Approach (EMA), also referred to as the efficient
market approach, is a theory that particularly claims that share prices
accurately reflect all available information and that it is difficult to
TURN TO THE consistently generate alpha. Following is the brief information in the
WEB context of the Efficient Markets Approach:
Search and study about the
‰‰ Generally, the equity class of stock is usually traded as per their
concepts of EMA (Efficient
Market Approach) fair value on their respective stock exchanges. According to EMA,

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 Comparable Company Analysis  99

it is next to impossible for any investor or group of investors to

purchase undervalued stocks or sell the same for premium prices.
‰‰ The only way an investor can earn larger returns is by making
riskier bets, as it should be impossible to outperform the market as
a whole through excellent stock selection or market timing.
‰‰ According to the efficient market approach, new information
immediately affects stock prices.
‰‰ Technical analysis does not examines past stock prices to forecast
future prices.
‰‰ Fundamental analysis, which examines financial data, cannot
assist investors in generating returns that are higher than those of
a portfolio of randomly chosen stocks.

S
‰‰ The author examines the most recent research from three schools
of thought that contend that there is evidence of predictable pat-
terns in stock prices and so question the efficient market theory.
IM
How efficiently prices represent all available information is referred
to as market efficiency. According to the efficient markets approach,
since everything is already fairly and precisely priced, there is no
room for investing to generate excess gains.

This suggests that there is minimal chance of outperforming the mar-

ket, however, passive index investing can help you match market
M

returns.

A market will grow more efficiently as more individuals participate,

compete and bring more and varied forms of information to bear on
the price. In the case where markets become more active and liquid,
arbitrageurs will also appear. They will profit by correcting minor
N

inefficiencies wherever they may appear and quickly re-establishing

efficiency.

SELF ASSESSMENT QUESTIONS

11. According to the efficient market approach, new information

immediately affects __________.
a. Asset value b. Expenses value
c. Stock price d. Income
12. A market will grow more __________ as more individuals
participate, and compete.
a. Inefficient
b. Efficiently
c. May be efficient or maybe inefficient
d. Cannot be determined

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100 FINANCIAL MODELLING

ACTIVITY

Find out the disadvantages of using the Efficient Market Approach.

ENTERPRISE VALUE (EV) AS THE

3.8 PRESENT VALUE OF THE FREE CASH
FLOWS
Given a certain rate of return, Present Value (PV) is the current value
of a future financial asset or stream of cash flows. The discount rate
TURN TO THE
WEB determines how much future cash flows are discounted, and the
Search and study about the main higher the discount rate, the lower the present value of those future
difference between levered and cash flows will be.

S
unlevered firm or company.
To calculate the Enterprise Value (EV) of the company, the terminal
value predicted at the conclusion of the projection period and the
Unlevered Free Cash Flows (UFCFs) anticipated during the projec-
IM
tion period are discounted to their present values using the chosen
discount rate. The timing assumptions for the cash flows within a pro-
jection interval have an impact on the calculation of EV. Mid-period
convention assumes that the UFCFs occur amid each projection inter-
val, as opposed to the end-period convention, which assumes that the
UFCFs occur at the end of each interval. Because it is more conserva-
tive, the end-period convention is frequently adopted in practice (the
UFCFs are discounted at a time more distant from the present).
M

In the EV calculation above, the end-period convention is taken for

granted. Based on the mid-year convention, the EV is calculated using
the following formula:
FCF1 FCF2 FCFn TV
N

EV = 0.5
+ 1.5
+ .... + n − 0.5
+
(1 + r) (1 + r) (1 + r) (1 + r) n
EV-= Enterprise value
NOTE FCF= Future Cash Flows
Weighted Average Cost of
Capital is an important concept TV= Terminal Value
used in the calculation of EV.
r= WACC (Weighted Average Cost of Capital)

The following formula is used to compute the EV based on the mid-

year convention:
FCF1 FCF2 FCFn TV
EV = 0.5
+ 1.5
+ .... + n − 0.5
+
(1 + r) (1 + r) (1 + r) (1 + r) n
To advance the current value of UFCFs using the end-period conven-
tion by half a year, multiply it by (1+r)0.5 as follows:

EV (mid-period convention) =
TV
EV ( mid − period convention) = PV of UFCF
PV of UFCFs S (end − period
(end-period ) × (1 + r)0.5 +
convention×
convention)
(1 + r) n

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 Comparable Company Analysis  101

You can arrive at a range of equity values by deducting the constant

net debt value from the range of EVs determined as outlined above
because net debt is independent of the assumptions made in the DCF
valuation. Divide the equity value by the current outstanding diluted
shares as an additional step to arrive at a hypothetical range of share
prices based on the DCF valuation.

SELF ASSESSMENT QUESTIONS

13. Which of the following is not the attribute used in the formula
of calculation of EV?
a. Enterprise value b. Future cash flows
c. Terminal value d. Debt value

S
14. _____________ is the current value of a future financial asset or
stream of cash flows
a. Future value b. Present value
IM
c. Market value d. Book value

ACTIVITY

Find out the importance of calculating WACC.

M

3.9 SUMMARY S
‰‰ Professionals such as financial analysts and many others perform
certain activities to make certain analyses of the business corpo-
ration.
N

‰‰ Comparably by contrasting a firm’s valuation multiples with those

of its competitors, a relative valuation method known as “Com-
pany Comparable Analyses” or “Comps” can be used to determine
the value of a specific business entity or any company.
‰‰ A corporation can be valued in a variety of ways. Based on cash
flows and relative performance in comparison to peers, the most
popular methodologies are used.
‰‰ Using specific financial data from previous Merger and Acquisi-
tion (M&A) deals and transactions, precedent transaction analysis
is a technique for valuing businesses.
‰‰ To provide a credible approximation of the multiples or premiums
that others have paid for a publicly traded company, precedent
transaction analysis uses information that is readily accessible to
the general public.
‰‰ The first step in the procedure is to hunt for similar transactions
that have taken place in the recent (preferably) past and are in the
same sector.

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102 FINANCIAL MODELLING

‰‰ The process of calculating a business’s financial value is known as

business valuation or computation of enterprise value.
‰‰ Financial accounting: The difference between all claim’s supe-
rior to common stock, such as the company’s obligations, and the
accounting value of the company’s assets is referred to as book
value. Enterprise Value (EV) can be defined as a metric used to
determine a company’s overall worth.
‰‰ The Efficient Market Approach (EMA), also referred to as the effi-
cient market approach, is a theory that particularly claims that
share prices accurately reflect all available information.
‰‰ Given a certain rate of return, Present Value (PV) is the current
value of a future financial asset or stream of cash flows.

S
KEY WORDS

‰‰ Book value: The difference between all claims senior to com-

IM
mon equity (such as the company’s liabilities) and the account-
ing value of the company’s assets
‰‰ EV: A metric used to determine a company’s overall worth
‰‰ EMA: The efficient market approach, is a theory that partic-
ularly claims that share prices accurately reflect all available
M

information
‰‰ PV: Given a certain rate of return, Present Value (PV) is the cur-
rent value of a future financial asset or stream of cash flows
N

3.10 MULTIPLE CHOICE QUESTIONS

MCQ 1. Comparably by contrasting a firm’s valuation multiples with
those of its competitors, a relative valuation method known as:
a. Company comparable analysis
b. Horizontal analysis
c. Vertical analysis
d. Budgeting
2. The company is ___________ if its valuation ratio is higher than
the average for its peer group.
a. Undervalued
b. Overvalued
c. May be undervalued or maybe overvalued
d. Cannot be determined

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3. When combined, the intrinsic and relative valuation models offer

a rough estimate of value that analysts can use to determine the
true value of a ___________.
a. Shares b. Debt
c. Company d. Current liabilities
4. Which of the following multiples cannot be used in CCA?
a. Enterprise value to sales ratio
b. Enterprise value to EBIT ratio
c. Price to earnings ratio
d. Employee retention ratio
5. EMA stands for

S
a. Efficient Market Approach
b. Elegant Market Approach
c. Efficient Manager Approach
IM
d. Emerged Market Approach
6. Using specific financial data from previous merger and
acquisition deals and transactions, __________ is a technique for
valuing businesses.
a. Comparable companies analysis
M

b. Companies comparable analysis

c. Comparable cost analysis
d. Precedent transaction analysis
N

7. The process of calculating a business’s financial value is known

as business valuation or computation of __________.
a. Share value b. Bonds value
c. Enterprise value d. Asset value
8. The process of determining a brand’s value or how much
someone is prepared to pay for it is referred to as___________.
a. Brand valuation approach
b. Income approach
c. Market approach
d. Cash approach
9. The book value per share is calculated by dividing book value by
the total number of outstanding _________.
a. Market value b. Net realisable value
c. Shares d. Acquisition value

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104 FINANCIAL MODELLING

10. Short-term investments, marketable securities, commercial

paper and money market funds are a few examples of __________.
a. Enterprise value b. Cash equivalents
c. Book value d. Acquisition value

3.11 DESCRIPTIVE QUESTIONS

? 1. Define the term CCA.
2. State the terminology of precedent transaction analysis.
3. Express the efficient market approach.
4. Define the book value.
5. Define the term present value.

S
HIGHER ORDER THINKING SKILLS
3.12
(HOTS) QUESTIONS
IM1. The company is _______ if the valuation ratio is lower than the
average for its peers.
a. Overvalued
b. Undervalued
c. Can be overvalued or undervalued
d. Cannot be determined
M

2. Price to earnings ratio will decrease if

a. Price of the share will increase
b. Earnings will decrease
N

c. Earnings will increase

d. Price remains the same and earnings decrease
3. Analysts prefer to confirm cash flow valuation with relative
comparisons in addition to __________.
a. Market valuation b. Book valuation
c. Intrinsic valuation d. Shares valuation

3.13 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Introduction to Comparable 1. a. Comparable Companies
Company Analysis Analysis
2. d. Name of the Business
Introduction to Precedent 3. a. Business
Transactions Analysis

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 Comparable Company Analysis  105

Topic Q. No. Answer

4. a. Finding out the relevant
event or transactions
Four Methods to Compute 5. d. Expenditure approach
Enterprise Value (EV)
6. b. Income approach
Using Accounting Book Values 7. c. Interest expense
to Value a Company
8. b. Book value
The Firm’s Accounting Enter- 9. a. Preferred stock
prise Value
10. c. Enterprise value
The Efficient Markets Ap- 11. c. Stock price
proach to Corporate Valuation

S
12. b. Efficiently
Enterprise Value (EV) as the 13. d. Debt Value
Present Value of the Free Cash
Flows
14.
IM b. Present Value

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. a. Company Comparable Analysis
2. b. Overvalued
M

3. c. Company
4. d. Employee retention ratio
5. a. Efficient Market Approach
6. d. Precedent transaction analysis
7. c. Enterprise value
N

8. a. Brand valuation approach

9. c. Shares
10. b. Cash equivalents

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. Comparably by contrasting a firm’s valuation multiples with
those of its competitors, a relative valuation method known as
“Company Comparable Analysis” or “Comps” can be used to
determine the value of a specific business entity or any company.
Refer to Section 3.2 Introduction to Comparable Company
Analysis
2. Using specific financial data from previous merger and acquisition
(M&A) deals and transactions, precedent transaction analysis is
a technique for valuing businesses. This approach of valuation,
often known as “precedents,” is frequently created by analysts
working in investment banking, private equity and corporate
development when attempting to value a whole organisation as

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106 FINANCIAL MODELLING

part of a merger or acquisition. Refer to Section 3.3 Introduction

to Precedent Transactions Analysis
3. The Efficient Market Approach (EMA), also referred to as the
efficient market approach, is a theory that particularly claims
that share prices accurately reflect all available information and
that it is difficult to consistently generate alpha. Refer to Section
3.7 The Efficient Markets Approach to Corporate Valuation
4. The process of calculating a business’s financial value is known
as business valuation or computation of enterprise value. This
valuation is done because it provides useful data during legal
proceedings and aids in creating your company’s exit strategy
for buying and selling businesses, obtaining capital and strategic
planning. Refer to Section 3.4 Four Methods to Compute
Enterprise Value (EV)

S
5. Book value or accounting book value can be defined as the
difference between all claims senior to common equity (such
as the company’s liabilities) and the accounting value of the
IM company’s assets. The accounting practice of documenting
asset value at the original historical cost in the books is where
the phrase “book value” originates. Refer to Section 3.5 Using
Accounting Book Values to Value a Company

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS
M

Q. No. Answer
1. b. Undervalued
2. c. Earnings will increase
3. c. Intrinsic valuation
N

3.14 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
‰‰ Swan, J. (2018). Practical financial modelling. Burlington, MA:
CIMA Publishing.
‰‰ Rees, M. (2018). Principles of financial modelling.

E-REFERENCES
‰‰ Dheeraj Vaidya, F. (2022). Comparable Company Analysis.
Retrieved 25 August 2022, from https://www.wallstreetmojo.com/
comparable-company-analysis-comps/
‰‰ Comparable Company Analysis: How To Identify Comparable
Companies In 2020? - SignalX AI. (2022). Retrieved 25 August
2022, from https://signalx.ai/blog/comparable-company-analysis/

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 CASE STUDIES
1 TO 3

CONTENTS

Case Study 1 Comparing and Analysing Sales in NEVTRA

Case Study 2 Internal Rate of Return
Case Study 3 Enterprise Value (EV)

S
IM
M
N

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108 FINANCIAL MODELLING

CASE STUDY 1

COMPARING AND ANALYSING SALES IN NEVTRA

COMPANY OVERVIEW
Case Objective
NEVTRA is a retail shop founded in 1990 by two friends, Yash
This case study discusses the
use of a chart for comparing
Vardhan and Vikas Rawat. The organisation started by selling
and analysing sales in only two computer hardware products, i.e., keyboard and mouse.
NEVTRA. As the business grew, NEVTRA started to sell various other com-
puter-related hardware and software products.

THEIR NEEDS

In NEVTRA, all purchase- and sales-related data of hardware and

software products were recorded manually in the register. Hence,

S
it was very time-consuming and tedious to calculate the total sales
of the different products in each quarter. To get an exact picture
of the growth rate of their business, the owners also wanted to
compare last year’s sales of products with that of the current year.
IM
Needless to say, the possibility of errors in such manual calcula-
tions remained always high. Hence, they decided to automate all
their data-related processes and calculations and discussed their
problem with their friend Mehul who was also the IT head of a
company.

SOLUTION
M

Mehul suggested they use the spreadsheet-based application to

store, analyse, manipulate and visualise their data in different
ways. With the guidance of Mehul, Yash and Vikas started to re-
cord all the purchase- and sales-related data of hardware and
N

software products in MS Excel. Now, they can easily calculate the

total sales of their hardware and software products by using var-
ious types of formulas and functions. The following figures show
how they have recorded their quarter-wise sales of different prod-
ucts in the MS Excel worksheet:

MS Excel also allowed them to represent the result of their data

analysis in the form of charts. Yash used the Column chart to com-

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 Case study 1: Comparing and Analysing Sales in NEVTRA 109

CASE STUDY 1

pare the sales for the Year 2018 and Year 2019, as shown in the
following figure:

S
IM
M
N

QUESTIONS

1. Why did the owners of NEVTRA decide to use the spread-

sheet application to record their business data?
(Hint: To calculate, compare and analyse the sales of dif-
ferent products)
2. Which feature of MS Excel enabled Yash to compare the
sales for Year 2018 and Year 2019?
(Hint: The chart feature of MS Excel application)

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110 FINANCIAL MODELLING

CASE STUDY 2

INTERNAL RATE OF RETURN

Global Capitals, a financial institution, was in the business of

Case Objective lending money, short-term loans and share broking. In the cur-
This case study highlights rent year, the company decided to initiate an investment plan for
how a manager used IRR the members and other investors. The company finalised to pay
for solving an investment `2,01,475 at the end of 10 years with the deposit of `15,000 p.a.
problem.
The implicit rate calculated by the manager because it generates
the return on the investment. They made the following calcula-
tion chart for the same purpose:

Yearly Yearly sum Rate of

Investment (`) (with interest) Interest

S
Start of 1st year 15,000 15,000.00
End of 1st year 15,000 30,795.04 5.30%
End of 2nd year 15,000 47,427.26 5.30%
IM
End of 3rd year 15,000 64,941.04 5.30%
End of 4th year 15,000 83,383.09 5.30%
End of 5th year 15,000 1,02,802.62 5.30%
End of 6th year 15,000 1,23,251.44 5.30%
End of 7th year 15,000 1,44,784.10 5.30%
M

End of 8th year 15,000 1,67,458.05 5.30%

End of 9th year 15,000 1,91,333.79 5.30%
End of 10th year 0 2,01,475.00 5.30%
N

In this way, the managers made use of the method of hit and trial
to achieve the expected outcome. And came out with the implicit
rate of return as 5.30%.

QUESTIONS

1. Identify the method of calculation used in the above case.

(Hint: The managers made use of the method of hit and
trial to achieve the expected outcome. It came out with
the implicit rate of return as 5.30%)
2. Discuss the merits and demerits of the IRR method.
(Hint: Merits: takes into the account time value of money,
and considers the cash flow stream in its entirety. Demer-
its: IRR may not be uniquely defined. It cannot distin-
guish between lending and borrowing)

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 Case study 3: Enterprise Value (EV) 111

CASE STUDY 3

ENTERPRISE VALUE (EV)

Mr. Tor Raj joined a global FICO score organisation following his
graduation from college school. After joining the association, he Case Objective
had an acceptance program on monetary detailing and budget re- This case study showcases
ports examination for 30 days. He was extremely curious to learn, enterprise value.
and he could overhaul his abilities in fiscal summaries examina-
tion about credit scores.

After finishing his enlistment, he was posted in corporate FICO

score. Then, at that point, he was requested to examine budget re-
ports from Alpha Company Limited and Beta Company Limited.
He required three days to gather the information and apply strat-
egies for budget reports investigation in these two organisations.

S
He also considered comparing the analysis of these two organisa-
tions with similar organisations under various financial scenarios.
Following three days, he arranged his power direct show toward
a gathering of ranking directors for their remarks and endorse-
IM
ment. The focal point of Mr. Tor’s examination depended on the
Balance Sheet, Income Statement and bookkeeping approaches
embraced by the organisations. The show was not considered,
and it was unacceptable. The ranking directors felt that he ought
to likewise involve income proclamation for examination and re-
turn with a new show on the following day. Therefore, Mr. Tor
reviewed what he learned about Cash stream points in the book-
M

keeping class. He recollected that income proclamation is among

the most valuable assertions for investigation alongside account-
ing reports and pay explanations. This assertion presents cash
in-streams and money out streams ordered under three classifi-
cations: money from working exercises, cash from putting away
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exercises and money from supporting exercises.

Cash from Operations addresses the money inflows and outpour-

ings produced out of centre business exercises of the association.
Cash deals and assortment from the clients are instances of mon-
ey inflows from tasks. Cash outpourings are connected with in-
stalments to representatives, sellers, charge specialists and oth-
ers expected for everyday activities are instances of money surges
from tasks.

Indian Accounting standard (Ind AS 7) permits the substance to

report the incomes from working exercises utilising either the im-
mediate. The organisation is allowed to choose a suitable tech-
nique.

Incomes from Investing exercises comprise money inflows and

outpourings connected with buy/offer of non-current resources
and non-current speculations XXXX. Instalments for acquiring

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CASE STUDY 3

property, plant and hardware and obtaining licenses are the in-
stances of money outpourings of financial planning exercises.

Assortment of money at a bargain of property, plant and gear and

different ventures are cash inflows of financial planning exercis-
es. At last, the net of these money inflows and surges address the
incomes from effective financial planning exercises.

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M
N

Incomes from Financing exercises comprise money inflows and

money outpourings connected with long haul and momentary
wellspring of funding. Issues of value shares, issues of bonds and
borrowings from banks are instances of money inflows of funding
exercises. Redemption of securities, reimbursement of borrow-
ings, instalment for share buyback and instalment of premium
on acquired capital and profit to value investors are the instances
of money outpourings of supporting exercises. The net of these
money inflows and surges addresses the incomes from financial
planning exercises.

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 Case study 3: Enterprise Value (EV) 113

CASE STUDY 3

Examination of income proclamation is a major test for Mr. Tor

since how he might interpret the instruments and procedures are
bound to the investigation of accounting reports and pay artic-
ulation. He was thinking about how to begin the examination of
income proclamations. He is considering some of the questions,
including why the income statement is different from the balance
sheet and the profit and loss statement, as well as how to inter-
pret something that is very similar. He was figuring out what ex-
tra investigation could be made given Cash stream proclamations
to prove his previous examination. The ranking director’s disap-
pointment is meandering in his mind.

QUESTIONS

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1. What does cash from operations exhibit?
(Hint: Cash from Operations addresses the money inflows
and outpourings produced out of centre business exer-
cises of the association)
IM
2. What do all incomes from financing exercises entail?
(Hint: Incomes from financing exercises comprise money
inflows and money outpourings connected with long haul
and momentary wellspring of funding. Issue of value
shares, issue of bonds and borrowings from banks are
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instances of money inflows of funding exercises)

N

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 C H A
4 P T E R

DISCOUNTED CASH FLOW (DCF) ANALYSIS

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CONTENTS

4.1 Introduction
4.2 Discounted Cash Flow (DCF) Analysis
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4.2.1 Understanding Unlevered Free Cash Flow
4.2.2 Forecasting Free Cash Flow
4.2.3 Forecasting Terminal Value
Self Assessment Questions
Activity
4.3 Present Value and Discounting
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Self Assessment Questions

Activity
4.4 Understanding Stub Periods
4.4.1 Analysis of bonds and swaps
Self Assessment Questions
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Activity
4.5 Performing Sensitivity Analysis
Self Assessment Questions
Activity
4.6 Cash Flows: DCF “Top Down” Valuation
Self Assessment Questions
Activity
4.7 Consolidated Statement of Cash Flows (CSCF)
Self Assessment Questions
Activity
4.8 Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF)
Self Assessment Questions
Activity
4.9 Free Cash Flows Based on Pro Forma Financial Statements
Self Assessment Questions
Activity

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116 FINANCIAL MODELLING

CONTENTS

4.10 Summary
4.11 Multiple Choice Questions
4.12 Descriptive Questions
4.13 Higher Order Thinking Skills (HOTS) Questions
4.14 Answers and Hints
4.15 Suggested Readings & References

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 Discounted Cash Flow (DCF) Analysis  117

INTRODUCTORY CASELET

SENSITIVITY ANALYSIS

Suppose you are an owner of a restaurant and running that

restaurant for about 4 years. The restaurant business is quite con- Case Objective
sistent and there is no increase in business in the last 2 years. You This caselet aims to explain
decided to invest some of your time in analysing the business and the sensitivity analysis.
find out what can be done to maximise the sales in the next com-
ing months. You chose to perform sensitivity analysis.

Sensitivity analysis works based on what-if analysis. It finds out

how independent factors can influence or impact the dependent
factor. Sensitivity analysis helps in predicting the result or out-
come when performed under some specific conditions. Sensitiv-
ity analysis is commonly used by investors or organisation who

S
considers the conditions or factors which may affect their poten-
tial investment. This analysis helps in testing, predicting and eval-
uating the outcome.
IM
You decided to consider multiple areas of the restaurant which
you want to modify or change and made assumptions related to
the outcome.

You have a list of changes you want to make in your restaurant,

such as a new menu, re-decoration, a new theme or new cousin
offering, additional catering, or an expansion of the dining area.
M

When you analysed each option closely, you realised that cost of
changing is going very high. You understood the result and also got
to know what the cost of the change will be. Upon analysing each
of the options, you found that changing the theme and expanding
the dining room size will be costlier than justified based on the
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amount of revenue each option would bring.

However, few changes can be made immediately for the success

of the restaurant. These changes can be reviewed and menu can
be changed. You can make additions to the catering. With the help
of these changes, you can easily increase the revenue by 14 to 16
per cent in the next 5 or 6 months. The sensitivity analysis helps in
revealing what each of these options offers to increase your reve-
nue without increasing costs.

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118 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Describe the Discounted Cash Flow (DCF) Analysis
>> Summarise the Present Value (PV) and discounting
>> Analyse the sensitivity analysis
>> Define the DCF “Top Down” valuation
>> Examine the consolidated statement of cash flows
>> Discuss the cash flows Based on Consolidated Statement of
Cash Flows (CSCF)
>> Elucidate the free cash flows based on pro forma financial

S
statements

4.1 INTRODUCTION
IM
In the previous unit, you studied comparable company analysis and
Quick Revision
precedent transactions analysis. You also studied the four methods to
compute Enterprise Value (EV). The Efficient Markets Approach to
Corporate Valuation and Enterprise Value (EV) as the Present Value
of the free cash flows were also discussed.
M

For a reporting period, an entity’s cash flows from operating, investing

and financing operations must be prepared and presented by the prin-
ciples and guidelines prescribed by Indian Accounting Standards 7.
The purpose of Indian Accounting Standards 7 is to give information
on an entity’s historical changes in cash and cash equivalents as a
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result of its operating, investing and financing activities throughout

the reporting period. Inflows and outflows of cash and cash equiva-
lents are known as cash flows.

Discounted Cash Flow (DCF) analysis refers to the method used to

value investment by discounting the estimated future cash flows. This
analysis is used for finding the value of a stock. DCF is applied to value
a company, a project and many other assets or activities. Therefore,
we can say that DCF analysis is widely used in both the investment
industry and corporate finance management.

One can calculate the value of return that an investment creates after
accounting for time value of money with the use of DCF analysis. This
analysis can be done for finding the value or worth of the projects or
investments that are expected to generate cash flows in future. It must
be noted that the DCF and initial investments are compared.

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If DCF > the Present Cost, then

The investment is profitable

The higher the DCF, the greater ROI generates.

If DCF < Present Cost then

Investors are recommended to hold the cash.

This chapter describes the discounted cash flow analysis in detail.

Also, sensitivity analysis and DCF top-down valuation is explained in
this chapter.

DISCOUNTED CASH FLOW (DCF)

4.2
ANALYSIS

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DCF Analysis is one of the techniques that are applied to measure
the value of current investment in future periods. It enables the com-
IM
pany to analyse the profitability of any long-term project which can
be the acquisition of any securities or any kind of fixed asset whether
it is tangible or intangible. It follows the concept of the time value of
money.

The investment is profitable only when the DCF is greater than today’s
value of investment whereas it incurs loss when the DCF is lower than
today’s investment value. This analysis could not be worth it for the
M

company as in future periods the predictions might get changed with

time.

DCF analysis is using the concept of the time value of money which
measures the worth of dollars being invested today and becomes more NOTE
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shortly. For instance, if a person is investing `100 in the bank at a dis- DCF analysis can be based on
count rate of 10%, this means he/ she is getting the amount after a determining the estimated cash
certain period at `110, that is, (`100 + `100 × 10%). It can also be flows of an investment by using
a discounted rate.
regarded as a present value analysis.

The formula for DCF analysis is given as under:

Cash flows

(1+discount rate )
time periods

Here,
‰‰ Cash flows represent the amounts of cash flows paid in a given
year
‰‰ Discount rate is the rate at which the value of cash flows is com-
puted.
‰‰ Time periods represent the time till the cash flows need to be dis-
counted.

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120 FINANCIAL MODELLING

For instance, a company is investing in a project worth `10,000 at

a discount rate of 10% with the provided cash flows given as under
Table 4.1:

TABLE 4.1: CASH FLOWS GIVEN TO CALCULATE

PRESENT VALUES
Number of Years Amounts of Cash flows (`)
First 2,000
Second 3,000
Third 5,000
Fourth 3,000

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Now, the present values are determined as under Table 4.2:

TABLE 4.2: CALCULATION OF PRESENT VALUES

Number Amounts PV of `1 = Discounted Cash flows =
IM
of Years of Cash 1
(cash flows × present value )
flows (1+discount rate )
time period

First `2,000 1 `2,000×0.9090= `1,818

= 0.9090
(1 + 0.10) 1

Second `3,000 1 `3,000×0.8264= `2,479.20

=0.8264
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(1 + 0.10) 2

Third `5,000 1 `5,000×0.7513=`3,756.50

= 0.7513
(1 + 0.10) 3

Fourth `3,000 1 `3,000×0.6830=` 2,049

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= 0.6830
(1 + 0.10)
4

4.2.1 UNDERSTANDING UNLEVERED FREE CASH FLOW

Unlevered free cash flow is the value that an organisation has before
reimbursing its financial liabilities. It is a kind of amount being deter-
mined before including any interest charges. This is being reported
in the accounting statements of an organisation. It is an ideal concept
being applied at the time of doing DCF Analysis. It is considered to be
the amount available for making reimbursements to debt and equity
investors. This is not an ideal concept for identifying the leverage of
the organisation as it completely ignores the changes in capital struc-
ture over the period.

The formula for computing unlevered cash flow is given as under:

Income before interest, taxes, depreciation and amortisation – Capital

expenditures – Working capital

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For instance, the financial data is given as under Table 4.3:

TABLE 4.3: FINANCIAL DATA

Particulars Amounts
MARK IT!
Depreciation `6,000
Income before taxes `10,000 Capital expenditures represent
the amount being spent on
Capital expenditure `4,000 the acquisition of fixed assets.
Current assets `12,000 Working capital represents
the amount left after deducting
Current liabilities `8,000 short-term assets and short-term
liabilities.
The unlevered cash flow is computed as follows under Table 4.4:

TABLE 4.4: UNLEVERED CASH FLOW

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Income before taxes `10,000
Add: Depreciation `6,000
Income after depreciation `16,000
Less: Capital expenditures (`4,000)
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Less: Change in working capital (`4,000) (`12,000 - `8,000)
Unlevered cash flow `8,000

4.2.2 FORECASTING FREE CASH FLOW

Free cash flows are one of the appropriate indicators for analysing the
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DCF valuation. It encompasses all the effects of leverage, that is, the
inclusion of interest charges. It enables a company to determine the
amount being provided to the organisation after adjusting its obliga-
tions.

When the cash from operating activities is more than the amount
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spent on the purchase of fixed assets and the working capital, that
amount is called free cash flows. It is an amount being reimbursed by
the organisation to its suppliers, for issuing dividends and interest to
its shareowners.

The formula for computing free cash flows is given as follows:

Free Cash Flow = Cash from Operations – Capital Expenditures

Here,
‰‰ Cash from operations is derived from the statement of cash flows.

‰‰ Capital expenditures refer to the money an organisation or cor-

porate body spends to purchase, maintain, or upgrade its fixed
assets, such as buildings, cars, equipment, or land.

When the free cash flows are derived based on estimated figures of
the accounting statements, it is said to be forecasted free cash flows. It
involves the estimations of profit or loss account, cash flow statement
and the balance sheet.

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122 FINANCIAL MODELLING

Free cash flows help in:

‰‰ Analysis of profit or loss statement: A profit or loss statement is
an accounting report which is prepared to determine the profit
earned or loss incurred by the company in an accounting period.
It is divided into two parts namely, incomes and charges. The net
profit arises only when the incomes earned are more than the
charges spent. The figure of profit after taxes can be required to
determine free cash flows.
‰‰ Analysis of balance sheet: A balance sheet is another accounting
report which is drafted after the profit or loss statement. It helps
in finding out the financial status of an organisation through assets
and liabilities. For free cash flows, the amounts of only the particu-
lar heads need to be analysed. The main focus should be placed on
the long-term liabilities, fixed assets, short-term assets and short-

S
term obligations.
‰‰ Analysis of cash flow statement: The statement of cash flows is
the third report that describes the cash position of an organisa-
IM tion. It is divided into three sub-heads namely, cash from opera-
tions, cash from investments and cash from finances. The main
emphasis must be made on the operating and investing activities
where the former helped in determining the amounts of changes
in working capital and the latter concerned with the investments
in the fixed assets.
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4.2.3 FORECASTING TERMINAL VALUE

Terminal value is the worth of an investment project that is determined

beyond the defined estimated period. In this scenario, the growth rate
is expected to be constant for an indefinite time. It is assumed that the
business of an organisation will expand at a set rate of growth with no
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fluctuations. It is determined at the end of the forecasted term of an

investment project.

It can be computed by applying two techniques namely, the exit mul-

tiple methods and the perpetuity growth method where the former is
used by industry professionals and the latter is applied by academic
institutions. The most commonly used technique is the perpetuity
growth method and the formula is given as under:
Forecasted free cash flows (1+growth rate )
Discount rate (1–growth rate )

Here,
‰‰ Forecasted free cash flows are discussed in the previous topic.
‰‰ Growth rate is the rate at which a business of an organisation
grows at a fixed rate.
‰‰ Discount rate is primarily the weighted average cost of capital
which is being derived based on certain financial concepts.

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For instance, certain figures are given as under Table 4.5:

TABLE 4.5: DATA GIVEN FOR

CALCULATING TERMINAL VALUE
Particulars Amounts
Forecasted free cash flows `250,000
Growth rate 3%
Discount rate 10%

The terminal value is computed as follows:

Forecasted free cash flows (1+growth rate )
Terminal value=
Discount rate (1–growth rate )

`250,000 (1 + 0.03 )

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=
0.10 (1 − 0.03 )

=`2,654,639.18
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SELF ASSESSMENT QUESTIONS

1. Which of the following method is not applied while computing

the values of discounted cash flows?
a. Unlevered cash flow
b. Levered cash flow
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c. Terminal value
d. Payback period
2. Which statement is being analysed for determining the
number of free cash flows?
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a. Income statement
b. Accounting statements
c. Annual report
d. Expense statement

ACTIVITY

Analyse the accounting reports of any renowned company from the

internet and apply the techniques of discounted cash flows in it.
Make a report and mention your observations with practical for-
mulas.

4.3 PRESENT VALUE AND DISCOUNTING

To know the concept of resent value let us first discuss the concept
of the time value of money. The time value of money is defined as the

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124 FINANCIAL MODELLING

worth of money in current times which is greater than the worth of

that money in upcoming periods. It has been studied based on two
concepts namely, present value and future value.

Let us discuss the concept of present value.

Present value/Current value is referring to the amount that existed

in the recent scenario. It is the amount which an investor has in their
hand before investing. For instance, a person who has `1,000 in his
hand is considered as current value unless he invests.

The formula for computing the present value is given as under:

Future worth
(1+rate of discount) time periods

Let us discuss the concept of future value.

Future value is defined as the amount estimated after discounting the

NOTE
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current worth based on the required number of periods. It is worth
Future value is usually greater being derived at the end of the period when the investment project
than the value being placed
at the start of the project as it expires.
increases over time and is also
subject to interest rates. The formula for computing future worth is given as under:
Present value × (1 + rate of discount)time periods
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If a person invests `1,000 in buying an asset or putting it in their

account, they will earn interest on the investment and the `1,000 will
grow over the time. Suppose the rate of interest is 2% for two years,
then the future value is:
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FV = `1,000 × (1 + 0.02)2 = `1,040

Let us now discuss the concept of discounting technique.

Discounting is referring to the method that measures the cash flows

in upcoming periods or the worth of the current value of the invest-
ment. It can be applied by computing the future values or the present
values as discussed in the previous chapter. The risk in the investment
project is higher where the rate of discount is more whereas the risk is
lower if the rate is also lesser.

The rates of discount can be varied with the type of investment secu-
rity. It can be identified as follows:
‰‰ The rate of discount is referred to as the risk-free rate in the capital
asset pricing model.
‰‰ As per investment in fixed interest securities, the rate of discount
is termed as coupon rate or cost of debt.

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‰‰ When the market value of a company’s securities is estimated,

then the rate is referred to as the weighted average cost of capital
(WACC).
‰‰ When the equity value of an enterprise is identified, the discount
rate is treated as a cost of equity.

SELF ASSESSMENT QUESTIONS

3. Which of the following is not considered to be a discount rate

while computing the present values?
a. Market value
b. Cost of equity
c. Cost of debt

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d. Coupon rate of bonds
4. Which concepts are not included in the determination of the
time value of money?
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a. Future worth
b. Current worth
c. Present value
d. Accounting the rate of return
M

ACTIVITY

Discuss a real-life situation where the concept of the time value of

money is being applied. Determine the future and present values in
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appropriate tabular formats.

4.4 UNDERSTANDING STUB PERIODS

The stub period is referring to the time duration between the starting
of an accounting year and the date of making a transaction. It could a
part of a whole year or a relevant quarter. As the valuations are occur-
ring during the entire year, therefore, a stub period occurs. It also
arises when the date of making a valuation is altogether varied from
the date of completing it.

It is ideally found at the time of acquisition of bonds and swaps by the Study
investors. This could be the period within which the interest is being Hint
received by the investor and is not similar to the coupon rates being A stub period is also referred
put on bonds. The stub period is followed in such a way by adjusting to as an interim or half period
the number of expected cash flows concerning the date of entering consisting of six months in a
year.
into a transaction and forecasted them to be obtained within the half-
yearly term.

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126 FINANCIAL MODELLING

4.4.1 ANALYSIS OF BONDS AND SWAPS

A bond swap entails the sale of one debt instrument and the subse-
quent purchase of another debt instrument with the profits. Bond
swapping is a strategy used by investors to strengthen their fixed-in-
come portfolio financial situations.

Bond swapping, for instance, may lower an investor’s tax bill, increase
yield, alter the length of a portfolio, or assist a client in diversifying
their holdings to lower risk.
‰‰ Bonds are tradeable security that provides a fixed interest to the
holders of bonds. When the maturity period is over, the company
has to reimburse the principal value of bonds along with interest.
The investors who are acquiring the bonds are called bondholders

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or bond investors.
‰‰ A swap is an agreement that allows two parties to share the cash
reimbursements arising from the varied tradeable securities. It
is a kind of derivative contract. The cash payments can be in the
IM
form of interest rates, exchange rates, prices of equity or commod-
ities. In this, one of the cash flows is not consistent and the other
one is fixed.

SELF ASSESSMENT QUESTIONS

5. Which type of security is experiencing a stub period?

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a. Shares
b. Stocks
c. Bonds
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d. Debentures
6. What term is being described for the duration between the
valuation date and the end of the financial year?
a. Accounting year
b. Maturity term
c. Stub period
d. Future periods

ACTIVITY

Study the financial securities of any company being offered in the

stock market. Analyse the transaction dates and the ending term of
their accounting year. Then apply the concept of stub periods in a
proper report format concerning any year.

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4.5 PERFORMING SENSITIVITY ANALYSIS

Sensitivity analysis analyses the effects of different values of an inde-
pendent variable on a certain dependent variable under a specified
set of assumptions. Sensitivity analyses, in other words, examine how MARK IT!
various sources of uncertainty in a mathematical model impact the
Both the corporate sector
model’s overall level of uncertainty. This method is applied within pre- and the study of economics
determined bounds that hinge on one or more input variables. use sensitivity analysis. It is
often referred to as a what-if
Sensitivity analysis can be used to aid in forecasting share prices for study and is frequently utilised
publicly traded corporations. Earnings of the company, the number by economists and financial
of outstanding shares, debt-to-equity ratios (D/E) and the number of experts.
competitors in the market are a few factors that have an impact on
stock prices. By changing the underlying assumptions or including

S
new variables, the analysis of future stock prices can be improved.
The impact of changing interest rates on bond prices can also be
ascertained using this model.
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The enterprise value of a company is determined by a discounted cash
flow analysis as the present value of its anticipated free cash flows.
The requirement to consider and forecast major business factors is the NOTE
strength of DCF analysis. But even little modifications might result in Bond prices are the dependent
significant value fluctuations because DCF valuation is so dependent variable in this scenario,
whereas interest rates are the
on fundamental assumptions. Understanding the sensitivity of the independent variable.
DCF model to important assumptions requires sensitivity analysis of
critical variables.
M

SELF ASSESSMENT QUESTIONS

7. Which of the following of an enterprise can be determined by

a discounted cash flow analysis?
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a. Enterprise value
b. Net present value
c. Changes in cash equivalents
d. DCF analysis
8. Which of the following cannot use sensitivity analysis?
a. Corporate sector
b Economic sector
c. Financial sector
d. Social sector

ACTIVITY

Discuss and analyse the applicability of sensitivity analysis in busi-

ness.

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128 FINANCIAL MODELLING

CASH FLOWS: DCF “TOP DOWN”

4.6
VALUATION
By beginning with high-level market data and working “down” to rev-
enue, top-down forecasting is a technique for predicting a company’s
future performance. This strategy begins by looking at the big picture
before focusing on a particular business. The discounted cash flow
(DCF) method is centred on the following two key ideas:
‰‰ The cash generated by a company’s operating activities is referred
to as free cash flows or FCFs.
‰‰ The weighted average cost of capital (WACC) of the company is
the discount rate that has been modified to account for the risk
associated with the FCFs.

S
∞
FCFt
EV = ∑

t=1 (1 + WACC)t
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Here, EV = Economic value and FCF = Free Cash Flows

The aim is to value a company by taking into account the present

value of the FCFs, where FCF is defined as the cash flow to the firm
from its assets. The present value of the future FCFs discounted at
the WACC is the company’s Enterprise Value (EV) (the word assets
is used broadly, and can be fixed assets, intellectual and trademark
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assets and net working capital). The amount of cash generated by the
company’s operations is measured by its Free Cash Flow (FCF). There
are two widely accepted definitions of the FCF, which are both ulti-
mately equivalent.
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SELF ASSESSMENT QUESTIONS

9. The amount of cash generated by the company’s operations is

the measurement of which the following?
a. Operating cash flow b. Financing cash flow
c. Free cash flow d. Investing cash flow
10. The _______________of the company is the discount rate that
has been modified to account for the risk associated with the
FCFs.
a. WACC b. Cost of capital
c. Enterprise value d. Market value

ACTIVITY

Prepare a PPT on ‘Cash flows’.

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CONSOLIDATED STATEMENT OF CASH

4.7
FLOWS (CSCF)
The financing, investment and operating cash flows of all majority-
owned, legally separate firms are combined in a consolidated cash
flow statement. As a result, you cannot consolidate general partner-
ships or sole proprietorships since they lack legal distinction. Because
it summarises all of the firm’s cash flows, a consolidated cash flow
statement is often thought to be more useful to review than individ-
ual cash flow statements. Consolidated cash flow statements must be
prepared by GAAP, just as individual business cash flow statements.

Consolidated financial statements are a collection of financial state-

ments that include the financials of the parent firm and all of its

S
interests. Consolidation is required by GAAP, or generally accepted
accounting principles, because examining the financials of each con-
nected company separately can produce an inaccurate representation NOTE
of reality. The firm with the majority ownership is the parent com- The term “controlled entity”
IM refers to a subsidiary or division.
pany, sometimes known as the “controlling entity” in accounting.

A more realistic picture of overall performance can be obtained by

combining the parent company’s financials with those of any other
companies it owns.

If a parent submits their cash flow statement, a consolidated cash

M

flow statement is shown. As much as is practical, the consolidated

financial statements are given in the same format as the parent’s sep-
arate financial statements.

The process of preparing a consolidated cash flow statement is to cre-

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ate a separate cash flow statement for the main company as well as
any applicable subsidiaries, majority-owned investments or joint ven-
tures first. Next, use a worksheet to adjust any line items to remove
intercompany sales and transfers. If you attempt to integrate data
while also making the edits directly on the statement, confusion may
arise. Add each cash flow statement after that, along with the modi-
fications from the spreadsheet. A consolidated cash flow statement is
the result.

The adjustments that are required to offset the net impact of inter-
company sales and transfers since consolidation combines all results
into one and there is no accounting rule permitting a company to sell
or transfer goods or services to itself. Your company must have the
majority of the outstanding stock, membership interests or limited
partner interests in a business for consolidation rules to be applicable.
Your corporation must exclude a company from the consolidation if it
exercises “voting control but not ownership control” over it but does
not own at least 50% of it.

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130 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

11. In which of the following situations, a consolidated cash flow

statement is needed?
a. At the time of merger
b. At the time of winding up
c. In the case of group companies
d. At the time of book closure
12. Which of the following items should be removed at the time of
preparing the consolidated cash flow statement?
a. Operating cash flows b. Intercompany cash flows

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IM c. Financing cash flows d. Investing cash flows

ACTIVITY

Discuss the outcomes of making a consolidated cash flow statement.

FREE CASH FLOWS BASED ON

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4.8 CONSOLIDATED STATEMENT OF CASH

FLOWS (CSCF)
Every financial statement includes a consolidated statement of cash
NOTE flows. It is the accountant’s explanation of the amount of cash the com-
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Operating, investment and pany generated and how it was generated. Operating, investment and
financing cash flows make up financing cash flows make up the 3 main components of the CSCF. We
the 3 main components of the
follow the general process outlined below when using the CSCF to
CSCF.
calculate FCFs:
‰‰ We carefully assess the investment cash flows, leaving the invest-
ment cash flows associated with productive operations for the FCF
and removing those associated with the firm’s investment in finan-
cial assets.
‰‰ We accept the operating cash flows in the form that the company
reported.
‰‰ None of the financial cash flows are included in the FCF.
‰‰ We take effort to identify if a certain item is one-time or recurring
in every circumstance, removing the one-time items from consid-
eration.
‰‰ We increase the amounts of the revised CSCF statistics by adding
back net interest paid.

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CSCF, Section 1: Operating Cash Flows

The operating cash flows correct the firm’s net income for changes in
the operating net working capital as well as non-cash income deduc-
tions.

Modern accounting statements frequently include non-cash elements;

therefore, converting the company’s accounts to a cash basis requires
numerous modifications:
‰‰ Depreciation is typically added back to the firm’s income as a cor-
rection.
‰‰ Depreciationmust be added back when making the cash adjust-
ment because it is a non-cash charge on the firm’s income.

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‰‰ Depreciation, however, is only the very beginning of non-cash
expenses.
Study
‰‰ The value of stock options granted to employees by companies is Hint
deducted from the company’s income.
IM The real option charge is a
‰‰ The reasoning behind this is by granting its employees options, non-cash deduction and is
the company has provided them with something of value that must added back to the CSCF.
be taken into account in its income statement.
‰‰ The decline in goodwill (also known as “impairment”) must be
disclosed in a company’s income statements. For the company’s
owners, this impairment—the decline in the value of an intangible
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asset—represents a financial loss.

‰‰ However, because it is not a cash flow loss, it is added back to the
CSCF. For purposes of computing the firm’s free cash flows, we can
usually leave all the items in the operating cash flow section of the
CSCF.
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‰‰ Many other items can be included in this list.

CSCF, Section 2: Investment Cash Flows

All of the firm’s investments are included in the second section of the
CSCF. Both investments in securities and those made in the compa-
ny’s operating assets are included in these investments.
‰‰ A securities investment might relate to the sale or acquisition
of securities held by the firm. Investments in securities are not
included in the company’s free cash flows, which are primarily
intended to evaluate cash flows associated with the company’s pri-
mary business operations.
‰‰ The firm’s FCFs are typically connected to investments in fixed
assets.
‰‰ We must distinguish between financial investment cash flows (not
included in the FCF) and investments in assets used to generate

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132 FINANCIAL MODELLING

the firm’s revenue to calculate the firm’s free cash flows (part of
the FCF).

CSCF, Section 3: Financing Cash Flows

Changes to the firm’s finance are covered in the CSCF’s last section.
We can omit this portion for the sake of FCF.

Following are ABC Corp’s CSCF in figure 4.1 for:

‰‰ 2008 -2012
‰‰ 2008-2017

A B C D E F G
ABC CORPORATION
1 Consolidated Statement of Cash Flows, 2008-2012

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2 2008 2009 2010 2011 2012
3 Operating Activities:
4 Net earnings 479,355 495,597 534,268 505,856 520,273
Adjustments to reconcile net earnings to net cash
5 provided by operating activities
6 Add back depreciation and amortization 41,583 47,647 46,438 45,839 46,622
7 Changes in operating assets and liabilities:
8 Subtract increase in accounts receivable 9,387 25,951 -12,724 1,685 -2,153
IM 9 Subtract increase in inventories
Subtract increase in prepaid expenses and
-37,630 -22,780 -16,247 -15,780 -5,517

-52,191 13,573 16,255 14,703 -2,975

10 other assets
Add increase in accounts payable, accrued
29,612 51,172 6,757 40,541 60,255
11 expenses, pensions, and other liabilities
12 Net cash provided by operating activities 470,116 611,160 574,747 592,844 616,505 <-- =SUM(F4:F11)
13
14 Investing Activities:
15 Short-term investments, net -5,000 -55,000 50,000 -10,000 20,000
16 Purchases of property, plant, and equipment -48,944 -70,326 -89,947 -37,044 -88,426
Proceeds from dispositions of property, plant and
197 6,956 22,942 6,179 28,693
17 equipment
18 Net cash used in investing activities -53,747 -118,370 -17,005 -40,865 -39,733 <-- =SUM(F15:F17)
19
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20 Financing Activities:
21 Repayment of debt 0 0 -300,000 0 -7,095
22 Proceeds from revolving credit facility borrowings 1,242,431 0 0 0 250,000
23 Proceeds from the issuance of stock 48,286 114,276 69,375 68,214 37,855
24 Dividends paid -332,986 -344,128 -361,208 -367,499 -378,325
25 Stock repurchased -150,095 -200,031 -200,038 -200,003 -597,738
26 Net cash used in financing activities 807,636 -429,883 -791,871 -499,288 -695,303 <-- =SUM(F21:F25)
27
28 Changes in cash balances 1,224,005 62,907 -234,129 52,691 -118,531 <-- =F12+F18+F26
29
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30 Supplemental disclosure of cash flow information

31 Cash paid during the period for
32 Income taxes 255,043 175,972 314,735 283,618 305,094
33 Interest 83,553 83,551 70,351 57,151 57,910
34
35 Income tax rate 34.73% 26.20% 37.07% 35.92% 36.96% <-- =F32/(F4+F32)

Figure 4.1: Consolidated Statement of Cash Flows

Source: https://mzfsir.weebly.com/uploads/6/3/0/5/6305731/financial_modeling.compressed.pdf

To turn this CSCF into free cash flows:

‰‰ We keep all the items under operating activities.
‰‰ In the section for Investing Activities, we delete items that are not
related to operations. For instance, we would remove “short-term
investments, net” from the list of investing activities because these
transactions involve buying and selling financial assets. .
‰‰ We completely ignore the cash flows under Financing Activities
(that’s why it is blurred).
‰‰ We add back after-tax net interest to the sum of the remaining
items to neutralise the subtraction of interest from the net income.

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 Discounted Cash Flow (DCF) Analysis  133

The CSCF rewritten to free cash flow shown in Figure 4.2:

A B C D E F G
ABC CORPORATION
1 CSCF rewritten to Free Cash Flow (FCF)
2 2008 2009 2010 2011 2012
3 Operating Activities:
4 Net earnings 479,355 495,597 534,268 505,856 520,273
Adjustments to reconcile net earnings to net cash
5 provided by operating activities
6 Add back depreciation and amortization 41,583 47,647 46,438 45,839 46,622
7 Changes in operating assets and liabilities:
8 Subtract increase in accounts receivable 9,387 25,951 -12,724 1,685 -2,153
9 Subtract increase in inventories -37,630 -22,780 -16,247 -15,780 -5,517
Subtract increase in prepaid expenses and -52,191 13,573
10 other assets 16,255 14,703 -2,975
Add increase in accounts payable, accrued 29,612 51,172
11 expenses, pensions and other liabilities 6,757 40,541 60,255
12 Net cash provided by operating activities 470,116 611,160 574,747 592,844 616,505 <-- =SUM(F4:F11)
13
14 Investing Activities:
15 Short-term investments, net
16 Purchases of property, plant and equipment -48,944 -70,326 -89,947 -37,044 -88,426
Proceeds from dispositions of property, plant and
197 6,956 22,942 6,179 28,693
17 equipment
18 Net cash used in investing activities -53,747 -118,370 -67,005 -30,865 -59,733 <-- =SUM(F15:F17)
19
20 Financing Activities:
21 Repayment of debt

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22 Proceeds from revolving credit facility borrowings
23 Proceeds from the issuance of stock
24 Dividends paid
25 Stock repurchased
26 Net cash used in financing activities <--
27
28 Free cash flow before interest adjustment 416,369 492,790 507,742 561,979 556,772 <-- =F12+F18+F26
29 Add back after-tax net interest 54,537 61,658 44,271 36,620 36,504 <-- =(1-F37)*F35
30 Free cash flow (FCF) 470,906 554,448 552,013 598,599 593,276 <-- =F28+F29
31
32 Supplemental disclosure of cash flow information
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33 Cash paid during the period for
34 Income taxes 255,043 175,972 314,735 283,618 305,094
35 Interest 83,553 83,551 70,351 57,151 57,910
36
37 Income tax rate 34.73% 26.20% 37.07% 35.92% 36.96% <-- =F34/(F4+F34)

Figure 4.2: CSCF Rewritten to Free Cash Flow

Source: https://mzfsir.weebly.com/uploads/6/3/0/5/6305731/financial_modeling.compressed.pdf
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In another example, a company may be valued as shown in Figure 4.3:

A B C D E F G H
1 ABC CORP. VALUATION
Free cash flow (FCF)
2 year ending 31 Dec. 2012 593,276 <-- 593275.77278229
3 Growth rate of FCF, years 1-5 8.00% <-- Optimistic about short-term growth
4 Long-term FCF growth rate 5.00% <-- More pessimistic about long-term growth
5 Weighted average cost of capital, WACC 10.70%
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6
7 Year 2012 2013 2014 2015 2016 2017
8 FCF 640,738 691,997 747,357 807,145 871,717 <-- =F8*(1+$B$3)
9 Terminal value 16,057,940 <-- =G8*(1+B4)/(B5-B4)
10 T otal 640,738 691,997 747,357 807,145 16,929,657 <-- =G8+G9
11
12 Enterprise value 13,063,055 <-- =NPV(B5,C10:G10)*(1+B5)^0.5
Add back initial cash and marketable
13 securities 73,697 <-- From current balance sheet
14 Subtract out 2012 financial liabilities 1,379,106 <-- From current balance sheet
15 Equity value 11,757,646 <-- =B12+B13-B14
16 Per share (1 million shares outstanding) 11.76 <-- =B15/1000000

Figure 4.3: Valuation of ABC Corp.

Source: https://mzfsir.weebly.com/uploads/6/3/0/5/6305731/financial_modeling.compressed.pdf

SELF ASSESSMENT QUESTIONS

13. Which of the following section is the compulsory section of

free cash flow?
a. Financing cash flow
b. Operating cash flow
c. Investing cash flow
d. Total cash flow

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134 FINANCIAL MODELLING

14. ________________ is the part of free cash flow.

a. Productive investing activities
b. Financing activities
c. Sale of debentures
d. Sale of investment

ACTIVITY

Find out the difference between investment cash flow and financ-
ing cash flow.

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FREE CASH FLOWS BASED ON PRO
4.9
FORMA FINANCIAL STATEMENTS
Building a set of predicted financial statements based on our knowl-
IM
edge of the company and its financial statements is another method
for estimating free cash flows. Typical Pro Forma might resemble the
one shown in Figure 4.4:
A B C D E F G
1 PRO FORMA FINANCIAL MODEL
2 Sales growth 10%
3 Current assets/Sales 15%
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4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest paid on cash and marketable securities 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
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13 Year 0 1 2 3 4 5
14 Income statement
15 Sales 1,000 1,100 1,210 1,331 1,464 1,611
16 Costs of goods sold (500) (550) (605) (666) (732) (805)
17 Interest payments on debt (32) (32) (32) (32) (32) (32)
18 Interest earned on cash and marketable securities 6 9 14 20 26 33
19 Depreciation (100) (117) (137) (161) (189) (220)
20 Profit before tax 374 410 450 492 538 587
21 Taxes (150) (164) (180) (197) (215) (235)
22 Profit after tax 225 246 270 295 323 352
23 Dividends (90) (98) (108) (118) (129) (141)
24 Retained earnings 135 148 162 177 194 211
25
26 Balance sheet
27 Cash and marketable securities 80 144 213 289 371 459
28 Current assets 150 165 182 200 220 242
29 Fixed assets
30 At cost 1,070 1,264 1,486 1,740 2,031 2,364
31 Depreciation (300) (417) (554) (715) (904) (1,124)
32 Net fixed assets 770 847 932 1,025 1,127 1,240
33 Total assets 1,000 1,156 1,326 1,513 1,718 1,941
34
35 Current liabilities 80 88 97 106 117 129
36 Debt 320 320 320 320 320 320
37 Stock 450 450 450 450 450 450
38 Accumulated retained earnings 150 298 460 637 830 1,042
39 Total liabilities and equity 1,000 1,156 1,326 1,513 1,718 1,941

Figure 4.4: Pro Forma Financial Model

Source: https://mzfsir.weebly.com/uploads/6/3/0/5/6305731/financial_modeling.compressed.pdf

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 Discounted Cash Flow (DCF) Analysis  135

The free cash flow can be calculated as follows using the concept of
free cash flow analysis as shown in figure 4.5:

A B C D E F G
41 Year 0 1 2 3 4 5
42 Free cash flow calculation
43 Profit after tax 246 270 295 323 352
44 Add back depreciation 117 137 161 189 220
45 Subtract increase in current assets (15) (17) (18) (20) (22)
46 Add back increase in current liabilities 8 9 10 11 12
47 Subtract increase in fixed assets at cost (194) (222) (254) (291) (333)
48 Add back after-tax interest on debt 19 19 19 19 19
49 Subtract after-tax interest on cash and mkt. securities (5) (9) (12) (16) (20)
50 Free cash flow 176 188 201 214 228

Figure 4.5: Free Cash Flow

Source: https://mzfsir.weebly.com/uploads/6/3/0/5/6305731/financial_modeling.compressed.pdf

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Enterprise value can be calculated as shown in figure 4.6 using the
free cash flow calculated above.

A B C D E F G H
53 Valuing the firm
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54 W eighted average cost of capital 20%
55 Long-term free cash flow growth rate 5%
56
57 Year 0 1 2 3 4 5
58 FCF 176 188 201 214 228
59 Terminal value 1,598 <-- =G58*(1+B55)/(B54-B55)
60 Total 176 188 201 214 1,826
61
62 Enterprise value, present value of row 60 1,348 <-- =NPV(B54,C60:G60)*(1+B54)^0.5
63 Add in initial (year 0) cash and mkt. securities 80 <-- =B27
64 Asset value in year 0 1,428 <-- =B63+B62
65 Subtract out value of firm's debt today (320) <-- =-B36
66
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Equity value 1,108 <-- =B64+B65
67 Share value (100 shares) 11.08 <-- =B66/100

Figure 4.6: Enterprise Value

Source: https://mzfsir.weebly.com/uploads/6/3/0/5/6305731/financial_modeling.compressed.pdf
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SELF ASSESSMENT QUESTIONS

15. ________ should be added back to the operating profit of the

company for the calculation of free cash flow.
a. Depreciation
b. Discount
c. Rent
d. Insurance
16. Which of the following should be subtracted from the profits
to come at the free cash flow figure of the company?
a. Depreciation expense
b. Increase in current liabilities
c. Increase in current assets
d. After-tax interest on debt

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136 FINANCIAL MODELLING

ACTIVITY

Discuss the use of the application of free cash flow.

S 4.10 SUMMARY
‰‰ Discounted Cash Flow (DCF) analysis refers to the method used to
value investment by discounting the estimated future cash flows.
‰‰ DCF Analysis is one of the techniques that are applied to measure
the value of current investment in future periods.
‰‰ Unlevered free cash flow is the value that an organisation has
before reimbursing its financial liabilities.

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‰‰ Free cash flows are one of the appropriate indicators for analysing
the DCF valuation. It encompasses all the effects of leverage, that
is, the inclusion of interest charges.
‰‰ Terminal value is the worth of an investment project that is deter-
IM
mined beyond the defined estimated period. In this scenario, the
growth rate is expected to be constant for an indefinite time.
‰‰ Present value is referring to the amount that existed in the recent
scenario. It is the amount which an investor has in their hand
before investing.
‰‰ Future value is defined as the amount estimated after discounting
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the current worth based on the required number of periods.

‰‰ Discounting is referring to the method that measures the cash
flows in upcoming periods or the worth of the current value of the
investment.
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‰‰ The stub period is referring to the time duration between the start-
ing of an accounting year and the date of making a transaction.
‰‰ Sensitivity analysis assesses the effects of various independent
variable values on a particular dependent variable.
‰‰ For publicly traded firms, sensitivity analysis can be used to help
forecast share values. Top-down forecasting is a technique for pre-
dicting a company’s future performance.

KEY WORDS

‰‰ Discounting: The method that measures the cash flows in

upcoming periods or the worth of current value of an invest-
ment
‰‰ Stub period: The time duration between the starting of an
accounting year and the date of making a transaction
‰‰ Swaps: An agreement that allows two parties to share the cash
reimbursements arising from the varied tradeable securities

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 Discounted Cash Flow (DCF) Analysis  137

‰‰ Enterprise Value (EV): The present value of the future FCFs

discounted at the WACC
‰‰ Consolidated Statement of Cash Flows (CSCF): The explana-
tion of the amount of cash generated by the business, and how
the cash was generated

4.11 MULTIPLE CHOICE QUESTIONS

MCQ
1. When DCF is greater than the present cost, the investment
is ___________.
a. Non-profitable
b. Profitable

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c. Hold cash
d. At equilibrium
2. ___________ rate is the rate at which the value of cash flows is
being computed.
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a. Market
b. Future
c. Discount
d. Current
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3. Which is the value that an organisation has before reimbursing

its financial liabilities?
a. Unlevered free cash flow
b. DCF analysis
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c. Profit or loss statement

d. Terminal value
4. In forecasting terminal value scenarios, which of these is
expected to be constant for an indefinite time?
a. Market rate
b. Growth rate
c. Discount rate
d. Current rate
5. ___________ is the amount which an investor has in their hand
before investing.
a. Future value
b. Present value
c. Time value
d. Historical value

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138 FINANCIAL MODELLING

6. ___________ period is also referred to as an interim or half period

consisting of six months in a year.
a. Bonds
b. Valuation
c. Stub
d. Swaps
7. The amount of cash generated by the company’s operations is
measured by its ___________.
a. Free Cash Flow (FCF)
b. Discounted Cash Flows (DCF)
c. Time Value of Money

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d. CSCF
8. ___________ is similar to what-if study or analysis.
IM a. Sensitivity analysis
b. Historical analysis
c. Tradable security analysis
d. Stub period
9. The rates of ___________ can be varied with the type of investment
security.
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a. Discount
b. Market
c. Investment
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d. Growth
10. The statement of ___________ is the third report that describes
the cash position of an organisation.
a. Profit and loss
b. Cash flows
c. Balance sheet
d. Income

4.12 DESCRIPTIVE QUESTIONS

?
1. Describe the sensitivity analysis in detail.
2. Explain the concept of present value and discounting.
3. Define the terminal value.
4. What is discounted cash flow analysis? Also, define the free cash
flow.
5. Elaborate the stub period.

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HIGHER ORDER THINKING SKILLS

4.13
(HOTS) QUESTIONS
1. Match the following:

List I List II

I. Investment in securities i. Operating cash flows, invest-

ment cash flows and financing
cash flows.

II. Sensitivity analysis ii. The present value of the future

FCFs discounted at the WACC

III. Enterprise value iii. Evaluates how various values

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of an independent variable
impact a specific dependent
variable.

IV. Consolidated Statement of iv.

IM The sale or the purchase of
Cash Flows (CSCF) securities held by the firm.

Choose the right option.

a. I-i, II-iii, III-ii, IV-iv
b. I-iv, II-ii, III-i, IV-iii
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c. I-i, II-iii, III-iv, IV-i

d. I-iv, II-iii, III-ii, IV-i
2. This is followed in such a way by adjusting the number of expected
cash flows concerning the date of entering into a transaction and
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forecasting them to be obtained within the half-yearly term. It

is also referred to as an interim or half period consisting of six
months in a year. Choose the correct option.
a. Historical periods
b. Stub periods
c. Weighted Average Cost of Capital (WACC)
d. Discounting period
3. __________ represent the amount being spent on acquisition
of fixed assets and __________ represents the amount left after
deducting short-term assets and short-term liabilities.
a. Working capital, capital expenditure
b. Fixed assets, liquid assets
c. Capital expenditure, working capital
d. Goodwill, profit and loss account

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140 FINANCIAL MODELLING

4.14 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topics Q. No. Answer

Discounted Cash Flow (DCF) 1. d. Payback period
Analysis
2 b. Accounting statements

Present Value and Discount- 3. a. Market value

ing
4. d. Accounting rate of return

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Understanding Stub Periods 5. c. Bonds
6. c. Stub period
Performing Sensitivity Anal- 7. a. Enterprise value
IM
ysis
8. d. Social sector
Cash Flows: DCF “Top Down” 9. c. Free cash flow
Valuation
10. a. WACC
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Consolidated Statement of 11. c. In the case of group com-

Cash Flows (CSCF) panies
12. b. Intercompany cash flows
Free Cash Flows Based on 13. b. Operating cash flow
Consolidated Statement of
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Cash Flows (CSCF)

14. a. Productive investing
activities
Free Cash Flows Based on 15. a. Depreciation
Pro Forma Financial State-
ments
16. c. Increase in current assets

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Profitable
2. c. Discount
3. a. Unlevered free cash flow
4. b. Growth rate

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 Discounted Cash Flow (DCF) Analysis  141

Q. No. Answer
5. b. Present value
6. c. Stub
7. a. Free Cash Flow (FCF)
8. a. Sensitivity analysis
9. a. Discount
10. b. Cash flows

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. A sensitivity analysis examines how different values of an
independent variable affect a certain dependent variable in

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accordance with a particular set of assumptions. Sensitivity
analysis, in other words, examine how various types of uncertainty
in a mathematical model affect the level of uncertainty in the
model generally. Refer to Section 4.5 Performing Sensitivity
IM
Analysis
2. Present value is referring to the amount that existed in the
recent scenario. It is the amount which an investor has in their
hand before investing. For instance, a person who has $1,000 in
his hand is considered as current value unless he invests. Refer
to Section 4.3 Present Value and Discounting
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3. Terminal value is the worth of an investment project that is

determined beyond the defined estimated period. Refer to
Section 4.2 Discounted Cash Flow (DCF) analysis
4. DCF Analysis is one of the techniques that are applied to measure
the value of current investment in future periods. It enables the
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company to analyse the profitability of any long-term project

which can be the acquisition of any securities or any kind of fixed
asset whether it is tangible or intangible. It follows the concept of
the time value of money. Refer to Section 4.2 Discounted Cash
Flow (DCF) analysis
5. The stub period is referring to the time duration between
the starting of an accounting year and the date of making a
transaction. Refer to Section 4.4 Understanding Stub Periods

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. d. I-iv, II-iii, III-ii, IV-i
2. b. Stub Periods
3. c. Capital expenditure, working capital

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142 FINANCIAL MODELLING

4.15 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
‰‰ Swan, J. (2008). Practical financial modelling. Burlington, MA:
CIMA Publishing.
‰‰ Larrabee, D., & Voss, J. (2013). Valuation techniques. Hoboken,
New Jersey: John Wiley & Sons, Inc.

E-REFERENCES
‰‰ Borad, S., & Borad, S. (2022). Discounted Cash Flow Model.
Retrieved 25 August 2022, from https://efinancemanagement.com/
investment-decisions/discounted-cash-flow-model

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 C H A
5 P T E R

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

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CONTENTS

5.1 Introduction
5.2 Weighted Average Cost of Capital (WACC)
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Self Assessment Questions
Activity
5.3 Using the CAPM to Estimate the Cost of Equity
5.3.1 Estimating the Cost of Debt
5.3.2 Understanding and Analysing WACC
5.3.3 Concluding Valuation
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Self Assessment Questions

Activity
5.4 Computing the Value of the Firm’s Equity, E
5.4.1 Computing the Value of the Firm’s Debt, D
5.4.2 Computing the Firm’s Tax Rate, TC
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5.4.3 Computing the Firm’s Cost of Debt, rD

Self Assessment Questions
Activity
5.5 Two Approaches to Computing the Firm’s Cost of Equity, rE
Self Assessment Questions
Activity
5.6 Implementing the Gordon Model for rE
Self Assessment Questions
Activity
5.7 The CAPM: Computing the Beta, β
5.7.1 Using the Security Market Line (SML) to Calculate Merck’s
Self Assessment Questions
Activity
5.8 Cost of Equity, Ke/Ri.
Self Assessment Questions
Activity

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CONTENTS

5.9 Computing the WACC, Three Cases

5.9.1 Computing the WACC for Merck (MRK)
5.9.2 Computing the WACC for Whole Foods (WFM)
5.9.3 Computing the WACC for Caterpillar (CAT)
Self Assessment Questions
Activity
5.10 Summary
5.11 Multiple Choice Questions
5.12 Descriptive Questions
5.13 Higher Order Thinking Skills (HOTS) Questions
5.14 Answers and Hints

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5.15 Suggested Readings & References
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M
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 Weighted Average Cost of Capital (WACC) 145

INTRODUCTORY CASELET

WEIGHTED AVERAGE COST OF CAPITAL

The Weighted Average Cost of Capital (WACC) is useful to the

management or investors to arrive at an appropriate decision. Case Objective
For example, to evaluate different investment options, it is very This caselet study provides
important to use the relevant WACC with the help of which the a prelude to the Weighted
estimated future cash flows from available investment projects Average Cost of Capital
are converted into the present value of benefits by discounting (WACC).
them. Similarly, the WACC acts as the cut-off rate for appraising
and comparing the performance of a particular business project
against the hurdle rate. The WACC is used as a benchmark for
framing the firm’s credit and debt policies and for evaluating cap-
ital budgeting decisions. It is used to discount or compound the

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cash flows or a stream of cash flows.

The WACC can be described in two ways, i.e., the explicit cost of
capital and the implicit cost of capital. The explicit WACC pertains
to the clear cash outflows of a firm towards the utilisation of capi-
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tal, such as in the form of interest payment to debenture holders,
dividend payment to shareholders and repayment of the princi-
pal loan amount to financial institutions. Conversely, the implicit
WACC pertains to the opportunity loss of foregoing a better invest-
ment option by choosing an alternative course and it is not a cash
outflow. For instance, when a firm uses its bank deposit for busi-
ness purposes which earns an interest of 9.5% p.a., it forgoes the
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interest earnings from the bank on this deposit. The implicit cost
of capital, in this case, shall be 9.5% interest that could have been
earned by not using the deposit for business purposes.

The WACC for each source of finance can be determined sepa-

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rately, such as cost of equity, cost of preference share capital, cost

of long-term debt and cost of retained earnings.

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146 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Discuss the concept of Weighted Average Cost of Capital
(WACC)
>> Estimate the equity costs using CAPM
>> Utilise the common financial functions
>> Explain the concluding valuation
>> Describe the value of the firm’s equity, E
>> Compute the firm’s cost of equity, rE, using various approaches
>> Summarise the Gordon model for rE

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5.1 INTRODUCTION
Quick Revision In the previous chapter, you studied the Discounted Cash Flow (DCF)
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analysis, unlevered free cash flow, forecasting free cash flow and fore-
casting terminal value. The chapter also gave insight into Present
value and discounting, stub periods, performing sensitivity analysis
and DCF “Top Down” valuation of cash flows. In this chapter, you will
be apprised about Consolidated Statement of Cash Flows (CSCF),
free cash flows based on CSCF and free cash flows based on pro forma
financial statements.
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A business organisation collates finance from its investors (both equity

and debt investors) and utilises those funds to generate returns. These
investors are thus assuming a risk by enforcing trust that the organ-
isation will spend their financial resources prudently. Subsequently,
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investors require a return to compensate for owing the risk. This is

what we infer as the “investors’ required return” or you can say that
the shareholders’ position is the shareholders’ required return.

To gauge the return, you tend to use Weighted Average Cost of Capital
(WACC), which infers the anticipated rate of return on a portfolio of all
the business entity securities. WACC can be harnessed as the hurdle
rate (cost of capital/discount rate) for appraising upcoming projects. A
project that provides a yield that is greater than the WACC is liable for
analysis (i.e., positive NPV) since it furnishes an amount in surplus of
that which would be required to recoup the investors.

The cost of capital of an investor, in finance parlance, is at par with

the return, an investor can yield from the next ideal alternative invest-
ment. In other words, it is the opportunity cost of investing the same
money in various investments entailing the same risk and associated
traits. From a financing perspective, WACC is simply the cost which
is paid for making use of the capital. In another way, it exhibits a

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 Weighted Average Cost of Capital (WACC) 147

percentage return on investment that influences an investor to divert

money towards a particular project or company.

In place of their contribution to the total capital, the WACC is rep-

resented in terms of the return that long-term capital suppliers to a
business entity (such as shareholders, debenture holders, or lenders)
anticipate to receive as payment. When businesses get financing from
various sources, they are required to repay a sum of money in addition
to the principal, typically in the form of recurring interest payments.

In this chapter, you will study the Weighted Average Cost of Capital
(WACC), using the CAPM to estimate the cost of equity, estimating the
cost of debt, understanding and analysing WACC, concluding valua-
tion and aggregating the three methodologies. The chapter will give

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insight into computing the Value of the Firm’s Equity, computing the
Firm’s tax rate and computing the firm’s cost of debt. You will also gain
knowledge of two approaches to computing the firm’s cost of equity.
NOTE
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You will also gain perspective on implementing the Gordon model.
Also, CAPM: Computing the Beta, β along with using the Security The Weighted Average Cost of
Market Line (SML) to calculate Merck’s. Towards the end, you will Capital (WACC) serves as the
discount rate for calculating the
get to know about computing the WACC, Three Cases, computing the Net Present Value (NPV) of a
WACC for Whole Foods (WFM) and computing the WACC for Cater- business.
pillar (CAT).
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WEIGHTED AVERAGE COST OF CAPITAL

5.2
(WACC)
The average after-tax cost of capital of the firm from all sources which
consists of common stock, preferred stock and other forms of debt is
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called the Weighted Average Cost of Capital (WACC). It is the typical

interest rate expected by the company to finance its assets.

The required rate of return is calculated using the popular method,

that is, the WACC because it reflects the return that both the bond-
holders and the shareholders are required to supply the firm with cap-
ital in a single value.

A company’s WACC is probably going to be greater if its stock is

extremely volatile or if its debt is seen as risky since investors will
expect bigger returns.

WACC and its formula are used by all analysts, investors and firm
management for a variety of purposes. The cost of capital of the com-
pany is significant to calculate in corporate finance for different rea-
sons. For example, a corporation may calculate its net present value
using the WACC discount rate.

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148 FINANCIAL MODELLING

WACC is crucial when assessing the advantages of taking on new ini-

tiatives or buying an existing company. A merger is probably a wise
decision for the firm if it thinks it will, for example, create a return
greater than its cost of capital. Its management will want to deploy its
cash more wisely if they predict a return that will be less than what its
investors are hoping for.

The cost of capital becomes a crucial factor in determining a firm’s

potential for net profitability since the majority of enterprises rely on
borrowed money to operate. The cost of capital for a corporation is
calculated using its WACC. Both the company’s debt and equity are
taken into account in the WACC formula’s computation.

A lower WACC often implies a robust company that may draw inves-
tors at a reduced cost. A greater WACC, on the other hand, is often

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associated with enterprises that are seen to be riskier and need to
reward investors with larger returns.

Calculating a company’s cost of capital would be relatively easy if

Know More
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it only received funding from one source, such as common stock. If
The WACC is the rate at which investors believed they would receive a 10% return on their invest-
future cash flows must be ment in exchange for their shares, the firm’s cost of capital would be
discounted for a firm in order
to determine the current value
the same as its cost of equity or 10%. The cost of debt, for instance,
of the company. It depicts how would be 5% if the corporation received an average return of 5% on
the cash flows are thought to its existing bonds.
be risky.
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SELF ASSESSMENT QUESTIONS

1. Which of the following is calculated using the popular method,

that is, the Weighted Average Cost of Capital (WACC) because
it reflects the return that both the bondholders and the
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shareholders are required to supply the firm with capital in a

single value?
a. Required rate of return
b. Cost of capital
c. Risk-free return
d. None of these
2. Which of the following is crucial when assessing the advantages
of taking on new initiatives or buying an existing company?
a. Cost of capital
b. WACC
c. Required rate of return
d. Risk-free return

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 Weighted Average Cost of Capital (WACC) 149

ACTIVITY

Find out the advantages of Weighted Average Cost of Capital

(WACC).

USING THE CAPM TO ESTIMATE THE

5.3
COST OF EQUITY
A financial model used to determine an asset’s anticipated rate of
return is known as the capital asset pricing model (CAPM). The pre-
dicted returns on the market and a risk-free asset, as well as the asset’s
correlation with or sensitivity to the market, are used by CAPM to
achieve this (beta).

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The cost of shareholder equity is calculated using the Capital Asset
Pricing Model (CAPM) by corporate accountants and financial ana-
lysts when preparing capital budgets. The CAPM is often used to price
risky securities, generate anticipated returns for assets given the asso-
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ciated risk and determine the cost of capital. It is defined as the link
between systematic risk and expected return for assets.

CAPM is calculated by using the below formula:

E(Ri) = Rf + βi(E(Rm) – Rf)

E(Ri) = Capital asset expected return

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Rf = Risk-free rate of interest

βi = Sensitivity
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E (Rm) = Expected return of the market

The Weighted Average Cost of Capital (WACC) includes the cost of

equity as a fundamental component. The entire projected cost of all
capital under various financing schemes is often calculated using the
WACC. In an attempt to determine the most economical combination
of debt and equity financing, WACC is often utilised.

Let us say Company XYZ has a 15% rate of return and trades on the NOTE
S&P 1,000. With a beta of 1.5, the company’s stock is somewhat more The link between systematic
erratic than the general market. Based on a three-month T-bill, the risk, or the broad risks of
investing, and expected return
risk-free rate is 7.5%. for assets, particularly stocks, is
described by the Capital Asset
The cost of the company’s equity financing is 18.75% based on this Pricing Model (CAPM).
information.

RISK-FREE RATE

The Risk-Free Rate (rf) is the theoretical rate of return received on

zero-risk assets, which serves as the minimum return required on risk-

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150 FINANCIAL MODELLING

ier investments. The rate should reflect the yield to maturity (YTM) on
default-free government bonds of equivalent maturity as the duration
of the projected cash flows.

Real risk free rate is calculated by using below formula:

1 + Nominal Rf Rate
Real risk-free rate =
1+Inflation Rate

Nominal Risk-free Rate = (1 + Real Rf Rate) × (1 + Inflation Rate) – 1

First, here’s the formula:

Real Risk-Free Rate = Risk-Free Rate – Inflation Premium

Example: Say you’d like to invest in a 12-month certificate of deposit

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(CD) that yields 2.50%. If the current risk-free rate is 2.04%—the yield
of a 12-month T-bill—you’re coming out almost half a percentage point
ahead of the T-bill with the CD. Great work! Or is it?
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Let’s suppose the inflation rate is the same as it was in May 2022: 8.3%.
Now, do the math again.
Real Risk-Free Rate = 2.04% – 8.3%

So the real risk-free rate is -6.26%. By investing in the CD, you’d be

falling 6.26% short of keeping Cost of Equity = Risk-Free Rate of
Return + Beta × (Market Rate of Return - Risk-Free Rate of Return)
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current inflation rates.

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of

Return – Risk-Free Rate of Return)
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 .5% + (1.5 × (15% – 7.5%))

=7

= 18.75%

5.3.1 ESTIMATING THE COST OF DEBT

The effective interest rate that a business pays on its obligations,

such as bonds and loans, is known as the cost of debt. The cost of
debt may be expressed as either the before-tax cost of debt, which is
the amount owed by the business before taxes or the after-tax cost of
debt. The fact that interest charges are tax deductible accounts for the
majority of the difference between the cost of debt before and after
taxes.

The capital structure of the company consists of both the debt and
the equity. The capital structure of a company refers to how it uses
various funding sources, including debt, such as bonds or loans, to
support its overall operations and growth.

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 Weighted Average Cost of Capital (WACC) 151

Understanding the entire rate that a firm pays to employ different

kinds of debt financing is made easier with the assistance of the cost Know More
of debt measure. Because riskier businesses often have higher loan The compensation a business
costs, the metric may also provide investors with a sense of how risky gives to its creditors and debt
holders is known as the cost
the firm is in comparison to others. of debt. In order to cover any
risk exposure associated with
There are a few different approaches to determining a company’s cost lending to a firm, these capital
of debt. sources must be paid.

The after-tax cost of debt may be calculated by multiplying the for-

mula (Risk-free Rate of Return + Credit Spread) by the (1 - Tax Rate).
The theoretical rate of return for investment with zero risk is known
as the risk-free rate of return and it is most often used for the U.S.
Treasury bonds. The term “credit spread” refers to the yield differen-

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tial between the U.S. Treasury bond and another financial instrument
with the same maturity but a different credit grade.

This method is helpful since it considers changes in the economy as

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well as the debt load and credit score relevant to the organisation. The
credit spread will be bigger if the firm has more debt or a worse credit
rating.

Let us take an example where the company’s credit spread is 6%, risk-
free rate of return is 2.5% and its pre-tax cost of debt is 7%, if the tax
rate is 40 per cent.
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Solution:

The cost of debt after taxes is 5.1% or [(0.025 + 0.06) × (1 - 0.40)].

A corporation might figure out the total amount of interest it is pay-

ing on each of its obligations for the year as an alternate method of
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calculating the after-tax cost of debt. The risk-free rate of return and
the credit spread from the formula above is included in the interest
rate that a firm pays on its loans since the lender(s) will consider both
when originally computing an interest rate.

The amount of interest paid by the business for the year is divided
by the sum of its debt. This represents the company’s overall average
interest rate on debt. The average interest rate is multiplied by the
(1 - tax rate) for the calculation of the after-tax cost of debt.

For example: A business had an `3,00,000 loan with an 8% interest

rate and an `10,00,000 million loan with a 4% interest rate. The aver-
age interest rate is 4.92%, which is [(`10,00,000 × 0.04) + (`300,000 ×
0.08)] ÷ `13,00,000, or the pre-tax cost of debt. The tax rate for the
business is 40%. Therefore, its cost of debt after taxes is 2.95%, or
[0.0492 × (1 - 0.40)].

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5.3.2 UNDERSTANDING AND ANALYSING WACC

The WACC of a company is a measure of its total cost of capital, which

includes debt, common shares and preferred shares. Each sort of cap-
ital’s cost is multiplied by how much of the overall capital it makes up.

WACC is used in financial modelling as the discount rate to determine

a business’s net present value.

WACC’s formula is as follows:

WACC = (E/V × rE) + ((D/V × rD) × (1 – T))

Where,
E = market value of the firm’s equity (market cap)

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D = market value of the firm’s debt
V = total value of capital (equity plus debt)
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E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
rE = cost of equity (required rate of return)
rD = cost of debt (yield to maturity on existing debt)
NOTE
The Weighted Average Cost of T = tax rate
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Capital (WACC), which includes

ordinary stock, preferred stock, Following is an expanded version of the WACC formula that incorpo-
bonds, and other types of debt, rates the price of preferred stock (for companies that have it):
is the average after-tax cost
of capital for a company. The WACC = Cost of Equity × % Equity + Cost of Debt × % Debt × (1 –
WACC is the typical interest
rate that a business anticipates
Tax Rate) + Cost of Preferred Stock × % Preferred Stock
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paying to finance its assets.

Based on the ratio of equity, debt and preferred stock a firm possesses,
the WACC’s goal is to calculate the cost of each component of the cap-
ital structure. Each element costs the firm money.

The interest rate on the company’s debt is fixed, and the yield on its
preferred stock is also set. Even if a company’s return on common
stock is not predetermined, equity holders are often paid dividends in
the form of cash.

Since the WACC is a crucial component of a DCF valuation model, it is

crucial for finance professionals to comprehend this idea, particularly
those who work in investment banking and corporate development.

WACC PART 1 – COST OF EQUITY

The Capital Asset Pricing Model (CAPM), which compares rates of

return to volatility, is used to determine the cost of stock (risk vs.
reward).

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 Weighted Average Cost of Capital (WACC) 153

The cost of equity formula is as follows:

rE = rF + β × (rM − rF)

Where,

rF = the risk-free rate (typically the 10-year U.S. Treasury bond yield)

β = equity beta (levered)

rM = annual return of the market

An implied cost or opportunity cost of capital is the cost of equity. It is

the rate of return that, in principle, investors need to be compensated
for the risk involved in stock investments. The beta measures how
volatile a stock’s returns are compared to the market as a whole (such

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as the S&P 500).

RISK-FREE RATE
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The return that may be obtained by investing in an asset that carries
no risk, such as the U.S. Treasury bonds, is known as the risk-free
rate. The risk-free rate is typically calculated using the yield of the
10-year US Treasury.

EQUITY RISK PREMIUM (ERP)

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Equity Risk Premium (ERP) is the additional yield that may be obtained
by investing in the stock market above the risk-free rate. Subtract- NOTE
ing the risk-free return from the market return is a straightforward The extra return that stock
method for estimating ERP. Usually, this information is sufficient for market investing offers above
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most simple financial analyses. ERP estimation may, however, be a far a risk-free rate is referred to as
more complex undertaking in practice. Banks often adopt ERP from the equity risk premium.
a journal called Ibbotson’s.

LEVERED BETA

The term “beta” describes how volatile or risky a stock is in compari-

son to all other equities on the market. There are several methods for
calculating a stock’s beta.

The first and easiest method is to determine the company’s history

beta (using regression analysis) or simply to use Bloomberg to get the
company’s regression beta.

The second and more comprehensive method is to update the beta

calculation using similar public business data.

This method involves calculating each company’s unlevered beta after

obtaining the beta of similar firms from Bloomberg.

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154 FINANCIAL MODELLING

The unlevered beta is calculated by using below formula:

Unlevered Beta = Levered Beta ÷ (1 + (1 – Tax Rate) × (Debt ÷

Equity))

Know More Levered beta takes into account both company risk and debt-related
In order to quantify this systemic risk. Unlevered beta (asset beta), however, is computed to eliminate
risk, CAPM was developed. It is extra risk from debt to examine pure business risk since various
frequently used in the financial organisations have varied capital structures.
industry to value hazardous
securities and calculate
The capital structure of the firm being appraised is then taken into
projected returns for assets
given their risk and cost of account when calculating and re-levying the average of the unlevered
capital. betas.

The levered beta is calculated by using below formula:

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Levered Beta = Unlevered Beta × ((1 + (1 – Tax Rate) × (Debt /
Equity))

When beta is re-levered, the firm’s present capital structure is often

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used. Beta would then be re-levered using the firm’s goal capital
structure if there was any indication that the capital structure of the
company would change in the future.

After determining the equity risk premium, risk-free rate and lever-
aged beta, The Cost of Equity = Risk-free Rate + Equity Risk Pre-
mium × Levered beta. Figure 5.1 shows the slope of the line:
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Beta = Slope of the Line

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Market (% change)

Share (% change)

Figure 5.1: Slope of the Line

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 Weighted Average Cost of Capital (WACC) 155

WACC PART 2 – COST OF DEBT AND PREFERRED STOCK

The simplest element of the WACC calculation is arguably calculat-

ing the cost of debt and preferred shares. The yield on the company’s
debt is the cost of debt, while the yield on the preferred stock is the
cost of preferred stock. Just multiply the preferred stock yield and the
proportion of debt and preferred stock in the capital structure of the
company.

The cost of debt must be multiplied by (1 - Tax rate), which is referred

to as the value of the tax shield since interest payments are tax deduct-
ible. Because preferred dividends are paid from after-tax earnings,
this is not done for preferred shares.

The after-tax cost of debt to be utilised in the WACC calculation is

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obtained by multiplying the weighted average current yield to matu-
rity of all existing debt by one less the tax rate.

5.3.3 CONCLUDING VALUATION

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Forecasting a company’s Free Cash Flow (FCF) into the future and
discounting it to its Net Present Value (NPV) at the WACC is known as
financial modelling and valuation. Alternative techniques of valuing
include previous deals and examination of similar companies. These
techniques are used to value businesses in preparation for mergers,
purchases and capital raising.
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The technique of valuation analysis is used to determine the rough

value or worth of any item, including businesses, stocks, fixed-income
securities, commodities, real estate and other assets. For various asset
types, the analyst may use various methodologies to value research,
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but a common theme will be a focus on the fundamentals of the asset.

A certain amount of art and science go into value research since the
analyst must make assumptions regarding model inputs (number
crunching). In essence, the value of an asset is determined by the NOTE
Present Value (PV) of all projected future cash flows. For instance, the The conclusion of value may be
estimating model for a business includes a number of assumptions expressed as a single value or a
range of values
regarding sales growth, margins, financing choices, capital expendi-
tures, tax rates, discount rates for the PV calculation, etc.

After the model is created, the analyst may play about with the
variables to see how valuation changes when other hypotheses are
included. Not all asset classes can be included into one model. While
a real estate company would be best modeled with current net operat-
ing income (NOI) and capitalisation rate (cap rate) and a manufactur-
ing company may be amenable to a multi-year DCF model, commodi-
ties like iron ore, copper, or silver would be subject to a model focused
on global supply and demand forecasts.

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? DID YOU KNOW SELF ASSESSMENT QUESTIONS

Investors anticipate receiving 3. The cost of shareholder equity is calculated using which of
compensation for the time value
the following model by corporate accountants and financial
of money and risk. The time
value of money is taken into analysts when preparing capital budgets?
consideration by the risk-free a. Weighted Average Cost of Capital
rate in the CAPM calculation.
The other elements of the CAPM b. Capital asset pricing model
formula take the investor’s
increased risk into account. c. Cost of capital
d. Risk-free return
4. Forecasting a company’s __________ into the future and
discounting it to its Net Present Value (NPV) at the Weighted
Average Cost of Capital (WACC) is known as financial

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modelling and valuation.
a. Discounted Cash Flow (DCF)
b. Free Cash Flow (FCF)
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c. Both a. and b.
d. None of these
5. Which of the following is the cost of equity; is the rate of return
that, in principle, investors need to be compensated for the
risk involved in stock investments?
a. Sunk cost b. Opportunity cost
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c. Product cost d. None of these

6. Which of the following describes how volatile or risky a stock
is in comparison to all other equities on the market?
a. Levered beta
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b. Unlevered beta
c. Risk-free Rate
d. Equity Risk Premium (ERP)

ACTIVITY

Discuss the limitations of the cost of equity.

COMPUTING THE VALUE OF THE FIRM’S

5.4
EQUITY, E
The value of the company’s equity may be calculated in the simplest
of all WACC calculations: Take E to be the product of the number of
shares outstanding times the current share price as long as the firm is
publicly traded.

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 Weighted Average Cost of Capital (WACC) 157

Take Red Bull & GoPro Partners, a corporation listed on the New York
Stock Exchange that owns gas pipelines and gas storage facilities, as
an example. There are `2,10,00,000 shares of EPB outstanding as of
July 30, 2021, at an `55 share price. The corporation is worth Equity of
`1,15,50,000 which is shown in Figures 5.2 and 5.3:

Figure 5.2: Formula used in Computation of the Value of Equity

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Figure 5.3: Computation of the Value of Equity

5.4.1 COMPUTING THE VALUE OF THE FIRM’S DEBT, D

The market value of the company’s financial debt less the market
value of its surplus liquid assets is used to calculate the debt value of
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the company. The amount of the company’s debt on the balance sheet,
less the value of the firm’s cash holdings and less the value of its mar-
ketable securities, is a popular estimate for this quantity. Figures 5.4
and 5.5 provide illustrations for Delta:
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Figure 5.4: Formula used in Calculating Net Debt

Figure 5.5: Computation of Net Debt

To calculate the WACC, additional debt-related things such as pension

obligations and deferred taxes are not included in our definition of

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158 FINANCIAL MODELLING

debt. Although we include them as debts, it is difficult to assign a cost

to them. Instead, we choose to use solely financial commitments net of
liquid assets to approximate the WACC.

A corporation may have negative net debt, which happens when it has
more cash on hand and marketable securities than debt. We set D in
the WACC calculation to be negative in this case. Examples include
Intel and Whole Foods Markets in Figures 5.6 and 5.7:

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Figure 5.6: Formula using in Calculating Debt
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Figure 5.7: Computation of Debt

5.4.2 COMPUTING THE FIRM’S TAX RATE, TC

The firm’s marginal tax rate should be measured using TC in the

WACC calculation, however, it is typical to do so by calculating the
firm’s reported tax rate. Typically, this shouldn’t be an issue, as shown
by the Figures 5.8 and 5.9:

Figure 5.8: Formula used in Calculating Tax Rate

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 Weighted Average Cost of Capital (WACC) 159

Figure 5.9: Computation of Tax Rate

With a range of 11% to 16%, Whole Foods’ tax rate is comparatively

consistent. We would most likely use the current tax rate or the aver-
age of the last several years in our WACC calculation.

In some cases, however, this does not work, as shown in Figures 5.10
and 5.11:

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Figure 5.10: Formula using in Calculating Merck Tax Rate
M

Figure 5.11: Computation of Merck Tax Rate

A reasonable estimate for the tax rate appears to be between 8% and

11%. A company like Merck is quite good at allocating its income
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to practical tax havens. Despite Merck having a low income year

in 2019, these tax planning strategies did not succeed. We would
most likely infer that Merck’s company’s future tax rate TC is in
the range of the tax rates from 2018 and 2020, assuming that Mer-
ck’s future profitability is suggested by the two strong years 2018
and 2020.

5.4.3 COMPUTING THE FIRM’S COST OF DEBT, RD

The cost of debt, rD and calculation is the next step. In theory, rD is

the marginal cost of borrowing an extra dollar from the corporation Know More
(before corporate taxes). The effective interest rate that a
business pays on its obligations,
The cost of debt for the company may be determined in at least three such as bonds and loans, is
known as the cost of debt. The
different ways. Following a brief description of them, we will demon- cost of debt may be expressed
strate the usage of two approaches that, although having certain theo- as either the before-tax cost of
retical shortcomings, are often employed in reality. debt, which is the amount owed
by the business before taxes, or
‰‰ Practicallyspeaking, the average cost of the firm’s current debt the after-tax cost of debt.
may often be used to estimate the cost of debt. This technique has

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160 FINANCIAL MODELLING

the drawback of perhaps confounding the historical expenses with

the projected future costs of debt, which is what we want to assess.
‰‰ We may take advantage of the yield of recently issued, similarly
risky corporate securities. We may use the average yield on medi-
um-term, A-rated debt as the firm’s cost of debt if a corporation
has predominantly medium-term debt and is rated A. Because the
cost of debt is the anticipated return on a firm’s debt, as opposed to
the yield on a bond, this measure is rather troublesome. The prom-
ised return is often greater than the anticipated return since there
is typically a danger of default. However, despite the drawbacks,
Know More this approach is often a suitable compromise.
The effective after-tax rate that
a borrower pays on its loan is ‰‰ We may use a model that calculates the cost of debt based on
known as the cost of debt. The information on the bond prices issued by the company, predicted

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cost of preferred stock and the default probability and expected pay-outs to bondholders in the
cost of equity make up the other
two elements of a company’s event of default. It would only be considered in the cost of capi-
total cost of capital, which tal estimates if the company we are examining had a significant
includes the cost of debt. amount of hazardous debt.
IM
The first two techniques mentioned above are quite simple to use, and
many of the issues or mistakes they face are not serious.

The cost of the firm’s debt is not effectively taken into account by any
of these methods for determining risk, theoretically. The third strat-
egy, which determines the anticipated return on a company’s debt, is
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more in line with standard financial theory but also more difficult to
put into practice. As a result, the effort might not be worthwhile.

The cost of debt for Indian Steel and Merck is calculated using the first
two of these approaches in the remaining paragraphs of this section.
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Method 1: Indian Steel’s Average Cost of Debt

For Indian Steel we compute the average cost of debt:

Current Year's Net Interest Paid

rD =
Average Net Debt Over this and Pr evious Year

Figures 5.12 and 5.13 illustrate a number of features important to note

in our computations:

Figure 5.12: Formula used in Calculating Cost of Debt

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 Weighted Average Cost of Capital (WACC) 161

Figure 5.13: Computation of Cost of Debt

It is crucial to include all financial debt in the calculation of the aver-

age cost of debt (rD) based on the financial accounts, without making
a distinction between short-term and long-term obligations. Liquid

S
assets such as cash and its equivalents are treated as negative debt
and are subtracted from the firm’s debt. The concept behind this is
that the company might utilise some of its cash to pay off some of its
debt, leaving the remaining amount as the firm’s actual debt financ-
IM
ing. The application of this specific theory, however, is primarily a
matter of judgement, we may not want to calculate the firm’s cost of
borrowing instead of the interest it earns on cash, and we might not
want to assign all cash to the potential of paying off debt.

If we were to anticipate Indian Steel’s future cost of debt using its

average cost of debt, we most likely would use its present cost, rD =
M

4.76%, in the WACC calculation. This is due to our conviction that past
debt expenses are not very indicative of future expenditures.

CASH RAISES THE COST OF DEBT: THE CASE OF MERCK

N

The average cost of debt, based on net interest and net debt, is greater
than the cost of borrowing when a corporation has cash holdings that
generate less interest than the cost of borrowing.

Assume that the interest rate on cash is lower than the interest rate on
debt to observe this:
Interest Paid – Interest Earned
Average Cos t of debt =
Interest Paid Debt– –Interest
Cash Earned
Average Cos t of debt =
Average Cos t of debt =
Interest Paid –
Debt × iDebt – CashCash
Debt –Interest Debt × iDebt – Cash × ( iCash
× iCash Earned − ε)
= Interest Paid
Debt – –Interest
Cash =Earned
Debt × iDebt – Cash × ( iCash − ε)
Average Cos t of debt = Debt ×Debt
iDebt –– Cash ×
Cash Cash = i Debt – Cash
=
(Debt
Debt×Debt
−iDebt
Debt
Cash
– Cash
) × iDebt× +iCash
– Cash ε ×= Debt
Cash × i – Cash
Debt – Cash
Debt × ( iCash − ε)
=
= Debt × i – Cash × i Debt × i – Cash × ( iCash − ε)
=
=
(Debt Debt− Debt
Cash
Debt ) ×− iCash
– Cash Debt + ε × =
Cash Cash Debt – Cash
Debt

=
(Debt Debt− Cash
Debt
Cash ) ×− iCash
– Cash
Debt + ε × Cash
Debt – Cash
= i(Debt
Debt + − Cash ) × iDebt×+ε ε>×iDebt Cash
=i DebtCash
Debt − Cash
− Cash
= Debt + Debt − Cash× ε > iDebt
DebtCash− Cash
= iDebt + Cash × ε > iDebt
= iDebt + Debt − Cash × ε > iDebt
Debt − Cash

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162 FINANCIAL MODELLING

The Figures 5.14 and 5.15 below show Merck’s spectacular perfor-
mance:

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Figure 5.14: Formula used in Calculating Merck Cost of Debt
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Figure 5.15: Calculation of Merck Cost of Debt

In 2021, Merck’s borrowing costs were 4.23%, but the company made
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a respectable 1.46% on its significant cash and short-term investment

assets. We may incorrectly conclude that this shows that there is debt
between these two numbers, which represents Merck’s normal net
cost. Rather, the calculations demonstrate that rD = 13.38%
Average Net Interest Paid 2020 2021
rD =
Average Net Debt 2020 2021
5,50,000
=
41,12,000

= 13.38%

This estimate of rD takes into account the expenses associated with

maintaining large liquid asset reserves that provide such meagre
financial returns. Merck would have benefitted its shareholders from
a strictly financial standpoint by utilising the liquid assets to repay its
debt or by paying them out as dividends or share repurchases.

What figure would we use in the WACC equation to indicate the mar-
ginal cost of borrowing? This relies on how we see Merck’s financial

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 Weighted Average Cost of Capital (WACC) 163

strategy: 13.38% can be a plausible estimate of the cost of debt if we

assume that the company will continue to maintain high levels of
financial debt while also building up its cash reserves. On the other
hand, if we assume that Merck’s marginal debt financing consists only
of debt, without a concurrent accumulation of cash, then rD should be
closer to 4%.

Method 2: rD as the Rating-Adjusted Yield for Merck

Another technique to calculate Merck’s borrowing costs is to extrap-

olate the marginal cost of its loan from a yield curve for the relevant
debt. Merck has ratings from Fitch of A +, Standard & Poor’s of
BBB + and Moody’s of BAA2. We get information for more than 1,000
A-Fitch rated bonds from Yahoo; most of this information is buried in
Figure 5.16:

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Know More
The free cash flow yield for
Merck’s most recent twelve
months is 6.3%. From the fiscal
years ending in December 2017
through 2021, Merck’s free
cash flow yield averaged 3.8%.
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From the fiscal years ending in

December 2017 through 2021,
Merck’s had a median free cash
flow yield of 3.9%.
Figure 5.16: Calculation of Fitch Rate

These statistics are graphed, which either demonstrates that they

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cover a broad range of real credit risks or that the market is inefficient
as shown in Figure 5.17:
10% Term Structure, A Bonds, 17 August 2022

8%

6%

4%

2% y = 8E-06x3- 0.0004x2+0.008x + 0.0005

R2 = 0.4895

0%
5 10 15 20 25 30 35
Bond Maturity
-2%

Figure 5.17: Term Structure of a Bond Maturity

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164 FINANCIAL MODELLING

About 50% of the variability of the yields as a function of time to matu-

rity is described by the polynomial regression line. The cost of bor-
rowing for Merck is 3.96% when using this regression equation and
assuming a 7-year average term for its debt as shown in Figures 5.18
and 5.19:

Figure 5.18: Formula used in Calculating Merck’s r D

from the A-Yield Curve

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Figure 5.19: Calculation of Merck’s r D from the A-Yield Curve

SELF ASSESSMENT QUESTIONS

7. Which of the following of the company’s financial debt less the

market value of its surplus liquid assets is used to calculate
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the debt value of the company?

a. Current value b. Historical value
c. Market value d. None of these
8. Which of the following are treated as negative debt and are
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subtracted from the firm’s debt?

a. Non-current assets b. Liquid assets
c. Non-current liabilities d. Fixed assets

ACTIVITY

Write a short note on the importance of the Firm’s Equity.

TWO APPROACHES TO COMPUTING THE

5.5
FIRM’S COST OF EQUITY, RE
The Weighted Average Cost of Capital (WACC) is calculated as follows:
WACC = E / (E + D) × rE + E / (E + D) × rD × (1 – TC). We have already
covered the estimate of four of the five WACC equation parameters in
this chapter: E, D, TC and rD. The calculation of the cost of equity, or rE,

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 Weighted Average Cost of Capital (WACC) 165

is the most challenging of the calculations linked to the WACC param-

eters. There are two methods for computing rE that are simple to use:

According to the Gordon dividend model, rE is calculated based on the

current dividend, Div 0, the stock price, P 0 and the expected growth
of future dividends, g:

Div 0 (1 + g )
rE = +g

P0

The anticipated return on the market E (rM), the risk-free rate rf and a
firm-specific risk measure are used in the capital asset pricing model
(CAPM) to calculate rE:
rE = rF + β [E(rM) – rF]

S
Where,

rF = the market risk-free rate of interest

NOTE
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E (rM) = the expected return on the market portfolio The return needed by either
a business or an individual to
Cov ( rstock , rM ) justify an investment in equity is
β = a firm-specific risk measure = known as the cost of equity.
Var ( rM )
M

SELF ASSESSMENT QUESTIONS

9. According to the Gordon dividend model, rE is calculated

based on
a. Current dividend
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b. Ex-dividend
c. Both a. and b.
d. None of these

ACTIVITY

Find some more examples to calculate the cost of equity.

IMPLEMENTING THE GORDON MODEL

5.6
FOR RE
The Gordon Dividend Model uses the following deceptively simple
sentence to calculate the cost of equity:

The present value of a share’s projected future dividend stream, dis-

counted at the appropriate risk-adjusted cost of equity (rE), is what
determines the share’s worth.

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166 FINANCIAL MODELLING

When dividend growth is expected to remain constant in the future,

the Gordon model may be used with ease. If the present stock price
is P0, the current dividend is Div 0 and the predicted growth rate of
future dividends is g, then these factors are all true. According to the
Gordon model, the stock price is equal to the future dividends that
have been discounted (at the appropriate cost of equity, rE):

Div 0 (1 + g ) Div 1 × (1 + g ) Div 1 × (1 + g ) Div 1 × (1 + g )

2 3 4

P0 = + + + ...
1 + rE (1 + rE ) 2
(1 + rE ) 3
(1 + rE )4
Div 0 × (1 + g )
∞ t

=∑
t=1 (1 + rE )t
Div 0 × (1 + g )
∞ t

Provided that | g | < rE, the expression = ∑

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can be
t=1 (1 + rE )t
Div 0 (1 + g )
reduced to (We will save you from reading this derivation,
rE − g
IM
which is based on a geometric series formula typically covered in high
school.) Thus, we obtain the Gordon model cost of equity given a con-
stant expected dividend growth rate as follows:
Div 0 (1 + g ) , provided |g| < r
P0 = E
rE − g
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The Gordon formula for the cost of equity may be found by solving the
? DID YOU KNOW aforementioned equation for r E:
When evaluating a company’s
shares, the Gordon Growth Div 0 (1 + g )
Model (GGM) makes the rE = + g, provided |g| < rE
P0
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assumption that it will always

exist and that dividends will rise
steadily. Note the proviso after this equation: For the infinite sum on the first
line of the formula to have a finite solution, the dividend growth rates
must be lower than the discount rate. In our analysis of the Gordon
model with supernormal growth rates, we go back to the condition
when this is false as shown in Figure 5.20. Consider a company whose
share price is P0 = `50 and whose current dividend is Div 0 = `3 per
share to use this formula. Let us say it is projected that the dividend
will increase by 12% annually. The firm’s cost of equity is 17.6% at that
point as shown in Figures 5.21:

Figure 5.20: Formula using in Calculating Gordon

Model Cost of Equity

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 Weighted Average Cost of Capital (WACC) 167

Figure 5.21: Computation of Gordon Model Cost of Equity

Using the Gordon Model to Compute the Cost of Equity for Merck

The 10-year dividend history of Merck is shown here, take notice that
part of the data has been obscured when we apply the Gordon model
to this company as shown in Figures 5.22 and 5.23:

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Figure 5.22: Formula used in Calculating Merck Dividend History
M
N

Figure 5.23: Computation of Merck Dividend History

Depending on the time frame used, the historical dividend growth

rate for Merck might be either 1.55% or 2.02%. Which of these rates is
a better predictor of future expected dividend growth rates to calcu-
late the cost of equity rE? We take into account both scenarios in the

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168 FINANCIAL MODELLING

worksheet that follows. Merck’s stock price as of the end of June 2012
is used in the computations is

P0 = `41.75 as shown in Figure 5.24:

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Figure 5.24: Computation of Merck r E With the Golden Model

Given the uncertainty in our future projections, these figures are, in

IM
all practical respects, equal, keep in mind that we are attempting to
forecast future dividend increases based on historical dividend distri-
butions.
Adjusting the Gordon Model to Account for All Cash Flows to Equity
The Gordon model is calculated on a per-share basis and just for divi-
dends, as was previously shown. However, the Gordon model needs to
M

be expanded to incorporate all cash flows to equity to value the firm’s

equity. Cash flows to equity consist of at least two additional elements
in addition to dividends:
‰‰ Around 50% of the total cash distributed to shareholders by Amer-
ican firms today comes through share repurchases.
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‰‰ The company’s issuing of shares represents a significant negative

cash flow to equity. The most significant stock issuance occurs
when workers exercise their stock options in numerous compa-
nies.
We must update the Gordon model in terms of total equity value to
account for these new cash flows to equity. Gordon’s fundamental val-
uation methodology is now:

Cash Flow to Equity 0 × (1 + g )

∞ t

Market value of equity = ∑

t=1 (1 + rE )t
Where
g = Anticipated growth rate of cash flow equity
This gives the formula for the cost of equity rE as:
Cash Flow to Equity 0 (1 + g )
rE = + g, if |g|< rE
Market Value of Equity

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 Weighted Average Cost of Capital (WACC) 169

For Merck, we consider the data below as in Figures 5.25 and 5.26:

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Figure 5.25: Formula used in Calculating Golden Model Merck’s Eq-
uity Pay-outs
M
N

Figure 5.26: Computation of Golden Model Merck’s Equity Pay-outs

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170 FINANCIAL MODELLING

Merck’s cost of equity is rE = 19.46% if we assume that its historical

growth rate of cash flow to equity, which is 13.71%, would continue
indefinitely. This seems a little excessive.

“Supernormal Growth” and the Gordon Model

Div 0 (1 + g )
A basic condition of the Gordon formula rE = + g is the cir-
P0
cumstance | g | rE. In financial instances, breaches of | g | rE often
happen for very fast-growing enterprises, where we predict extremely
high growth rates, at least temporarily, such that g > rE. The origi-
nal dividend discount calculation demonstrates that P0 would have an
endless value if such “supernormal” growth were to continue over the

S
* (1 + g )
t
∞
Div 0 ×
long term because when g > rE, the expression ∑ =∞
t=1 (1 + rE )t
As a result, a period of very high dividend growth rates (where, g > rE)
IM
must be followed by a time where the long-term growth rate of divi-
dends is lower than the cost of equity, where g rE

Let us say that the company expects to pay high-growing dividends for
periods 1... and m and that the dividend growth rate would be reduced
for years after that.
M

The deferred value of these predicted future pay-outs may be

expressed as follows:

Share value today = Present value of dividends

N

Div 0 *× (1 + g 1 ) Div 5 *× (1 + g 2 )
t t−m
m m
=∑ + ∑
t=1(1 + rE ) 

t
( 1 + rE )
t= m +1


t


↑ ↑
PV of m years of PV of remaining
high − growth g1 normal − growth g2
dividends dividends

Finding the cost of equity rE from expected growth rates is often a

challenge. In the example below, we calculate rE, which equalises the
values on both sides of the equation, using the VBA function Two
Stage Gordon.

According to the presumption, a company’s share price is currently

P0 = 30, its dividend is D0 = 3, and after five years of 35% dividend
growth, the dividend growth rate will slow to 8%.

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 Weighted Average Cost of Capital (WACC) 171

In Figure 5.27, you can see that rE = 32.76%:

Figure 5.27: Calculation of the Golden Model with Two Growth Rates

SELF ASSESSMENT QUESTIONS

10. Which of the following is expected to remain constant in the

S
future, the Gordon model may be used with ease?
a. Dividend growth
b. Predicted growth
IM
c. Future dividends
d. All of these

ACTIVITY

Discuss with your team the limitations of the Gordon Model.

M

5.7 THE CAPM: COMPUTING THE BETA, β

The Capital Asset Pricing Model is the only feasible alternative to the
N

Gordon model for calculating the cost of capital (CAPM). It is also the
cost of equity model that is used the most due to its beautiful theoret-
ical design and simple implementation. The CAPM’s connection with
market return determines the company’s cost of capital. For the firm’s
cost of equity, the standard CAPM calculation is as follows:

E =Frf + β  E ( rM ) − r
rE r= r +  rFf 

Where,
rF = the market risk-free rate of interest
NOTE
E (rM) = the expected return on the market portfolio The Capital Asset Pricing
Model (CAPM) is an idealised
Cov ( rStock , rM ) representation of how securities
β = a firm-specific risk measure =
Var ( rM ) are valued in financial markets,
which in turn establishes
projected returns on capital
The remaining portion of this part focuses on calculating the firm; investments.
the subsequent section demonstrates how to use the CAPM to get the
firm’s cost of equity rE.

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172 FINANCIAL MODELLING

The S&P 500, which we use as a stand-in for the whole stock market,
NOTE and Merck’s five years of monthly prices and returns are shown in the
Beta is the Regression spreadsheet below. We regress the Merck returns on the 500 returns
Coefficient of the Firm’s Stock in cells B2 to B4 as shown in Figure 5.28:
Returns on the Market Returns
rMerck,t = α Merck + βMerck rSP,t
= −0.0018 + 0.6435rSP,t , R2 = 0.2245

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M
N

Figure 5.28: Computation of the BETA for Merck

What we may learn from this regression is as follows:

‰‰ Merck’s beta, β Merck, demonstrates the stock’s vulnerability to
market returns. The formula used to compute it is as follows:
Covariance (SP500 returns, Merck returns)
βMerck =
Variance (SP500 returns)

Either directly using the method above (column B5 above) or

by utilising the Excel Slope function, we may calculate (cell B4).
Merck’s returns increased or decreased by 0.6435% for every 1%
change in the S&P 500’s monthly returns for the period under
consideration. The T-Slope statistic (cell B6) reveals that Merck is
extremely significant (the construction of this function is described
below).

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 Weighted Average Cost of Capital (WACC) 173

‰‰ According to Intel’s alpha, Merck, the monthly return on the com-

pany over time was Merck = 0.18%, regardless of fluctuations in
the S&P 500. This translates to a 12-month annualised return of
2.18% (12×0.18), which suggests that, in the language of the finan-
cial markets, Merck performed well throughout the period. But
take note of the T-Intercept in cell B5: This function demonstrates
that the negative intercept is not substantially different from zero
(its development in Excel is detailed here).
‰‰ According to the R2 of the regression, the S&P 500’s volatility
accounts for 22.45% of the variance in Merck’s returns. Although
an R 2 of 22% may appear low, it is typical in the CAPM litera-
ture. It claims that the volatility in the return of the S&P 500
may account for around 22% of the variance in Merck’s returns.

S
By integrating Merck shares in a diversified portfolio of shares, the
remaining variance in Merck returns may be eliminated.

The average R 2 for stocks is between 30% and 40%, which means that
IM
market variables make up around this much of a stock’s variability
and stock-specific factors make up the remaining portion. As you can
see, Merck’s R 2 is a little on the low side, which indicates that it has a
higher level of risk than the typical stock.

5.7.1 USING THE SECURITY MARKET LINE (SML) TO

M

CALCULATE MERCK’S

In the capital asset pricing model, the securities market line (SML) is
used to calculate the risk-adjusted cost of capital. Two SML formula-
tions are examined in this section. These two methods differ in how
taxes are taken into account when determining cost of capital.
N

Method 1: The Classic SML

Taxes are disregarded in the security market line (SML) calculation

used in the traditional CAPM formula:

Cost of equity, rE = rrFf + β E ( rM ) − rFf 

Here, rf stands for the economy’s risk-free rate of return and E (RM) for
the market’s anticipated rate of return. Choosing settings for the SML
parameters is often difficult. A typical strategy is to pick:
‰‰ rf is equivalent to the economic risk-free interest rate, such as the
yield on Treasury notes. For the time being, we choose rF = 2% as
an example.
‰‰ E (rM) is the historical market return average, which is the aver-
age return of a portfolio made up of many different market invest-
ments. A different strategy based on market multiples is also pos-

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174 FINANCIAL MODELLING

sible; both of these are covered in the section below. E (rM) = 8% is

the value we utilise for this section.

The figure 5.29 below shows how to calculate Merck’s cost of equity
using the traditional CAPM method.

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Figure 5.29: Calculation of Merck’s Cost of Equity using the
Traditional CAPM Method
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Method 2: The Tax-Adjusted SML

The traditional CAPM methodology does not account for taxes. The
SML must be modified to account for the economy’s marginal corpo-
rate tax rate, as shown by Benninga-Sarig (1997). The tax-adjusted
SML represents the corporation tax rate by TC as follows:
M

Cost of equity rF TC E rM rF TC = (1− ) + _ [ ( ) − (1− )]

This formula can be applied by substituting rF (1 − TC) for rF in the

classic CAPM. Note that the Tax-adjusted cost of equity has a lower
intercept and a higher slope than the classic CAPM:
N

‰‰ The intercept is rF (1 − TC) instead of rF . This intercept is lower

than the rF intercept of the classic CAPM.
‰‰ The slope is E (rM) − rF (1 − TC) instead of E (rM) − rF. This slope
can be written as the classic CAPM slope plus TC rF : E (rM) − rF
(1 − TC) = [E (rM) − rF] + TC rF

Another way to write the tax-adjusted cost of equity is:

Tax-adjusted cost of equity

rF (1 − Tc ) + β E ( rM ) − rF (1 − Tc )
= rF + β E ( rM ) − rF  + TC rF [β − 1]
 
↑
Classic CAPM rE

This rewrite makes it apparent that the corporation tax rate TC, the
risk-free rate rf and the equity beta (β) are what determine the differ-
ence between the conventional rE and the tax-adjusted rE. The tax-ad-

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 Weighted Average Cost of Capital (WACC) 175

justed method results in a somewhat higher cost of equity for Merck

as shown in Figure 5.30:

Figure 5.30: Computation of the Cost of Equity for

Merck Tax-adjusted CAPM

S
Even though the tax-adjusted CAPM is more consistent with a taxed
economy, we must admit that the tax-adjusted CAPM may not be
more valuable given the uncertainty surrounding the cost of capital
calculations.
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SELF ASSESSMENT QUESTIONS

11. Which of the following is determined using the securities

market line (SML) in the capital asset pricing model?
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a. Risk-free rate of return

b. Market return
c. Market premium return
d. Risk-adjusted cost of capital
N

ACTIVITY

Write a short note on the uses of the capital asset pricing model.

5.8 COST OF EQUITY, KE / RI

The return a business needs to determine if an investment satisfies
capital return criteria is known as the cost of equity. It is often used by
businesses as a cap for the needed rate of return.

The price the market is willing to pay to possess an asset and assume
ownership risk is known as a company’s cost of equity. The Capital
Asset Pricing Model (CAPM) and the dividend capitalisation model
are the two conventional formulas for calculating the cost of equity.

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176 FINANCIAL MODELLING

The cost of equity according to the dividend capitalisation model is:

DPS
Cost of Equity = + GRD
CMV

Where,

DPS = Dividends per share, for next year

CMV = Current market value of stock

GRD = Growth rate of dividends​

Depending on the parties involved, there are two distinct ideas

referred to as the “cost of equity.” The needed rate of return on an

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equity investment, if you are the investor, is known as the cost of
equity. If you are a business, the needed rate of return on a certain
project or investment is determined by the cost of equity.
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A business may raise cash using either debt or equity. Debt is less
expensive, but the corporation has to repay it. Although equity does
not need repayment, it often costs more than borrowed capital since
interest payments are tax deductible. Stock often offers a better rate
of return than debt since the cost of equity is higher.

SELF ASSESSMENT QUESTIONS

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12. The return a business needs to determine if an investment

satisfies capital return criteria is known as
a. Cost of debt
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b. Cost of capital
c. Cost of equity
d. None of these
13. Which of the following often offers a better rate of return than
debt since the cost of equity is higher?
a. Warrants
b. Stock
c. Derivatives
d. Options

ACTIVITY

Find some advantages of the Cost of Equity.

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 Weighted Average Cost of Capital (WACC) 177

5.9 COMPUTING THE WACC, THREE CASES

We calculate the WACC for Merck, Whole Foods and Caterpillar in
the sections that follow. For each of these scenarios, we choose E (rM)
= 8.45% and rF = 0.06%, which is the rate on 3-month Treasury bills.
These three instances—for Merck, Whole Foods and Caterpillar—
illustrate various scenarios as well as how necessary the WACC cal-
culations are.

5.9.1 COMPUTING THE WACC FOR MERCK (MRK)

In earlier parts, we spoke about Merck’s cost of equity rE and cost of

debt rD. These calculations are summarised in Figure 5.31:

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Figure 5.31: Computation of WACC for Merck

The predicted WACC for Merck (cell B32) contains a decision: We

averaged the three estimates that were the closest in value, excluding
the one estimate that seemed excessive to us.

5.9.2 COMPUTING THE WACC FOR WHOLE FOODS MARKET

(WFM)

Earlier, we used Whole Foods Market (WFM) as an example of a cor-

poration with negative net debt since it has more liquid assets than
debt.

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178 FINANCIAL MODELLING

Dividend payments from the corporation have decreased over the last
five years, with a pause between July 2008 and January 2011 as shown
in Figure 5.32:

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Figure 5.32: Computation of WFM r E with the Golden Model
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The average of the two dividend growth rates in B9 and B10 is used in
the WACC template after this paragraph.

The business has absorbed stock from the capital markets during the
last three years, according to Whole Foods’ total equity distributions.
We do not believe that the total equity distributions have any growth
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rate that can be included in the WACC calculation.

For WFM, we disregard this approach when calculating the cost of

equity in Figures 5.33 and 5.34:

Figure 5.33: Calculation of Equity Pay-outs with Golden Model

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 Weighted Average Cost of Capital (WACC) 179

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Figure 5.34: Calculation of WACC for WFM

5.9.3 COMPUTING THE WACC FOR CATERPILLAR (CAT)

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Caterpillar’s cost of debt is very low as shown in Figure 5.35:

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Figure 5.35: Calculation of WACC for Caterpillar (CAT)

When Caterpillar earns a lot of money, its tax rate is comfortably

around 25% as shown in Figure 5.36:

Figure 5.36: Calculation of Caterpillar Tax Rate

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180 FINANCIAL MODELLING

The last ten years of CAT’s dividend history are shown here. In
our approach, we will use the Gordon dividend model to determine
CAT’s rE using the past five years of annual dividend growth as shown
in Figure 5.37:

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Figure 5.37: Caterpillar Dividend Growth and Golden Dividend

Equity distributions at Caterpillar are very erratic. We base the pay-

ment method of determining rE on the growth over the previous two
years as shown in Figure 5.38:

Figure 5.38: Calculation of Caterpillar’s Equity Pay-outs

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 Weighted Average Cost of Capital (WACC) 181

We get the following template for CAT’s WACC using these values as
shown in Figure 5.39:

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Figure 5.39: Calculation of WACC for Caterpillar (CAT)

Our WACC estimates are divided into two categories: those produced
by the two Gordon-based models and those by the two CAPM-based
techniques. Here, we average the results of the two most recent cal-
culations (our general preference is often for CAPM over the dividend
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models).

SELF ASSESSMENT QUESTIONS

14. Which of the following model is used to determine CAT’s rE

using the past five years of annual dividend growth?
a. Caterpillar (CAT)
b. Weighted Average Cost of Capital
c. Both a. and b.
d. None of these

ACTIVITY

How WACC is useful for any firm? Discuss

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182 FINANCIAL MODELLING

S 5.10 SUMMARY
‰‰ The average after-tax cost of capital of the firm from all sources
which consists of common stock, preferred stock and other forms
of debt is called the Weighted Average Cost of Capital (WACC).
‰‰ A merger is probably a wise decision for the firm if it thinks it will,
for example, create a return greater than its cost of capital.
‰‰ The CAPM is often used to price risky securities, generate antic-
ipated returns for assets given the associated risk and determine
the cost of capital.
‰‰ The effective interest rate that a business pays on its obligations,
such as bonds and loans, is known as the cost of debt.

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‰‰ A corporation might figure out the total amount of interest it is pay-
ing on each of its obligations for the year as an alternate method of
calculating the after-tax cost of debt.
‰‰ The Weighted Average Cost of Capital (WACC) of a company is a
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measure of its total cost of capital, which includes debt, common
shares and preferred shares.
‰‰ An implied cost or opportunity cost of capital is the cost of equity.
It is the rate of return that, in principle, investors need to be com-
pensated for the risk involved in stock investments.
‰‰ The term “beta” describes how volatile or risky a stock is in com-
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parison to all other equities on the market.

‰‰ Beta would then be re-levered using the firm’s goal capital struc-
ture if there was any indication that the capital structure of the
company would change in the future.
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‰‰ Forecasting a company’s Free Cash Flow (FCF) into the future and
discounting it to its Net Present Value (NPV) at the Weighted Aver-
age Cost of Capital (WACC) is known as financial modelling and
valuation.
‰‰ The market value of the company’s financial debt less the market
value of its surplus liquid assets is used to calculate the debt value
of the company.
‰‰ The present value of a share’s projected future dividend stream,
discounted at the appropriate risk-adjusted cost of equity (rE), is
what determines the share’s worth.
‰‰ Gordon’s model needs to be expanded to incorporate all cash flows
to equity to value the firm’s equity.
‰‰ The only practical alternative to the Gordon model for figuring out
the cost of capital is the Capital Asset Pricing Model (CAPM).
‰‰ A business may raise cash using either debt or equity. Debt is less
expensive, but the corporation has to repay it.

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 Weighted Average Cost of Capital (WACC) 183

KEY WORDS

‰‰ Cost of debt: The effective interest rate that a business pays on

its obligations, such as bonds and loans
‰‰ Cost of equity: The return a business needs to determine if an
investment satisfies capital return criteria
‰‰ Levered beta: The term “beta” describes how volatile or risky a
stock is in comparison to all other equities on the market
‰‰ Weighted Average Cost of Capital (WACC): The average after-
tax cost of capital of the firm from all sources which consists of
common stock, preferred stock and other forms of debt

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5.11 MULTIPLE CHOICE QUESTIONS
1. Which of the following is probably a wise decision for the firm if
it thinks it will, for example, create a return greater than its cost MCQ
of capital?
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a. Acquisition
b. Consolidation
c. Merger
d. Both a. and c.
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2. Which of these factors are included under the CAPM to calculate

the cost of equity?
a. Risk-free rate of return
b. Beta
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c. Market rate of return

d. All of these
3. The CAPM is often used to price risky securities, generate
anticipated returns for assets given the associated risk and
determine which of these?
a. Cost of capital
b. Risk-free rate of return
c. Weighted Average Cost of Capital (WACC)
d. None of these
4. Which of these is known as the effective interest rate that a
business pays on its obligations, such as bonds and loans?
a. Cost of equity
b. Cost of capital

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184 FINANCIAL MODELLING

c. Cost of debt
d. Both a. and c.
5. Which of the following refers to how it uses various funding
sources, including debt such as bonds or loans, to support its
overall operations and growth?
a. Cost of debt
b. Cost of capital
c. Cost of equity
d. Capital structure
6. WACC is used in financial modelling as which rate to determine
a business’s net present value?

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a. Discount rate
b. Interest rate
c. Yield rate
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d. Bond rate
7. Weighted Average Cost of Capital is a crucial component of which
of these?
a. Initial Public Offering (IPO) model
b. Leveraged Buyout (LBO) model
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c. Discounted Cash Flow (DCF) valuation model

d. All of these
8. Which of these is known as the returns that may be obtained
by investing in an asset that carries no risk, such as the U.S.
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Treasury bonds?
a. Risk-free rate of return
b. Cost of capital
c. Weighted average rate of return
d. Market return
9. Which of the following is the additional yield that may be obtained
by investing in the stock market above the risk-free rate?
a. Levered beta
b. Equity Risk Premium (ERP)
c. Risk-free rate of return
d. Weighted average rate of return
10. The company’s issuing of shares represents a significant:
a. Positive cash flow to equity
b. Negative cash flow to equity

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 Weighted Average Cost of Capital (WACC) 185

c. Discounted cash flow to equity

d. Future cash flow to equity

5.12 DESCRIPTIVE QUESTIONS

1. Explain the Weighted Average Cost of Capital (WACC). ?
2. Discuss the computation of the value of the firm.
3. Describe the cost of equity.

HIGHER ORDER THINKING SKILLS

5.13
(HOTS) QUESTIONS
1. Which method of calculating the cost of capital comprises

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dividing the dividend by the market price or net proceeds per
share?
a. Adjusted price method
b. Price earning method
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c. Dividend yield method
d. Adjusted dividend method
2. In Weighted Average Cost of Capital, an organisation can affect
its cost of capital through _________.
a. The policy of investment
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b. The policy of capital structure

c. The policy of dividends
d. All of these
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3. ____________ is the rate of return that a corporation will forfeit by

choosing any other project over the most attractive investment
opportunity.
a. Implicit cost
b. Specific cost
c. Explicit cost
d. None of these

5.14 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Weighted Average Cost of 1. a. Required rate of return
Capital (WACC)

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186 FINANCIAL MODELLING

Topic Q. No. Answer

2. b. Weighted Average Cost of
Capital (WACC)
Using the CAPM to Estimate 3. b. Capital asset pricing model
the Cost of Equity
4. b. Free Cash Flow (FCF)
5. b. Opportunity cost
6. a. Levered beta
Computing the Value of the 7. c. Market value
Firm’s Equity, E
8. b. Liquid assets

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Two Approaches to Comput- 9. a. Current dividend
ing the Firm’s Cost of Equity,
rE
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Implementing the Gordon 10. a. Dividend growth
Model for rE
The CAPM: Computing the 11. d. Risk-adjusted cost of capital
Beta, β
Cost of Equity, Ke / Ri 12. c. Cost of equity
13. b. Stock
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Computing the WACC, Three 14. a. Caterpillar (CAT)

Cases

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

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Q. No. Answer
1. c. Merger
2. d. All of these
3. a. Cost of capital
4. c. Cost of debt
5. d. Capital structure
6. a. Discount rate
7. c. Discounted Cash Flow (DCF) valuation model
8. a. Risk-free rate of return
9. b. Equity Risk Premium (ERP)
10. b. Negative cash flow to equity

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 Weighted Average Cost of Capital (WACC) 187

HINTS FOR DESCRIPTIVE QUESTIONS

1. The average after-tax cost of capital of the firm from all sources
which consists of common stock, preferred stock and other forms
of debt is called Weighted Average Cost of Capital (WACC). It is
the typical interest rate expected by the company to finance its
assets. Refer to Section 5.2 Weighted Average Cost of Capital
(WACC)
2. The value of the company’s equity may be calculated in the
simplest of all WACC calculations: Take E to be the product
of the number of shares outstanding times the current share
price as long as the firm is publicly traded. Refer to Section 5.4
Computing the Value of the Firm’s Equity, E
3. The return a business needs to determine if an investment

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satisfies capital return criteria is known as the cost of equity. It is
often used by businesses as a cap for the needed rate of return.
The price the market is willing to pay to possess an asset and
assume ownership risk is known as a company’s cost of equity.
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Refer to Section 5.8 Cost of Equity, Ke/Ri

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
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1. c. Dividend yield method

2. d. All of these

3. a. Implicit cost
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5.15 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
Bloss, M. and Dirnberger, M., n.d. Financial Modeling.
‰‰ Pfaff,
P., 1990. Financial modeling. Needham Heights, Mass.: Allyn
and Bacon.
‰‰ Zivot,E. and Wang, J., 2003. Modeling financial time series with
S-Plus. New York: Springer.

E-REFERENCES
‰‰ Corporate Finance Institute. 2022. WACC. [online] Available at:
<https://corporatefinanceinstitute.com/resources/knowledge/
finance/what-is-wacc-formula/> [Accessed 30 August 2022].

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188 FINANCIAL MODELLING

‰‰ Financial Modeling Prep. 2022. Weighted Average Cost Of Capital

(WACC) - FinancialModelingPrep. [online] Available at: <https://
financialmodelingprep.com/weighted-average-cost-of-capital>
[Accessed 30 August 2022].
‰‰ Varsity by Zerodha. 2022. Weighted average cost of capital and Ter-
minal Growth – Varsity by Zerodha. [online] Available at: <https://
zerodha.com/varsity/chapter/weighted-average-cost-of-capi-
tal-and-terminal-growth/> [Accessed 30 August 2022].

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 C H A
6 P T E R

BUILDING AN INTEGRATED CASH FLOW MODEL

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CONTENTS

6.1 Introduction
6.2 Building an Integrated Cash Flow Model
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6.2.1 Use Automation to Improve Your Forecasting Model’s Reliability
6.2.2 Summary: How to Create a Cash Flow Forecast in Excel
Self Assessment Questions
Activity
6.3 Understanding Circularity
6.3.1 An alternative approach to solving circular interest
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6.3.2 Using algebra to solve circular interest

Self Assessment Questions
Activity
6.4 Setting up and Formatting the Model
6.4.1 A Consistent Colour Scheme
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6.4.2 Exact Figures in Financial Model Formatting

6.4.3 Text with Custom Formatting
6.4.4 Financial Model Formatting Matters
Self Assessment Questions
Activity
6.5 Selecting Model Drivers and Assumptions
6.5.1 Model Tab: Detailed Calculations and Operating Build-up
Self Assessment Questions
Activity
6.6 Creating the Debt and Interest Schedule
Self Assessment Questions
Activity
6.7 Free Cash Flow (FCF): Measuring the Cash Produced by the Business
Self Assessment Questions
Activity

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190 FINANCIAL MODELLING

CONTENTS

6.8 Merck: Reverse Engineering the Market Value

Self Assessment Questions
Activity
6.9 Summary
6.10 Multiple Choice Questions
6.11 Descriptive Questions
6.12 Higher Order Thinking Skills (HOTS) Questions
6.13 Answers and Hints
6.14 Suggested Readings & References

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 Building an Integrated Cash Flow Model  191

INTRODUCTORY CASELET

CASH FLOW

In conjunction with the other financial statements, the cash flow

statement offers data that enables users to assess changes in an Case Objective
organisation’s net assets, its financial structure (including its
This caselet highlights the
liquidity and solvency) and its capacity to control the amounts overview of cash flow.
and timing of cash flows to respond to new situations and oppor-
tunities. The ability of an organisation to produce cash and cash
equivalents may be evaluated using cash flow statistics. Users can
also create models to evaluate and compare the present value of
the future cash flows of other firms. Because it eliminates the con-
sequences of applying various accounting procedures to the same
transactions and events, it also improves the comparability of the

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reporting of operating performance by various firms.

The quantity, timing and predictability of future cash flows are

frequently predicted using data on historical cash flows. Addition-
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ally, it helps analyse the reliability of previous forecasts of future
cash flows, the link between profitability and net cash flow and
the effects of fluctuating pricing.

An organisation displays the cash flows from operating, investing

and financing operations in the way that is best suitable for its
industry. Users may evaluate the effects of different activities on
the enterprise’s financial condition and the quantity of cash and
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cash equivalents by looking at data that is categorised by activity.

The linkages between such actions can also be evaluated using
this information.
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192 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Define the meaning of cash flow
>> Explain the building of an integrated cash flow model
>> Discuss the circularity
>> Describe the setting up and formatting of the model
>> Analyse the selecting model drivers and assumptions
>> Summarise the creation of the debt and interest schedule

6.1 INTRODUCTION

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Quick Revision In the previous chapter, you have studied the Weighted Average Cost
of Capital (WACC). A business organisation collates finance from its
investors (both equity and debt investors) and utilises those funds to
generate returns. These investors are, thus, assuming a risk by enforc-
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ing trust that the organisation will spend their financial resources
prudently. Subsequently, investors require a return to compensate
for owing the risk. This is what we infer as the “investors’ required
return” or we can say that the shareholders’ position is the sharehold-
ers’ required return.

Information regarding the cash flows of an organisation is beneficial in

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offering users of financial statements with useful information to gauge

the calibre of the organisation to generate cash and cash equivalents
and the needs of the organisation to make use of those cash flows.

The economic decisions that are initiated by decision makers man-

date an evaluation of the ability of an organisation to generate cash
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and cash equivalents along with appropriate timing and certainty of

their generation.

The Cash Flow Model revolves around the provision of information

about the historical changes in cash and cash equivalents of an organ-
isation through the transferring of a cash flow statement which cate-
gorises cash flows during the timeline from operating, investing and
financing activities. Users of an organisation’s monetary statements
are willing to delve into how the organisation generates cash and cash
equivalents and how it is being utilised.
NOTE Organisations require financial resources for many reasons, how-
A cash flow model is a thorough ever, their key revenue-producing model might be different. Business
representation of a client’s enterprises require cash to run day-to-day business operations, fulfil
assets, investments, liabilities, financial obligations and provide returns to their investors.
income and outlays that is
projected ahead, year by year,
In this chapter, building an integrated cash flow model, understand-
utilising estimated rates of
growth, income, inflation, pay ing circularity, setting up and formatting the model, selecting model
increases and interest rates. drivers and assumptions, creating the debt and interest schedule,

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 Building an Integrated Cash Flow Model  193

Free Cash Flow (FCF), measuring the cash produced by the business,
Merck: reverse engineering the market value, etc., are discussed in
details.

BUILDING AN INTEGRATED CASH FLOW

6.2
MODEL
The reporting framework and logic that results in a cash flow predic-
tion are known as cash forecasting models. A business’s cash flow and
a predetermined reporting interval are the two parameters that are
generally used to build cash forecasting models.

Businesses may more effectively prepare for future cash shortages

and surpluses by using a well-designed forecasting model. However,

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each firm’s well-designed forecasting model will be different since the
optimal approach to creating the model relies on the particular busi-
ness objectives of each organisation.

The method we advise for creating a cash forecasting model is

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described below. It will provide your company with the visibility it
needs to manage its cash effectively.
‰‰ Determine Your Business Objective: Your forecasting model will
be more likely to offer insightful data if you specifically tune it to
a given business goal. Therefore, defining the goal you want your
model to assist with is the first step in creating an effective model.
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We discover that the following goals are those for which firms most
frequently employ cash forecasts:
 Short-term liquidity planning: Continually keeping an eye on
your company’s financial position to satisfy commitments such
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as payroll or vendor payments.

 Interest and debt reduction: Organise payments for any loans
or other debt that your company has incurred.
 Covenant and key date visibility: Forecasting cash levels on
important reporting dates, such as a month, quarter or year-
end
 Liquidity risk management: Recognising potential liquidity
constraints so you may make plans to overcome them.
 Growth planning: Managing working money to finance initia- Know More
tives that will support corporate growth. The operational cash flows
that remain after capital
It is important to keep in mind that forecasting models that expenditures, which represent
work well for one purpose and those that work best for another the expenses of sustaining
the asset base, are used as
frequently overlap. Businesses who want to develop a model to the basis for the valuation
help liquidity risk management, for instance, could also find that technique. To evaluate the entire
model valuable for lowering interest and debt. company, this cash flow is taken
into account before interest
The upcoming two processes will determine how much of an payments to debt holders.
overlap there is.

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194 FINANCIAL MODELLING

‰‰ Choose a Reporting Period: Your reporting period describes how

NOTE precisely you anticipate cash levels. The daily, weekly and monthly
A form of model that predicts a reporting cycles are the most typical. The business objective you
company’s income statement, picked above and the amount of time you want to estimate cash
balance sheet, and cash flow
flow will determine the optimal reporting period to use for your
statement is known as an
integrated 3-statement financial forecasting model.
model.
Here are three of the most typical reporting intervals together with
the business goals they serve.
i. 
Daily reporting: Cash flow data is categorised daily by daily
reporting. Daily Cash Forecasting is especially beneficial for
managing short-term liquidity when businesses need a clear
picture of cash balances and utilise a cash forecasting model to
control their day-to-day cash needs.

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Figure 6.1 shows an example of a daily cash forecasting tem-
plate, where each row of the table lists cash inflows and out-
flows by category and each column represents a single day:
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Figure 6.1: Daily Cash Forecasting

It takes a lot of data and granularity to get a daily picture of
liquidity levels that is correct. Therefore, rather than using
more general financial categories such as trade payments or
receipts, cash flows are frequently recorded based on custom-
ers or suppliers.
For reporting cash flows up to four weeks in the future, daily
forecasting intervals work best.
ii. 
Weekly reporting: Cash flow forecasts are categorised weekly
in weekly reporting. Companies who need to prepare for debt
repayments have debt covenants they must uphold from
lenders, need reporting date visibility or are attempting to
manage future liquidity concerns may find weekly reporting
periods to be very helpful.

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Figure 6.2 shows an illustration of a weekly cash prediction,

where each column forecasts cash levels for a particular week: Know More
Three-statement financial
models can be built in a variety
of different layouts and designs.

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Figure 6.2: Forecasts Cash Levels for A Particular Week
A 13-week Cash Flow Forecast is the most popular weekly fore-
casting model because it offers both a decent level of accuracy
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and a constant, quarterly perspective of impending cash flows.
For forecasting one to four months out, weekly forecasting pe-
riods work well.
iii. Monthly reporting: Cash flow roles are categorised monthly
by monthly reporting. A logical extension of budgeting
procedures, monthly forecasting periods are excellent for
longer-term planning objectives. In Figure 6.3, cash flows for
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several months are shown in each column of a monthly cash

forecast:
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Figure 6.3: Cash Flows for Several Months

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196 FINANCIAL MODELLING

For projecting 12 to 18 months into the future, monthly forecasting

NOTE periods work well. However, they may also be utilised in mixed
The number of forecast periods period forecasts, where the first quarter is provided weekly and
is constant for a rolling monthly the following quarters are reported monthly.
cash flow projection (for
example, 12 months and 18 ‰‰ Choose a Forecasting Method Based on Available Data: The
months). Every time there is a data and data gathering procedure you employ to fill in the cash
month of previous data to enter,
inflows and outflows in your model is your forecasting methodol-
the prediction gets advanced.
ogy. You will have to decide between the following two predicting
techniques:
i. 
Direct forecasting: Uses real cash flow information from
your bank accounts and Enterprise Resource Planning (ERP)
systems to feed your model. Since it might be difficult to get
reliable cash flow information more than 90 days in the future,

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direct forecasting works best for daily and weekly forecasting
periods.
ii. 
Indirect forecasting: To forecast future liquidity levels, balance
sheets for accounts payable and receivable are compared. As
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it frequently lacks the level of information that short-term
reporting frequently demands, indirect forecasting is best
suited for medium to long-term perspectives.

In general, direct forecasting is the most accurate technique, provided

that you have access to real cash flow and can dependably gather it.
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6.2.1 USE AUTOMATION TO IMPROVE YOUR FORECASTING

MODEL’S RELIABILITY

The majority of businesses still use spreadsheets to manually man-

age their cash forecasting models. Although no treasury or financial
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department could function without spreadsheets, the human effort

necessary to manage your model in a spreadsheet creates the poten-
tial for mistakes. This is especially true in bigger companies when the
process of gathering and manipulating data involves several parties.

Simply said, if the data you use to feed your forecasting model is
correct, your model will only yield trustworthy insights. In addition
to reducing the possibility of mistakes that might lower the data’s
dependability, automating the gathering of cash flow data straight
from ERP systems or bank accounts can help businesses save more
than 90% of the human effort required to maintain their forecasting
model(s).

6.2.2 SUMMARY: HOW TO CREATE A CASH FLOW

FORECAST IN EXCEL

It is required to know how to use Excel to build a cash flow forecast as

a result of this course. Creating a sheet with the key assumptions and
tying them to the sales, revenue and cost assumptions were covered

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 Building an Integrated Cash Flow Model  197

at the outset. In addition, it demonstrated how to utilise the terminal

value to compute expected returns on stock investments. NOTE
Estimating your upcoming
The procedure for creating the Excel Cash Flow Forecast that was revenues and costs is part
utilised in this summary is listed as follows: of the cash flow forecasting
process. A cash flow prediction
1. Make a spreadsheet containing the company plan’s key drivers. is an essential tool for your
Don’t forget to include a remark column outlining the reasoning company since it will let you
know whether you will have
behind each premise. enough money to run or grow
the enterprise.
2. On a different Excel page, create a monthly cash flow forecast.
Connect estimates to the revenue and expense assumptions.
3. For calculations, use simple Excel formulae. Use formulae such
as SUM, IF, SUMIFS and COUNTIF to learn.

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4. Put cash flow projections into a quarterly or yearly perspective.
To help understand forecasting patterns, provide graphics.
5. Estimate the amount of equity needed to finance the model.
Describe the cost categories in detail to show how the investment
IM
will finance the strategy.
6. Using forecasts, calculate the enterprise and exit values.
Calculating the returns on investment requires discounting the
cash flows.
7. Include important financial metrics such as NPV, IRR or cash
flow break-even points. To assess the feasibility of prediction,
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compute margins.
8. Utilising the Assumptions sheet, construct scenarios and test
the cash flow model. To determine the model’s breaking points,
subject it to stress testing.
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9. Include the balance sheet, P&L and cash flow statements. The
Excel sheets are linked together so that changes made to one
influence the results of the other.
10. Examine the effect that debt calculations will have on the cash
flow forecast. Note the modifications to the investment return
criteria and the equity requirement.

SELF ASSESSMENT QUESTIONS

1. Which of the following is created for the business plan’s

assumptions, and add a remark column?
a. Excel page
b. Word page
c. Data table
d. None of these

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198 FINANCIAL MODELLING

2. Excel financial model template assumes that which of the

following comes from subscription fees and monthly recurring
income?
a. Expenses
b. Revenues
c. Both a. and b.
d. None of these

ACTIVITY

Find out the uses of the cash flow model with the help of the inter-
net.

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6.3 UNDERSTANDING CIRCULARITY
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When a formula depends either directly or indirectly on itself, a circu-
? DID YOU KNOW lar reference is produced. When C = A + B, yet A or B is a function of
You want to make sure there are C in turn, this is known as circular logic.
no circular references in the
file. Go to tab ‘Formulas’, choose Although the problem may be solved via an iterative process, this vio-
‘Error-checking’ and ‘Circular lates a key principle of effective financial modelling. The frequently
References’. Excel will show you adopted market solution is riddled with flaws. That’s why we chose
exactly in which cell(s) circular
to use a straightforward algebraic formula to show how we addressed
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references are detected.

the issue. The formula is as follow:

2.OB.r
I=
(2 − r )
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6.3.1 AN ALTERNATIVE APPROACH TO SOLVING

CIRCULAR INTEREST

By utilising a copy-and-paste macro to isolate the circular reference,

the issue may be fixed, although inelegantly. This entails copying the
interest calculation and pasting it into the account, updating the inter-
est calculation and repeating the loop.

This is carried out until a tolerance threshold is reached in all peri-

ods for the difference between “calculated interest” and “value copied
interest.” This macro must be executed once more whenever the mod-
el’s input parameters change. This is standard practice in the indus-
try, but it also has the following disadvantages:
‰‰ It is difficult to utilise “data tables,” a potent scenario tool.
‰‰ The user must understand when and how to utilise the macro.
‰‰ Without a “solid” VBA code, the cell references could change.

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 Building an Integrated Cash Flow Model  199

There are easy ways and difficult ways to do financial calculations.

A more elegant analytical method, as opposed to an iterative one, is
often taken after reflecting on the problem you are seeking to address.

6.3.2 USING ALGEBRA TO SOLVE CIRCULAR INTEREST

When interest is determined by the average loan balance, a circular

reference is created. Think about this Know More
‰‰ CB = Closing balance Some financial models might
include only a profit-and-loss
‰‰ OB = Opening balance statement, some might include
simply a cash flow statement,
‰‰ I = Interest earned but many include all three. If a
financial model does contain all
‰‰ r = Deposit interest rate three, you might hear it referred

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as a three-way financial model.
I = r . (OB + CB)/2

And we have:
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CB = OB + I

Simultaneous substitution allows the aforementioned formulas to be

transposed, thus the algebraic answer of interest is:

2.OB.r
I=
(2 − r )
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SELF ASSESSMENT QUESTIONS

3. When a formula depends either directly or indirectly on itself,

which of the following is produced?
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a. Potent scenario tool

b. Circular logic
c. Circular reference
d. All of these

ACTIVITY

Note down the uses of circularity in MS Excel.

SETTING UP AND FORMATTING THE

6.4
MODEL
When building a financial model, everything from colours to figures
to formulae to text has a precise formatting rationale. Being a great

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200 FINANCIAL MODELLING

financial analyst requires excellent financial model formatting as

shown in Figure 6.4:

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IM
Figure 6.4: Building a Financial Model
Source: https://corporatefinanceinstitute.com/resources/knowledge/
modeling/financial-model-formatting/
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6.4.1 A CONSISTENT COLOUR SCHEME

The following systems are necessary for both text and numbers:
‰‰ Blue: Preferred for usage with historical, underlying assumptions
and driving factors as inputs (172.551 or = 258.849+9.988 – 2.624)
N

‰‰ Black: On the same schedule or page, this colour should be uti-

lised for computations and references (C4)

Know More ‰‰ Green: Green should be used to illustrate references to other

The purpose of a 3-statement
schedules or sheets (=Sheet1! B3).
model (i.e. an integrated ‰‰ Red: Red is a symbol of caution and should be used to alert other
financial statement model) is to
forecast or project the financial
users or link to another model (= [TTS v1.0xls] Sheet1! C3).
position of a company as a ‰‰ Dark Red: For a formula connecting to databases such as Capital
whole.
IQ (=CIQ ($E$2, “IQ TOTAL REV”, IQ FY)), a deep, dark crimson
is acceptable.

6.4.2 EXACT FIGURES IN FINANCIAL MODEL

FORMATTING

Depending on the format, Excel will always do the rounding-off. Excel

will display money input as `25.382 as `25.4, for instance. This will
guarantee that all computations are as precise as possible while main-
taining a tidy appearance.

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 Building an Integrated Cash Flow Model  201

NEVER INPUT THE SAME NUMBER TWICE

In this way, Excel will flow and be dynamic.

Don’t Embed Inputs in Formulas

The percentage symbol shouldn’t be used in calculations such as

=F5×(1+10%). Separate inputs into a different line item instead. The
10% must be entered into a different cell (G7 = 10%), and it must be
identified by the reference – =F5×(1+G7).

NUMBER FORMATTING BASICS

Access: Ctrl+1 (Format cells), Number tab

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There are a few fundamental guidelines that may assist keep things
organised and straightforward when arranging figures in a finan-
cial model. Use Excel’s standard kinds, such as numbers, currency,
accounting, etc., as a starting point. By aligning the decimals between
IM
positive and negative numbers in this way, Excel will recognise and
show items such as negative values in parentheses.

CUSTOM NUMBER FINANCIAL MODEL FORMATTING

Access: Ctrl+1 (Format cells), Number tab, Custom

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To ensure that numbers are calculated correctly and presented in the

right manner, one should employ custom formatting for percentages, NOTE
firm-specific formats and other inventive presentations. After using A cash flow model is a
the access mechanism, “Type” generates a bespoke number format. comprehensive representation
of a client’s assets, investments,
N

‰‰ # – if significant numbers are present, present them and often use liabilities, income, and outlays
that is projected forward, year
the (,) as a 1000 separator. by year, utilising estimated rates
‰‰ 0– displays small numerals and is often used for displaying deci- of growth, income, inflation, pay
increases and interest rates.
mals.

When the number 3.4 is entered as 0.0, it will appear as 0.0, however,
when it is entered as #, ###.0, it will appear as 3.4.

Interpreting the “Code”

The semicolon (;) is the symbol that distinguishes between positive

and negative format types. Three semi-colons may be used as format
separators (positive; negative; zero; text).

Example

POSITIVE SEPARATOR NEGATIVE

0.1% ; (0.5%)

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202 FINANCIAL MODELLING

The underscore (_) is used to align decimals for positive and negative
integers in a column by creating a gap in the size of the following char-
acters.

Example

POSITIVE SPACE ADDER NEGATIVE

0.1% _ (0.0%)

6.4.3 TEXT WITH CUSTOM FORMATTING

Whether working with multiples, basis points or years, it is typical to

see letters or words following a number. These will be interpreted by
Excel as “numbers” rather than “text.” For instance, if we wrote the
number 3.4 as #, ##0.0x, it would appear as 3.4x and if we typed 150

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as 0 “bps,” it would appear as 150 bps.

6.4.4 FINANCIAL MODEL FORMATTING MATTERS

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Quality analytical work and excellent presentation are both crucial for
a variety of reasons, therefore, formatting is crucial. The owner and
the company are represented by their work, to start with. Additionally,
unprofessional work might convey a false idea about the quality of the
task. Finally, even if the figures are entirely true, a poor presentation
could cost you a sale.
M

SELF ASSESSMENT QUESTIONS

4. On the same schedule or page, this colour should be utilised

for computations and references (C4). Which of the following
option is correct regarding the above statement?
N

a. Red
b. Dark red
c. Green
d. Black
5. Which of the following colour is preferred for usage with
historical, underlying assumptions and driving factors as
inputs (172.551 or = 258.849 + 9.988 – 2.624)?
a. Green
b. Blue
c. Black
d. Dark red

ACTIVITY

Find the method of formatting the model.

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 Building an Integrated Cash Flow Model  203

SELECTING MODEL DRIVERS AND

6.5
ASSUMPTIONS
The drivers (inputs) tab must appear right after the model’s cover
page. Given that non-finance operators are likely to use this tab the
most, you must make sure it is clear, succinct and simple to grasp. The
inputs tab should have two input sections, one for static inputs and
the other for dynamic inputs. Dynamic inputs are those that fluctuate
over time (for example, from month to month or year to year), such as
“inflation” assumptions, “cost of debt,” or “revenue growth” assump-
tions. Examples of static inputs are hypothetical “size of a power
plant” or “a company’s initial debt amount” as shown in Figure 6.5:

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IM
Know More
When building a model, you
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will generally be faced with a

number of considerations about
how exactly to build it.

Figure 6.5: Sample Drivers and Assumptions Tab

N

Source: https://www.toptal.com/finance/financial-modeling/financial-modeling-best-practices

This data is classified into two categories within both of the aforemen-
tioned static vs. dynamic input sections: (1) hard-coded figures that
remain the same regardless of the assumptions scenario, and (b) sen-
sitising parameters that will drive various assumptions scenarios and,
ultimately, sensitivity tables. But keep in mind that until the project is
finished, it will not completely know which parameters will be sensi-
tive and which will not.

6.5.1 MODEL TAB: DETAILED CALCULATIONS AND

OPERATING BUILD-UP

This tab serves as the model’s central hub, bringing together all of
the inputs, hypotheses and scenarios to forecast a company’s financial
success over the next years. This tab will also be used to run multiple
assumption-driven scenarios and to complete the valuation portion of

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204 FINANCIAL MODELLING

the exercise before making the ultimate strategic choice as shown in

Figure 6.6:

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IM
M

Figure 6.6: Sample Model Tab

Source: https://www.toptal.com/finance/financial-modeling/financial-modeling-best-practices
N

SELF ASSESSMENT QUESTIONS

6. Which of the following tab must appear right after the model’s
cover page?
a. Assumptions b. Drivers (inputs)
c. Both a. and b. d. None of these
7. Which of the following remains the same regardless of the
assumptions scenario?
a. Hard-coded figures b. Sensitising parameters
c. Sensitivity tables d. All of these

ACTIVITY

Discuss with your friends the uses of model drivers.

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 Building an Integrated Cash Flow Model  205

CREATING THE DEBT AND INTEREST

6.6
SCHEDULE
A debt schedule lists every debt that a company has according to its
maturity on a timetable. Businesses often utilise it to create a cash
flow analysis. The following graph illustrates how principal repay-
ments move via the cash flow statement, closing debt balance flows
into the balance sheet and interest cost from the debt schedule flows
into the income statement (financing activities).

One of the supporting schedules that connect the three financial state-
ments is the debt schedule as shown in Figure 6.7:

S
Know More
A debt schedule lists every debt
that a company has according
to its maturity on a timetable.
IM
Businesses often utilise it to
create a cash flow analysis. The
following diagram illustrates
how principle repayments move
via the cash flow statement, the
closing debt balance flows into
the balance sheet, and interest
cost from the debt schedule
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flows into the income statement.

Figure 6.7: Debt and Interest Schedules

Source: https://corporatefinanceinstitute.com/resources/knowledge/modeling/debt-schedule/
N

The revenue statement includes interest expenditure for the amount

of interest expense estimated above (row 258). The whole debt amount
appears on the balance sheet under liabilities as the closing balance
(row 256). In this illustration, interest costs are calculated using a fixed
interest rate and the average debt balance over the specified period
(opening plus closing, divided by two).

COMPONENTS OF A DEBT SCHEDULE IN A FINANCIAL MODEL

An analyst will almost always need to create an Excel supporting

schedule that details debt and interest when creating a financial
model. The following are included in this schedule:
‰‰ Opening balance (beginning of the period)
‰‰ Repayments (decreases)
‰‰ Draws (increases)
‰‰ Interest expense
‰‰ Closing balance (end of the period)

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206 FINANCIAL MODELLING

The aforementioned elements make it possible to monitor the debt

till maturity. The interest cost goes to the income statement, while the
closing amount from the schedule flows back to the balance sheet.

AMORTISATION SCHEDULE

Amortisation schedule refers to the loans that amortise have constant

payment amounts throughout the course of the loan, but the compo-
nents of each payment—interest and principle—variate. An ordinary
mortgage is one of these loans.

The full table of periodic loan payments, including the amounts of

principal and interest that make up each level payment until the loan
is repaid in full after its term, is represented by a loan amortisation
schedule. The bulk of each payment is used to pay interest at the

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beginning of the schedule, as time goes on, the majority of payments
start to cover the loan’s remaining principal.
NOTE The lender should provide a copy of the loan amortisation schedule if
Based on your loan and your
IM
an individual taking out a mortgage or vehicle loan so it can quickly
needs, you may create your own determine how much the loan will cost and how the principal and
amortisation schedule. You may
interest will be divided throughout its term.
evaluate how making expedited
payments will speed up your
amortisation using more complex
According to a loan amortisation plan, the amount of each payment
amortisation calculators, such that is allocated to interest decreases somewhat with each payment,
as the Excel templates. while the amount allocated to the principal rises.
M

A 30-year fixed-rate mortgage for `1,65,000 with a 4.5% interest rate is

shown in Figure 6.8:
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Figure 6.8: The Loan Amortisation Schedule

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 Building an Integrated Cash Flow Model  207

Based on loan and needs, create an amortisation plan. Evaluate how

making expedited payments will speed up amortisation using more
complex amortisation calculators, such as Excel templates. These
tools are used to analyse how paying down the debt with a windfall
might change the loan’s maturity date and the amount of interest paid
throughout the loan, for instance, if it is anticipating an inheritance or
getting a certain annual bonus.

Along with mortgages, vehicle loans and personal loans also amor-
tise over a certain time with a fixed interest rate and a predetermined
monthly payment. The conditions change based on the asset. Most
traditional mortgages have terms of 15 or 30 years. Car owners often
take for a car loan with a five-year maximum repayment period.
3 years is a typical repayment period for personal loans.

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FORMULAS USED IN AMORTISATION SCHEDULES

Borrowers and lenders use amortisation schedules for installment

IM
loans with predetermined payment dates at the time the loan is
arranged, such as a mortgage or a car loan. Exact calculations are used
to produce a loan amortisation schedule. A software could already
include these calculations or it might need to start from scratch when
creating an amortisation plan.

There is a simple method to determine a loan amortisation plan with-

M

out using an online amortisation schedule or calculator if it is know

the loan term and the total amount of monthly payments. An amor-
tised loan’s monthly principle payment is determined using the fol-
lowing formula:
N

Principal Payment = Total Monthly Payment – [Outstanding Loan

Balance × (Interest Rate / 12 Months)]

Let’s use an example where a loan has a 30-year term, a 4.5% inter- Know More
est rate and an ` 1,266.71 monthly payment. Multiply the loan sum According to a loan amortisation
(` 250,000) by the recurring interest rate beginning in month one. plan, the amount of each
payment that is allocated to
The final equation is ` 250,000 × 0.00375 = ` 937.50 since the periodic
interest decreases somewhat
interest rate is one-twelfth of 4.5% (or 0.00375). The result is the inter- with each payment, while the
est payment for the first month. Calculate the part of the loan payment amount allocated to principle
allotted to the principal of the loan debt (` 329.21) by deducting that rises.
sum from the monthly payment (` 1,266.71 – ` 937.50).

Subtract the principal payment made in month one (` 329.21) from the
loan total (` 250,000) to get the new loan balance (` 249,670.79). Next,
use the same procedures as before to determine how much of the sec-
ond payment will go toward interest and how much toward principal.
Until you have a timetable for the loan’s whole life and keep going
through these procedures.

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208 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

8. Which of the following lists every debt that a company has

according to its maturity on a timetable?
a. Amortisation schedule b. Debt schedule
c. Both a. and b. d. None of these
9. Identify the items included in the debt schedule.
a. Opening balance (beginning of the period)
b. Repayments (decreases)
c. Draws (increases)
d. All of these

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ACTIVITY
IM
Find the advantages and disadvantages of the Debt Schedule.

FREE CASH FLOW (FCF): MEASURING

6.7 THE CASH PRODUCED BY THE
BUSINESS
M

Free Cash Flow is the amount of money a company has left over after
paying for operational costs and capital asset maintenance. In con-
trast to profits or net income, free cash flow is a measure of profitabil-
ity that accounts for both changes in working capital from the balance
sheet as well as spending on assets and machinery. The income state-
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ment is also cleared of non-cash elements.

Interest payments are not included in the widely accepted definition

of free cash flow. Investment bankers and analysts will evaluate a
company’s expected performance under alternative capital structures
using free cash flow variations, such as free cash flow for the business
and free cash flow to equity, which are adjusted for interest payments
and borrowings.

To measure the impact of dilution, free cash flow is often calculated on

a per-share basis.

The cash flow that a firm has available to pay dividends and inter-
est to investors, as well as its creditors, is known as Free Cash Flow
NOTE (FCF). Because these measurements exclude non-cash items from
Free cash flow = sales revenue the income statement, some investors prefer to use FCF or FCF per
- (operating costs + taxes) share as a measure of profitability over profits or earnings per share.
- required investments in FCF may be lumpy and uneven over time, however, since it takes into
operating capital. account investments in real estate, machinery and equipment.

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 Building an Integrated Cash Flow Model  209

BENEFITS OF FCF

FCF may provide significant insights into the value of a firm and the
health of its basic trends since it considers working capital movements.
A decline in accounts payable (outflow) might indicate that suppliers
want payments made more quickly. A decline in accounts receivable
(inflow) might indicate that consumers are paying the business more
quickly. A growing backlog of unsold goods may be indicated by a rise
in inventory (outflow). Working capital inclusion adds a dimension to
profitability metrics that the income statement neglects.

Assume, for example, that a business has earned ` 50,000,000 in net

profits every year for the previous ten years. On the surface, it seems
Know More
Free cash flow is important to
consistent, but what if FCF has been declining over the previous two investors and business analysts
years as stocks increased (outflow), consumers started delaying pay-

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because it shows how much
ments (outflow) and suppliers started requesting quicker payments cash your company has at its
from the company (outflow)? In this case, FCF would disclose a signif- disposal. They often assess your
free cash flow to determine
icant financial vulnerability that was not apparent by just looking at
whether your company has
the income statement.
IM enough cash to repay debts,
issue dividends and buy back
FCF is a good place for potential investors or lenders to start when shares.
determining whether the company will be able to cover its expected
dividends or interest. If the company’s loan payments were deducted
from FCF, the quality of cash flows available for future borrowings
would be better understood by lenders (free cash flow to the business).
Similar to this, by deducting interest expenses from FCF, investors
M

may assess the expected consistency of future dividend payments.

LIMITATIONS OF FCF

Consider a business with `1,000,000 in profits before interest, taxes,

N

depreciation and amortisation (EBITDA) each year. Assume further

that this company’s working capital (current assets minus current lia-
bilities) has not changed, but that at year’s end, `8,00,000 worth of new
equipment was purchased. Depreciation on the income statement will
be used to stretch out the cost of the new equipment over time, bal-
ancing the effect on profits.

The corporation will report `2,00,000 FCF (`10,00,000 EBITDA –

`8,00,000 equipment) on `10,00,000 of EBITDA that year, however,
since FCF takes into account the cash spent on new equipment in
the current year. EBITDA and FCF will be identical once again the
next year, assuming nothing else changes and no new equipment is
purchased. In this case, a potential investor must decide why FCF
dropped so sharply one year before rising again and if the trend is
likely to persist.

Further insights may be gained by comprehending the depreciation

mechanism being used. For instance, dependent on the amount of
depreciation taken each year of the asset’s useful life, net income and

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210 FINANCIAL MODELLING

FCF will vary. If the asset is being depreciated over a useful life of 10
years using the book depreciation method, then net income will be
`80,000 (`800,000/10 years) less than FCF for each year until the asset
is fully depreciated. On the other hand, if the asset is being depreci-
ated according to the tax depreciation method, the asset will be com-
pletely depreciated in the year it was acquired, resulting in net income
that equals FCF in later years.

CALCULATING FCF

Starting with the cash flows from operating activities on the state-
ment of cash flows, FCF may be determined since this figure will
already contain profits that have been adjusted for non-cash items
and changes in working capital.

S
Factor Location
+ Cash flow from operating activity Statement of Cash Flow
- Interest Expenses Income Statement
IM
- Tax Shield on Interest Expenses Income Statement
- Capital Expenditures (CAPEX) Statement of Cash Flow (Cash Flow
from Investing Activities)
= Free Cash Flow

FCF may also be calculated using the balance sheet and income state-
ment.
M

Factor Location
+ EBIT × (1- Tax Rate) Income Statement
+ Non-cash Expenses (Deprecation, Income Statement
Amortisation, etc.)
N

- Change in (Current Assets- Cur- Balance Sheet (current period and

rent Liabilities) previous period)
- Capital Expenditures (CAPEX) Balance Sheet: Property, Plant and
Equipment (Current period and
previous period)
= Free Cash Flow

The same computation may be made using additional data from the
cash flow statement, balance sheet and income statement. An investor
might determine the right computation, for instance, if EBIT was not
provided.

Factor Location
+ Net Income Income Statement
+ Interest Expenses Income Statement
- Tax Shield on Interest Expenses Income Statement (Net Interest
expenses × Tax rate)

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 Building an Integrated Cash Flow Model  211

Factor Location
+ Non-Cash expenses (Deprecia- Income Statement
tion, Amortisation, etc.)
- Change in (Current Assets- Cur- Balance Sheet (current period and
rent Liabilities) previous period)
- Capital Expenditures (CAPEX) Balance Sheet: Property, Plant and
Equipment (Current period and
previous period)
= Free Cash Flow

FCF is not required to give the same financial disclosures as other line
items in the financial statements, though. This is problematic because,
if you take into consideration the possibility that capital expenditures
(Capex) may cause the number to appear a little “lumpy,” FCF is a

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valuable tool for verifying a company’s declared profitability. Even
while the effort is important, not all investors possess the required
background knowledge or have the time to dedicate to manually cal-
culating the number.
IM
SELF ASSESSMENT QUESTIONS

10. The cash a firm earns after deducting cash expenditures for
operating expenses and capital asset maintenance is known
as
a. Discounted cash flow b. Balance sheet
M

c. Free cash flow d. Income statement

11. The commonly recognised notion of free cash flow excludes
a. Interest received b. Principal payment
N

c. Cash received d. Interest payments

ACTIVITY

Discuss the process of Free Cash Flow.

MERCK: REVERSE ENGINEERING THE

6.8
MARKET VALUE
The discounted cash flow (DCF) analysis is a stock valuation method
that may have come across if it is ever thumbed through a stock ana-
lyst’s report. To calculate DCF, a firm must anticipate its future cash
flows, apply a discount rate based on the risk it faces and determine a
precise value for its shares, sometimes known as a “target price.”

The issue is that forecasting future cash flows involves a fair amount
of speculation. There is a solution to this issue, however. It can deter-
mine the amount of cash flow that the firm would need to create to

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212 FINANCIAL MODELLING

achieve its present value by working backwards, beginning with the

current share price. It can determine if the stock is worth its going
price based on how likely the cash flows are to occur.

REVERSE-ENGINEERING DCF

However, there is another technique to utilise discounted cash flow

that avoids the challenging issue of precisely projecting future cash
flows. Start with what you do know for sure about the stock — its
present market value—instead of attempting to arrive at a target
stock valuation by beginning your study with an unknown, the com-
pany’s future cash flows. We can determine how much cash the firm
will need to generate to support that price by working backwards, or
reverse-engineering, the DCF from its stock price.

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The stock is overpriced if the present price expects greater future
cash flows than the business can generate. If, on the other hand, the
market’s expectations are lower than what the firm is capable of deliv-
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ering, we should conclude that it is undervalued.

SELF ASSESSMENT QUESTIONS

12. Which of the following analysis is a stock valuation method

that may have come across if it is ever thumbed through a
stock analyst’s report?
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a. Discounted cash flow (DCF)

b. Free cash flow (FCF)
c. Reverse-Engineering DCF
d. All of these
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ACTIVITY

Create an example of discounted cash flow with the help of MS

Excel.

S 6.9 SUMMARY
‰‰ When a formula depends either directly or indirectly on itself, a
circular reference is produced. When C = A+B, yet A or B is a
function of C in turn, this is known as circular logic.
‰‰ By utilising a copy-and-paste macro to isolate the circular refer-
ence, the issue may be fixed, although inelegantly.
‰‰ A more elegant analytical method, as opposed to an iterative one,
is often taken after reflecting on the problem that is seeking to
address.

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 Building an Integrated Cash Flow Model  213

‰‰ When building a financial model, everything from colours to fig-

ures to formulae to text has a precise formatting rationale.
‰‰ Quality analytical work and excellent presentation are both cru-
cial for a variety of reasons, therefore, formatting is crucial.
‰‰ The drivers (inputs) tab must appear right after the model’s cover
page. Given that non-finance operators are likely to use this tab
the most, must make sure it is clear, succinct and simple to grasp.
‰‰ A debt schedule lists every debt that a company has according to
its maturity on a timetable.
‰‰ An analyst will almost always need to create an Excel supporting
schedule that details debt and interest when creating a financial
model.

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‰‰ Loans that amortise have level payment amounts throughout the
loan, but the amounts of interest and principal that go into each
payment change.
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‰‰ The bulk of each payment is used to pay interest at the beginning
of the schedule, as time goes on, the majority of payments start to
cover the loan’s remaining principal.
‰‰ For instalment loans with known payment dates at the time the
loan is obtained, such as a mortgage or a vehicle loan, borrowers
and lenders utilise amortisation schedules.
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‰‰ The cash a firm earns after deducting cash expenditures for oper-
ating expenses and capital asset maintenance is known as Free
Cash Flow (FCF).
‰‰ The Discounted Cash Flow (DCF) analysis is a stock valuation
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method that may have come across if it is ever thumbed through a

stock analyst’s report.

KEY WORDS

‰‰ Amortisation schedule: The full table of periodic loan pay-

ments, including the amounts of principal and interest that
make up each level payment until the loan is repaid in full after
its term
‰‰ Debt schedule: A debt schedule lists every debt that a company
has according to its maturity on a timetable
‰‰ Free cash flow (FCF): The cash a firm earns after deducting
cash expenditures for operating expenses and capital asset
maintenance
‰‰ Reverse-Engineering DCF: There is another technique to uti-
lise discounted cash flow that avoids the challenging issue of
precisely projecting future cash flows

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6.10 MULTIPLE CHOICE QUESTIONS

MCQ
1. When building a financial model, everything from colours to
figures to formulae to text has a precise
a. Formatting rationale
b. Colour scheme
c. Custom formatting
d. Circular logic
2. Which of the following is a symbol for caution and should be used
to alert other users or link to another model (= [TTS v1.0xls]
Sheet1! C3)?

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a. Red
b. Green
c. Blue
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d. Black
3. For a formula connecting to databases such as Capital IQ (=CIQ
($E$2, “IQ TOTAL REV”, IQ FY)), a deep, dark crimson is
acceptable. Which of the following option is correct regarding
the above statement?
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a. Black
b. Green
c. Dark red
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d. None of these
4. Which of the following colour should be used to illustrate
references to other schedules or sheets (=Sheet1! B3)?
a. Black
b. Green
c. Yellow
d. Red
5. Which of the following will drive various assumptions scenarios
and, ultimately, sensitivity tables?
a. Assumptions
b. Inputs
c. Hard-coded figures
d. Sensitising parameters

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 Building an Integrated Cash Flow Model  215

6. The full table of periodic loan payments, including the amounts

of principal and interest that make up each level payment until
the loan is repaid in full after its term, is represented by
a. Amortisation schedule
b. Debt schedule
c. Both a. and b.
d. None of these
7. Which of the following should provide a copy of the loan
amortisation schedule if an individual taking out a mortgage or
vehicle loan?
a. Owner

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b. Lender
c. Lessee
d. All of these
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8. A decline in which of the following might indicate that suppliers
want payments made more quickly?
a. Accounts receivable
b. Accounts payable
c. Inventory
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d. Cash

6.11 DESCRIPTIVE QUESTIONS ?

1. Define the circularity.
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2. Discuss the debt schedule and amortisation schedule.

3. Explain the Free Cash Flow (FCF).

HIGHER ORDER THINKING SKILLS

6.12
(HOTS) QUESTIONS
1. A decline in which of the following might indicate that consumers
are paying the business more quickly?
a. Accounts receivable
b. Accounts payable
c. Inventory
d. Cash
2. Which of the following inclusion adds a dimension to profitability
metrics that the income statement neglects?
a. Fixed assets
b. Current assets

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216 FINANCIAL MODELLING

c. Working capital
d. None of these

6.13 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Building an Integrated Cash 1. a. Excel page
Flow Model
2. b. Revenues
Understanding Circularity 3. c. Circular reference
Setting up and Formatting 4. d. Black

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the Model
5. b. Blue
Selecting Model Drivers and 6. b. Drivers (inputs)
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Assumptions
7. a. Hard-coded figures
Creating the Debt and Inter- 8. b. Debt schedule
est Schedule
9. d. All of these
Free Cash Flow (FCF): Meas- 10. c. Free Cash Flow
uring the Cash Produced by
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the Business
11. d. Interest Payments
Merck: Reverse Engineering 12. a. Discounted Cash Flow
the Market Value (DCF)
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. a. Formatting rationale
2. a. Red
3. c. Dark red
4. b. Green
5. d. Sensitising parameters
6. a. Amortisation schedule
7. b. Lender
8. b. Accounts payable

HINTS FOR DESCRIPTIVE QUESTIONS

1. When a formula depends either directly or indirectly on itself,
a circular reference is produced. When C=A+B, yet A or B is a
function of C in turn, this is known as circular logic.

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 Building an Integrated Cash Flow Model  217

Although the problem may be solved via an iterative process,

this violates a key principle of effective financial modelling. The
frequently adopted market solution is riddled with flaws. Refer
to Section 6.3 Understanding Circularity
2. A debt schedule lists every debt that a company has according
to its maturity on a timetable. Businesses often utilise it to
create a cash flow analysis. The following graph illustrates how
principal repayments move via the cash flow statement, closing
debt balance flows into the balance sheet and interest cost from
the debt schedule flows into the income statement (financing
activities).
The full table of periodic loan payments, including the amounts
of principal and interest that make up each level payment until

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the loan is repaid in full after its term, is represented by a loan
amortisation schedule. The bulk of each payment is used to
pay interest at the beginning of the schedule; as time goes on,
the majority of payments start to cover the loan’s remaining
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principal. Refer to Section 6.6 Creating the Debt and Interest
Schedule
3. The cash a firm earns after deducting cash expenditures for
operating expenses and capital asset maintenance is known as
free cash flow (FCF). Free cash flow, as opposed to profits or
net income, is a metric of profitability that takes into account
both changes in working capital from the balance sheet as well
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as expenditure on assets and equipment. It also eliminates non-

cash items from the income statement. Refer to Section 6.7
Free Cash Flow (FCF): Measuring the Cash Produced by the
Business
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ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. a. Accounts receivable
2. c. Working capital

6.14 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
Bloss, M. and Dirnberger, M., n.d. Financial Modeling.
‰‰ Pfaff,
P., 1990. Financial modeling. Needham Heights, Mass.: Allyn
and Bacon.
‰‰ Zivot,E. and Wang, J., 2003. Modeling financial time series with
S-Plus. New York: Springer.

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E-REFERENCES
‰‰ Financial Edge. 2022. 3-Statement Model - Financial Edge. [online]
Available at: <https://www.fe.training/free-resources/finan-
cial-modeling/3-statement-model/> [Accessed 2 September 2022].
‰‰ Toptal Finance Blog. 2022. How to Prepare a Cash Flow Statement
Model That Balances. [online] Available at: <https://www.toptal.
com/finance/cash-flow-consultants/how-to-prepare-cash-flow-
statement> [Accessed 2 September 2022].
‰‰ O’Reilly Online Learning. 2022. Financial Modeling in Excel For Dum-
mies. [online] Available at: <https://www.oreilly.com/library/view/
financial-modeling-in/9781119357544/16_9781119357544-ch10.
xhtml> [Accessed 2 September 2022].

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 CASE STUDIES
4 TO 6

CONTENTS

Case Study 4 Sensitivity Analysis in Excel

Case Study 5 Weighted Average Cost of Capital
Case Study 6 Assessment of Cash flow

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CASE STUDY 4

SENSITIVITY ANALYSIS IN EXCEL

Joe Nicolas is an analyst and he in the case of bond pricing identi-

Case Objective fied the coupon rate and the yield to maturity as the independent
The aim of this case study is variables. He mentioned that the dependent output formula is the
to discuss the relevance and bond price. The coupon is paid in 6 months with a 1,000-dollar par
uses of sensitivity analysis. value. It is expected that the bond will expire in 5 years.

Joe evaluated the sensitivity of the bond price for multiple values
of coupon rate and yield to maturity. Let us understand how he
performed the sensitivity analysis.

Joe took the coupon rate range as (Refer to Table A):

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Table A: Range of Coupon Rate and Coupon Rate
Range of coupon rate (%) Coupon rate (%)
5.00 5
5.50 6
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6.00 7
6.50 8
7.00 9

Joe, based on the technique, considered all the combinations of

yield to maturity and coupon rate for calculating the bond price
sensitivity.
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Now, let us see how he performed the calculation of the bond

price. Below given table shows the bond price:

The Bond Price is $102,160

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CASE STUDY 4

Joe clicked on the Data tab in excel and selected the what-if anal-
ysis option for the calculation of Sensitivity Analysis. He clicked
on Data tables.

Below given excel sheet shows the changes in the bond price with
the change in yield to maturity and change in coupon rate:

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Relevance and Uses
‰‰ It
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is one of the powerful excel tools.
‰‰ Ithelps in knowing the result of the financial model under
various conditions.
‰‰ It is the perfect complement to another excel tool, i.e., scenario
manager.
‰‰ It gives flexibility to the valuation model during the process of
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analysis.
‰‰ Itis an effective and efficient method to give a presentation to
the boss or client.
Source: https://www.wallstreetmojo.com/sensitivity-analysis/
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QUESTIONS

1. Explain the role of what-if analysis in excel.

(Hint: Alter the values to see the effect of the changes,
and the outcome of formulas on the worksheet)
2. Describe the relevance and uses of sensitivity analysis.
(Hint: The result of the financial model, valuation model)

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222 FINANCIAL MODELLING

CASE STUDY 5

WEIGHTED AVERAGE COST OF CAPITAL

Mr. Aman is working as a financial analyst in the ABC Corpora-

Case Objective tion. Mr. Aman has several responsibilities out of which one is to
This case study exhibits about make sure that overall cost of capital of the corporation should be
calculating overall Weighted minimum without affecting the quality of return. For achieving
Average Cost of Capital. the same objectives Mr. Aman prepares a certain portfolio where
proportion of debt, equity and preferred stocks are arranged ins
such a manner that they do not increase the borrowing cost and
simultaneously help in providing better return.

Given that ABC Corporation is operating under the category of

perfect competition market. So, ABC Corporation also requires
ensuring that the proportion of their debt and equity should be

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equitable.

Suppose that the cost of common stock equity of ABC Corpora-

tions is 8.4%. The cost of preferred stock equity is 6.8% and the
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weighted average interest rate on the company debt is 6.9%. Also,
assume that the market value percentage of each component of
the capital structure are 55% common stock, 20% and 25% debt.
The corporate tax rate is 30%.

QUESTIONS

1. Find out the after-tax cost of debt?

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(Hint: Cost of debt (after tax) = Interest rate × (1-tax rate)

= 6.0 % × (1-0.3)
= 4.2% or 0.042
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2. Compute Weighted Average Cost of Capital (WACC)?

(Hint: WACC = {(proportion of equity / Value of firm ×
cost of equity) + proportion of preferred stock / value
of firm × cost of preferred stock) + (proportion of debt/
Value of firm × Cost of debt (after tax)}
= (8.4% × 55%) + (6.8% × 20%) + (4.2% × 25%)
= 7.03%

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 Case study 6: Assessment of Cash flow  223

CASE STUDY 6

ASSESSMENT OF CASH FLOW

In 2016, Mr. Rahul started a job, working as a driver with Mr. Abdul
Khan of M/s Khan and Sons. However, in April 2017, he decided to Case Objective
run his own business of operating and maintaining cabs. For this pur- This case study underscores
pose, he acquired a car costing `8,20,000. This payment comprised cash flow in the business.
` 40,000 on annual insurance, `70,000 on 15-year road tax and
`4,500 on expenses related to legal registration. Mr. Rahul paid
`2,15,000 as the down payment and undertook a mortgage loan
for the payment of the remaining balance. This mortgage loan
was structured in such a manner that it had 36 monthly instal-
ments of `19,000 each.

During the first year of commencement of the cab business, his

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only source of income was the fare money collected from the cab
service, which amounted to ` 2,28,000.

He had noted down all the detailed information of expenditure

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incurred by him in a pocket diary as given in Table A:

Particulars Amount (in `)

Groceries purchased for personal use 59,255
Clothes bought for himself and his family 3,590
Tuition fees for his son 900
Driver’s uniform for himself and the driver’s badge 3,155
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Refreshments while on duty 19,000

Sari bought it for his mother 1,300
Diesel and oil 1,89,500
Electricity bill payment for his house 12,000
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Loan EMI paid 2,20,000

Deposited in a savings bank account 8,160

He organised a small get-together party for his family and friends.

His wife was concerned that he had invested all his savings in the
cab business and did not save anything therefrom. His wife asked
him, “Did you make any profit?” After recalling his expenses and
making some mental computations, he replied, “As of now, I have
made a loss of `2,88,860.”

To take a second opinion, his wife insisted he consult her cousin,

Mrs. Divyanka Seth, who is a practising Chartered Accountant.
Mrs. Divyanka told her that the books of accounts need to be pre-
pared taking into consideration accounting concepts and basic
principles.

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224 FINANCIAL MODELLING

CASE STUDY 6

QUESTIONS

1. Do you think that Mr. Rahul’s judgement of loss computa-

tion is correct? Why or why not?
(Hint: Mr. Rahul had computed the amount of loss by net-
ting off all the Cash expenses incurred during the year
against the fare money earned from cab service. He did
not consider the nature of expenses incurred and failed
to segregate between the cash expenses for business and
personal expenses.)
2. Explain some measures to be adopted for the calculation
of actual profit (or loss) earned (or suffered) by Mr. Rahul.

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(Hint: After consultation with the Chartered Accoun-
tant, Mr. Rahul should analyse all the expenses incurred
during the financial year from the perspective of business
operations. For instance, the tuition fee paid, the grocer-
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ies purchased for personal use, etc.)
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 C H A
7 P T E R

PRO FORMA FOR FINANCIAL

STATEMENT MODELLING

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CONTENTS

7.1 Introduction
7.2 Meaning of Financial Statement Modelling
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Self Assessment Questions
Activity
7.3 Modelling and Projecting the Financial Statements
7.3.1 Projecting the Income Statement
7.3.2 Projecting the Balance Sheet
7.3.3 Projecting the Cash Flow Statement
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7.3.4 Drafting Cash Flow Projection

Self Assessment Questions
Activity
7.4 How Financial Models Work
7.4.1 Projecting Next Year’ s Balance Sheet and Income Statement
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Self Assessment Questions

Activity
7.5 Alternative Modelling of Fixed Assets
7.5.1 Gross Fixed Assets as a Function of Sales
7.5.2 Constant Net Fixed Assets
Self Assessment Questions
Activity
7.6 Sensitivity Analysis
Self Assessment Questions
Activity
7.7 Debt as a Plug
Self Assessment Questions
Activity
7.8 Incorporating a Target Debt/Equity Ratio into a Pro Forma
Self Assessment Questions
Activity

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226 FINANCIAL MODELLING

CONTENTS

7.9 Project Finance: Debt Repayment Schedules

Self Assessment Questions
Activity
7.10 Calculating the Return on Equity
7.10.1 The ROE in Our First Full Model
Self Assessment Questions
Activity
7.11 Tax Loss Carry Forwards
Self Assessment Questions
Activity
7.12 Summary

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7.13 Multiple Choice Questions
7.14 Descriptive Questions
7.15 Higher Order Thinking Skills (HOTS) Questions
7.16 Answers and Hints
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7.17 Suggested Readings & References
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 Pro Forma for Financial Statement Modelling  227

INTRODUCTORY CASELET

CASH FLOW STATEMENT

A cash flow statement is a type of financial statement that gives

total information about all of the cash inflows a business makes Case Objective
from continuing activities and outside investment sources. It also
This caselet highlights the
covers any cash outflows made within a specific time period to introduction of cash flow
cover investments and business expenses. statement.

The financial statements of a firm give investors and analysts a

picture of all the business transactions that take place, where
each transaction helps the company succeed. Because it tracks
the cash generated by the firm in three key ways—through opera-
tions, investments and financing—the cash flow statement is seen
to be the most understandable of all the financial statements. Net

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cash flow is the total of these three components.

Investors can estimate the worth of a firm’s shares or the com-

pany overall using these three separate portions of the cash flow
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statement. Every business that offers and sells stock to the public
is required to submit financial statements and reports to the Secu-
rities and Exchange Commission (SEC).

The balance sheet, income statement and cash flow statement are
the three primary financial statements. An important document
that gives interested parties’ information about all of a company’s
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activities is the cash flow statement. The two subfields of account-

ing are accrual and cash. Since accrual accounting is used by the
majority of publicly traded corporations, the cash position of the
business is not reflected in the income statement. However, the
cash flow statement is concentrated on cash accounting.
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Profitable businesses may not manage cash flow well, which is

why the cash flow statement is an essential tool for businesses,
analysts and investors. Operations, investment and financing are
the three distinct corporate activities that make up the cash flow
statement.

Consider a business that sells a product and gives its consumer

credit for the purchase. Even if it counts that transaction as
income, the corporation might not really be paid for it right away.
The corporation reports a profit on the income statement and
pays income taxes on it, but actual cash flow for the company may
be higher or lower than projected sales or revenue.

By monitoring an organisation’s cash flow, a cash flow statement

is a crucial tool for managing finances. This report is one of the
three crucial ones that determine a company’s success, together
with the income statement and the balance sheet.

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INTRODUCTORY CASELET

Making cash projection is often beneficial for facilitating short-

term planning. The cash flow statement lets you keep track of
incoming and departing cash by displaying the source of that
money. An organisation’s operational, investment and financial
operations all generate cash flow. The statement also provides
information on investments, business-related costs and cash with-
drawals at a certain moment in time. The knowledge you obtain
from the cash flow statement helps managers make wise decisions
for managing business operations. Businesses often strive for a
healthy cash flow because without it, they risk having to borrow
money to keep the firm afloat.

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 Pro Forma for Financial Statement Modelling  229

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Define the financial statements modelling
>> Discuss the modelling and projecting financial statements
>> Describe the alternative modelling of fixed assets
>> Elaborate the debt as a plug
>> Develop a pro forma that incorporates a target debt/equity
ratio
>> Analyse how are tax losses carried forward?

7.1 INTRODUCTION

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In the previous chapter, you studied about an integrated cash flow Quick Revision
model. The cash flow model revolves around the provision of infor-
mation about the historical changes in cash and cash equivalents of
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an organisation through conduit of a cash flow statement which cate-
gorises cash flows during the timeline from operating, investing and
financing activities. Users of an organisation’s monetary statements
are willing to delve into how the organisation generates cash and cash
equivalents and how it is being utilised.

There is no question about the value of financial statement predictions

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for corporate financial management. Many businesses rely heavily on

these projects, often known as pro forma financial statements. Pro
forma financial statements serve as the foundation for many credit
studies and are also used to estimate how much funding a company
will require in the coming years. A pro forma financial statement proj-
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ects performance over a future period using fictitious data or assump-

tions about probable values.

Pro forma financial statements are defined as “financial statements

predicted for future periods” in the Financial Accounting online
course. They may also be known as financial projections or financial
projects.

If the presumptions made when creating them are correct, the projec-
tions may be utilised “as a portrayal of what the financial statements Know More
for the firm will look like over a particular period of time,” according A pro forma financial statement
leverages hypothetical data or
to the course. assumptions about future values
to project performance over a
Pro forma can relate to a number of financial statements since it per- period that hasn’t yet occurred.
tains to projections or expectations such as:
‰‰ Income statements
‰‰ Balance sheets
‰‰ Cash flow statements

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230 FINANCIAL MODELLING

These estimates can be helpful in directing crucial company choices,

whether you are trying to create or evaluate pro forma financial state-
ments. Pro forma financial statements are really used by business
owners, investors, creditors and other important decision makers to
assess the possible effects of business choices.

Financial statement analysis has historically been used to comprehend

a company’s performance over a specific time period. While doing so
gives information about a company’s past performance, generating
pro forma financial statements is more concerned with the future.
Because of this, these reports may be used in a variety of ways, such
as risk analysis, investment projection and demonstrating anticipated
outcomes prior to the conclusion of a reporting period.

Pro forma reports are used extensively in decision making and strate-
NOTE

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gic planning processes. Pro forma financial statements, for instance,
Keep in mind that the general might be produced to represent the results of three different invest-
process of creating pro forma
ment scenarios for your company. By doing this, you may compare
financial statements isn’t
potential outcomes side by side to decide which is best and use that
significantly different from
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that of creating traditional information to direct your planning process.
statements. The difference
lies in the assumptions and In this chapter, you will study the meaning of financial statements
adjustments made about various modelling, alternative modelling of fixed assets, sensitivity analysis,
inputs, while the format and
debt as a plug, calculating the return on equity, tax loss carry forwards,
calculations remain the same.
etc., in detail.
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MEANING OF FINANCIAL STATEMENT

7.2
MODELLING
Financial statement modelling is a process of summarising a compa-
ny’s costs and profits in a spreadsheet that can be used to estimate the
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effects of a choice or event in the future. For business leaders, a finan-

cial statement model has various applications. It is most frequently
used by financial analysts to assess and forecast potential effects of
upcoming events or management choices on a company’s stock per-
formance.

Financial statement modelling is a way to see the past and present

performance of a business and its anticipated performance in future.
These models are designed to be instruments for making decisions.
They could be used by company leaders to predict the expenses and
profitability of a proposed new project.

They are employed by financial statement analysts to explain or fore-

see the effects of various events on a company’s stock, ranging from
internal elements such as a change in strategy or business model to
external ones such as a change in economic policy or legislation. Mod-
els of financial statements are used to determine a company’s value
or to assess how well a company is performing in comparison to its
competitors. They are also employed in strategic planning to evalu-

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 Pro Forma for Financial Statement Modelling  231

ate potential outcomes, determine project costs, establish budgets and

distribute resources throughout the organisation. Detailed appraisal,
sensitivity analysis and discounted cash flow analysis are a few exam-
ples of financial statement models.

SELF ASSESSMENT QUESTIONS

1. Which of the following is the practice of putting a company’s

costs and profits in a spreadsheet that can be used to estimate
the effects of a choice or event in the future?
a. Financial statement modelling
b. Sensitivity analysis
c. Discounted cash flow analysis

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d. All of these

ACTIVITY
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Write a short note on the uses of cash flow.

MODELLING AND PROJECTING

7.3
FINANCIAL STATEMENTS
A financial projection displays the anticipated earnings, costs and
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cash flows of a company over a given time frame. This projection may
be provided to other parties or used internally as the foundation for a
more thorough budget. A financial forecast may be used to persuade
a bank to lend money to a company or investors to purchase stock in
the company. A financial prediction is based on a mix of past perfor-
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mance, anticipated shifts in the relevant market and other alterations

in the business’s environment, such an investment in a new product
line.

It is always recommended to project income statement line items

when creating a three-statement model. The ability to forecast the
key income statement line items should become automatic. There are
factors that will affect the future values of each individual line item.
In fact, you might even be able to easily replicate the model and only
swap out the historical numbers if the financial model you are using is
comparable to another business you need to model.

7.3.1 PROJECTING THE INCOME STATEMENT NOTE

A projected income statement is just similar to Income statement or Similar to an income statement,
the Income Statement Projection
profit and loss statement. The key distinction is that the projected
follows the following Rule:
income statement contains estimates for a future time, whereas the
income statement has actual statistics. It is among the most signifi- Net Profit = (Total Revenues –
cant financial statement. The projected income statement anticipates Total Expenses)

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232 FINANCIAL MODELLING

the revenue and costs that the firm could incur in the upcoming time
frame. Depending on the needs, it might be either monthly, quarterly
or annually.

7.3.2 PROJECTING THE BALANCE SHEET

Small firms must accurately anticipate their future financial situation,

including a projection of the company’s assets, liabilities and capital,
in order to project a balance sheet. One of the most important finan-
cial statements for small business accounting is the balance sheet,
often known as the statement of financial position.

A balance sheet projection is crucial for businesses because it projects

NOTE the assets and liabilities that a company will have at a certain point
in time. Small firms can use projecting a balance sheet to determine

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All in all, the process of
preparing a pro forma balance what they will probably own and owe at a future date, which can help
sheet is much the same as them prepare for upcoming purchases and other crucial business
preparing a normal balance choices. Businesses evaluate previous financial statements to antici-
sheet. The same holds true for
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pate a balance sheet and utilise that historical information to project
the process of preparing income
statements and cash flow
future capital, assets, debt and equity. For a projected balance sheet,
statements. the steps below should be followed:
1. Project net working capital: Determine your company’s net
working capital first before you can anticipate a balance sheet.
The sum of your current assets and liabilities is your net working
capital. Examine your past asset and liability data to project your
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future net working capital. Using financial data from the previous
two years is a common practice. You may anticipate a reasonable
net working capital figure for your balance sheet projects based
on your company’s historical net working capital statistics and
how they’ve evolved over time.
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2. Project fixed assets: Projecting your fixed assets is the next

stage in a balance sheet projection. Your company’s fixed assets
are long-term physical assets that are relatively easy to estimate.
To anticipate your future fixed assets with accuracy, you must
take depreciation into account. The calculation to project your
future fixed assets is as follows:
Projected Fixed Assets = Fixed Assets Last Year + Capital
Expenditures – Depreciation
3. Estimate financial debt: The next step is to project your debt,
which is a simple procedure. Use this method to project the
financial debts of your company:
Projected Financial Debt = Financial Debt Beginning of Year +
Change in Financial Debt
4. Project equity position: Your predicted equity position follows
on your balance sheet prediction. When estimating equity, you
are predicting both retained earnings and the money you have

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invested in the company. Using the following formula, you may

predict the equity of your company:
Projected Equity = Equity Last Year + Net Income – Dividends
+ Change in Equity
5. Project cash position: Projecting your cash situation is the last
stage in predicting the balance sheet. You may estimate this
using your cash flow statement. The formula for predicting cash
position is as follows:
Projected Cash Position = Last Year’s Cash Position + Change
in Cash

7.3.3 PROJECTING THE CASH FLOW STATEMENT

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Once you have determined your volume-based sales predictions,
translate your sales volumes into income to get your cash flow projec-
tions. Accounts receivable are displayed in the example below based
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on cash sales with 30-, 60- and 90-day receivables. You can project
your monthly cash flow needs by subtracting outflows from all cash
inflows. It becomes a crucial choice whether or not to continue with
your business if you find yourself in a bad situation unless you can Know More
make reasonable modifications to either your inflows or outflows A projected cash flow statement
through the extension of accounts payable or authorised operating is described as a listing of all
lines of credit. These solutions should only be taken into account if expected cash inflows and
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outflows for the coming year.

there will be extra money in the coming months to pay off operating
loans and/or accounts payable.

The cash flow project, which includes the quantity and timing of antic-
ipated cash inflows and outflows, might be more crucial for a new
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company than the prediction of the income statement. Typically, lev-

els of earnings, especially during a business’s early years, will not be
enough to cover operational cash requirements. Furthermore, on a
short-term basis, cash inflows and outflows are not equal. These cir-
cumstances will be indicated by cash flow predictions, and if neces-
sary, the aforementioned cash flow management methods may need
to be put into practice.

The cash flow statement will demonstrate your peak working capital
needs and emphasise the need for and timing of additional financing
given a level of predicted sales, related costs and capital expenditure
plans over a certain time. You must decide how to receive, under what
conditions and how to repay this additional funding.

7.3.4 DRAFTING CASH FLOW PROJECTION

You may start creating your cash flow prediction after you have these
reasonable hypotheses at your disposal. At the beginning, add 12 col-

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234 FINANCIAL MODELLING

umns to the top of a spread sheet, one for each of the upcoming 12
months. Next, list the following cash flow categories in a separate col-
umn on the left and then input the correct amount for each column
for each month.
‰‰ Opening cash, beginning: The amount you’ll have at the start of
each month
‰‰ Sources of cash: All monthly revenue (receivable collections or
direct sales, loans, etc.).
‰‰ Total sources of cash: To the amount in the “Sources of cash” for
each month, add the amounts in the “Operating cash, starting”
row.
‰‰ Uses of cash: List all possible expenditures for your company,

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including wages, accounts payable to suppliers, rent, loan pay-
ments, etc.
‰‰ Total uses of cash: Add together all your costs to get a clear pic-
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ture of how much money will be spent each month.
‰‰ Excess of cash: The key metric is the excess (shortfall) of cash. It is
a positive sign if you notice positive results across the board. You
might have some additional money to put back into your company.
Do not become alarmed if one of the months has a negative figure;
you still have time to prepare your company.
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Here is an example of a cash flow projection that has been abbreviated

to 4 months for the sake of simplicity:
‰‰ XYZ Company, LLC
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‰‰ Internal Cash Flow Projections

‰‰ August to November

Operating cash, beginning

August September October November

Beginning amount `6,000 `2,000 `1600 `1600

Sources of cash

August September October November

(`) (`) (`) (`)

Receivable collec- 1,30,000 1,20,000 1,40,000 1,30,000

tions

Customer depos- 20,000 24,000 20,000 20,000

its

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August September October November

(`) (`) (`) (`)

Loans from the 36,000 40,000 30,000 32,000

bank - Revolving
line

Other 6,000 N/A 10,000 N/A

Total sources of 1,98,000 1,86,000 201,600 1,95,600

cash, beginning

Uses of cash
August September October November

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(`) (`) (`) (`)

Payroll, including payroll 40,000 44,000 40,000 40,000

taxes
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Accounts payable - vendors 36,000 30,000 34,000 36,000

Other overhead, including 32,000 32,000 32,000 32,000

rent

Owners compensation 32,000 32,000 32,000 32,000

Line of credit payments 30,000 30,000 46,000 30,000

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Long-term principal pay- 6,000 6,000 6,000 6,000

ments

Purchases of fixed assets 5,000 N/A N/A 20,000

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Estimated income tax, cur- N/A N/A N/A 20,000

rent year

Other 10,000 10,000 10,000 10,000

Total uses of cash 1,96,000 1,84,000 200,000 2,26,000

Excess (deficit) of cash 2,000 1,600 1,600 (42,400)

The company is projecting negative cash in November. What can you

do today to prevent the negative cash flow?

Key assumptions:
1. 75% of sales will be collected the month after the sale.
2. 25% of sales will be collected the 2nd month after the sale.
3. Payables are due in 25 days.
4. 60% of eligible receivables can be used for the revolving line of
credit.

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236 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

2. Which of the following displays the anticipated earnings, costs

and cash flows of a company over a given time frame?
a. Financial statement
b. Financial analysis
c. Financial projection
d. None of these
3. Which of the following is just similar to Income Statement or
Profit and Loss Statement?
a. Projected income statement

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b. Projected balance sheet
c. Both a and b
d. None of these
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ACTIVITY

Find some examples of the financial statements.

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7.4 HOW FINANCIAL MODELS WORK

The majority of the most significant financial statement variables are
NOTE believed to be functions of the firm’s sales level in almost all finan-
cial statement models, which are known as sales driven. For instance,
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Financial model is a
representation in numbers of
receivables are frequently calculated as a proportion of the compa-
a company’s operations in the ny’s sales. An example that is a little more difficult would assume that
past, present and the forecasted the amount of sales is a step function of the fixed assets (or any other
future. account):

 a if sales < A

Fixed assets =  b if A ≤ sales < B
etc.


To build a financial planning model, we must make a distinction

between financial statement items that involve policy decisions and
those that are functional linkages of sales and sometimes of other
financial statement items. The asset side of the balance sheet is typ-
ically thought to be solely dependent on functional relationships.
Alternately, the ratio of long-term debt to equity may be seen as a pol-
icy decision, allowing the current liabilities to just consist of functional
links.

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Here is a straightforward illustration. We want to project the financial

statements for a company whose most recent income statement and
balance sheet are shown in Figure 7.1:

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Figure 7.1: Financial Statement Analysis

Sales are currently at a 1,000 level (year 0). The company predicts the
following financial statement relationships as well as a 10% annual
growth in revenues:

Current assets Assumed to be 15% of end-of-year sales

Current liabilities Assumed to be 8% of end-of-year sales
Net fixed assets 77% of end-of-year sales
Depreciation 10% of the average value of assets on the books
during the year
Fixed assets at cost Sum of net fixed assets plus accumulated depre-
ciation

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238 FINANCIAL MODELLING

Debt The firm neither repays any existing debt nor

borrows any more money over the 5-year hori-
zon of the pro forma
Cash and marketable This is the balance sheet plug. Average balances
securities of cash and marketable securities are assumed
to earn 8% interest

A pro forma model’s plug will often be one of three financial balance
sheet items:
(i) Cash and marketable securities
(ii) Debt
(iii) Stock

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Take a look at our initial pro forma model’s balance sheet as an illus-
tration.

Assets Liabilities and Equity

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Cash and marketable securities Current liabilities
Current assets Debt
Fixed assets Equity
Fixed assets at cost Stock (net funds directly provided by
shareholders)
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– Accumulated depreciation
Net fixed assets Accumulated retained earnings (profits
not paid out)
Total assets Total liabilities and equity
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Cash and marketable securities are assumed to be the plug in the cur-
rent case. This presumption might signify two things:
1. Formally, cash and marketable securities are defined as total
liabilities and equity minus current assets minus net fixed assets.
Cash and marketable securities = Total liabilities and equity –
Current assets – Net fixed assets
By using this definition, assets and liabilities will always be
equal.
2. In addition to identifying the plug as cash and marketable
securities, we are also revealing how the company funds itself.
For instance, in the model below, the company does not sell any
more shares, refinance any of its current debt, or issue any new
debt. According to this definition, the firm’s cash and marketable
securities account will serve as the source of all extra funding (if
necessary), as well as any more cash that the company may have.

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7.4.1 PROJECTING NEXT YEAR’ S BALANCE SHEET AND

INCOME STATEMENT

Above we have given the financial statement for year 0. We now proj-
ect the financial statement for year 1 as shown in Figure 7.2:

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Figure 7.2: Setting up the Financial Statement Model

Most of the formulae are clear. It is crucial to note the dollar signs,
which say that the cell references to the model parameters shouldn’t
change when the formulae are duplicated. When you project years
two and beyond, the model won’t copy accurately if you don’t include
them.

SELF ASSESSMENT QUESTIONS

4. The majority of the most significant financial statement

variables are believed to be functions of the firm’s sales level
in almost all financial statement models, which are known as
a. Sales driven b. Cost of goods sold
c. Profit before tax d. All of these

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240 FINANCIAL MODELLING

ACTIVITY

Discuss some items of the financial statements.

ALTERNATIVE MODELLING OF FIXED

7.5
ASSETS
The models in this chapter are predicated on the notion that Net Fixed
Assets (NFA) are determined by sales. In essence, this means that we
assume that the fixed assets’ depreciation has actual economic rele-
vance and that their after-depreciation value accurately reflects their
capacity for productivity. This seems to us to be a reasonable assump-

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tion at the abstract level of the pro forma models in this chapter.

However, the financial modeler may wish to take into account two dis-
Know More
tinct models. The first of them is based on the notion that depreciation
Fixed assets are long-term
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physical assets used in a has no economic significance. In this instance, sales determine the
business, such as land, gross fixed assets. The second alternative model makes the assump-
buildings, equipment and
tion that, if properly maintained, the current fixed asset base can
patents. They are often referred
to as property, plant and support sustainable levels of future sales. The pro forma architecture
equipment (PP&E). already established may readily support both alternative models, as
shown below with examples.
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7.5.1 GROSS FIXED ASSETS AS A FUNCTION OF SALES

Assume that depreciation has no economic significance and that the

fixed assets at cost represent the assets’ potential for future produc-
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tivity. This just necessitates a little modification to the prior model as

shown in Figure 7.3:

Figure 7.3: Fixed Assets at Cost as a Function of Sales

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7.5.2 CONSTANT NET FIXED ASSETS

In some circumstances, it may be safe to presume that, with good

maintenance, the present fixed assets can support sustainable levels
of future sales.

For instance, if depreciation is thought of as the economic representa-

tion of the upkeep and asset replacement necessary to serve the cur-
rent customer base, then the net fixed assets of a supermarket would
remain constant over time. In a number of Harvard instances, this
assumption has been made.

This variation in our basic model is easily made, as shown below in

Figure 7.4:

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Figure 7.4: Constant Net Fixed Assets

This model implies that depreciation equals capital expenditure. This

can be seen in the free cash flows in Figure 7.5:

Figure 7.5: Free Cash Flow Calculation

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242 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

5. Which of the following can support sustainable levels of future

sales?
a. Present fixed assets
b. Present current assets
c. Past fixed assets
d. Past current assets

ACTIVITY

Find out the calculation of modelling of fixed assets.

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7.6 SENSITIVITY ANALYSIS
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Sensitivity analysis is a method used in financial modelling to examine
how various independent variable values impact a certain dependent
variable in a given set of circumstances. Numerous academic fields,
including biology, geography, economics and engineering, frequently
use sensitivity analysis.

As in any Excel model, we can perform extensive sensitivity analysis

NOTE
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on our valuation.
Sensitivity Analysis (SA) is a
method that measures how the Another option is to compute the impact of both long-term FCF growth
impact of uncertainties of one
and WACC on stock valuation. But you have to be careful here:
or more input variables can lead
to uncertainties on the output
FCF5 × (1 + long − term FCF growth )
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variables. Terminal Value =

WACC − long − term FCF growth

SELF ASSESSMENT QUESTIONS

6. As in any Excel model, we can perform which of the following

on our valuation.
a. Debt as a plug
b. Extensive Sensitivity analysis
c. Both a. and b.
d. None of these

ACTIVITY

Discuss some advantages of sensitivity analysis.

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7.7 DEBT AS A PLUG

In the model above, debt was a constant and the plugs were cash and
marketable securities. However, you can receive negative cash and
marketable securities for specific model parameter values. Take a
look at the example below, it uses the same model as the one before
but, as it says on the spreadsheet, with some different parameter val-
ues as shown in Figure 7.6:

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Figure 7.6: Example of Negative Cash Balance

This results in the cash and marketable securities account (row 27 in

the example above), which is plainly nonsensical, turning negative by
year 2 as a result of these modifications. The economic significance
of these negative statistics is evident, though: The company requires
more funding due to the increasing sales growth, higher current asset
and fixed asset requirements and increased dividend distributions.

What we need is a model that acknowledges that:

‰‰ The amount of cash cannot be 0.
‰‰ The business borrows money when it needs more finance.

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244 FINANCIAL MODELLING

Here is the model shown in Figure 7.7:

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Figure 7.7 Example of No Negative Cash Balance

For the year-5 entries, the formulae for cash (row 27) and debt (row 36)
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are indicated. In accounting words, what they do is as follows:

‰‰ Marketable securities and cash continue to be the model’s plug.
‰‰ The balance sheet’s debt passes the ensuing test:
Current assets + Net fixed assets > Current liabilities + Last
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year’s debt + Stock + Accumulated retained earnings?

In the preceding instance, in order to support the firm’s productive

activity even if cash and marketable securities equal zero, we must
increase loan levels.

Current assets + Net fixed assets < Current liabilities + Last year’ s
debt + Stock + Accumulated retained earnings

If this relationship persists, there is no need to expand debt; rather,

the company has to have positive cash and marketable securities as a
balancing item, which is taken care of by the fact that cash has been
made the plug.

This calculation becomes in Excel programming words (for the year

5, but each previous year has the same type of equation): Max (G28 +
G32-G35 -G37-G38, F36).

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SELF ASSESSMENT QUESTIONS

7. Which of the following was a constant and the plugs were

cash, and marketable securities?
a. Equity
b. Warrants
c. Debt
d. All of these

ACTIVITY

Write a note on the uses of debt for a firm.

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INCORPORATING A TARGET DEBT/
7.8
EQUITY RATIO INTO A PRO FORMA
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We could also wish to modify our model in relation to the plug. Assume
the company has a goal debt to equity ratio: It expects the debt/equity
ratio on the balance sheet to match a certain ratio in each of years 1
through 5 of the contract. The illustration of this scenario is shown in
Figure 7.8:
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Figure 7.8: Target Debt Equity Ratio

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246 FINANCIAL MODELLING

The spreadsheet’s row 41 lists the desired debt-to-equity ratio for each
of years 1 through 5. Over the next two years, the company plans to
reduce its existing debt/equity ratio from 53% to 30%. The following
are the pertinent adjustments to the equations of our initial model:
‰‰ Debt = Target debt/Equity ratio × (Stock + Retained earnings)
‰‰ Stock = Total assets – Current liabilities – Debt – Accumulated
retained earnings

It should be noted that the company will issue new debt in years 4 and
5, but in years 2 through 5 the stock account shrinks (signifying that
new equity is issued) (indicating a repurchase of equity).

SELF ASSESSMENT QUESTIONS

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8. Which of the following ratio expects on the balance sheet
to match a certain ratio in each of years 1 through 5 of the
contracts?
IM a. Net profit ratio b. Gross profit ratio
c. Debt to equity ratio d. None of these

ACTIVITY

Take some examples of equity ratio with calculation.

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PROJECT FINANCE: DEBT REPAYMENT

7.9
SCHEDULES
A typical instance of so-called “project financing” involves a company
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borrowing money to fund a project. Borrowing frequently has condi-

tions attached:
‰‰ Until the debt is settled, the company is not permitted to distribute
any dividends.
‰‰ The business is not permitted to issue any additional equity.
‰‰ The business must repay the loan over a predetermined time
frame.

The version of our fundamental model with cash balances used in the
next condensed example is a modification of that model. A new busi-
ness or endeavor is launched, in year 0:
‰‰ The company has 2,200 in assets, which are supported by debt of
1,000, equity of 1,100 and current liabilities of 200.
‰‰ Over the following five years, the obligation must be repaid in
equal principal payments. The corporation is not permitted to dis-
tribute dividends until the debt is settled (if there is extra cash, this

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will go into a cash and marketable securities account) as shown in

Figure 7.9:

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Figure 7.9: Project Finance

The model may take into consideration the terms of debt repayment
by simply reporting the debt balances at the end of each year. The
business is anticipated not to issue any further stock as a result of the
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financing restrictions, therefore the model’s plug cannot be on the lia-

bilities side of the balance sheet. The plug in our model is the account
for cash and marketable securities.

Another common assumption made regarding fixed assets is included

in the model, which is that the net fixed assets would remain the same
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over the duration of the project.

In essence, this implies that the fixed assets’ capital upkeep is appro-
priately reflected in the depreciation. Rows 29 through 31 above
demonstrate this by showing how the fixed assets at cost expand yearly
due to the rise in asset depreciation. Additionally, it implies that there
would be no net cash flow from depreciation as shown in Figure 7.10:

Figure 7.10: Free Cash Flow Calculation

In this example, the company has no trouble repaying the principal on

its loan. As credit analysts, we could be curious to see how the values

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248 FINANCIAL MODELLING

of the different parameters impact the firm’s capacity to make its pay-
ments. The COGS/sales ratio has been raised in the case below. The
company can no longer make its debt repayments in years 1-3 with the
revised parameter values. The pro forma demonstrates this fact: The
negative cash and marketable security balances in years 1-4 show that
the company had to borrow money in order to repay the loan’s princi-
ple as shown in Figure 7.11:

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Figure 7.11: Project Finance (With These Parameters

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the Project cannot Pay off its Debt)

SELF ASSESSMENT QUESTIONS

9. A typical instance of so-called ____________ involves a

company borrowing money to fund a project.
a. Forecast statement b. Capital structure
c. Project financing d. Return on equity

ACTIVITY

Discuss the importance of debt repayment schedules.

7.10 CALCULATING THE RETURN ON EQUITY

The pro forma models presented in this chapter can be used to calcu-
late the expected return on equity. Look at the prior illustration: The
project’s equity owners must pay 1,100 in year 0. They get no compen-

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sation in years 1-4, but in year 5 they become the company’s owners.
Assume that the assets’ book value correctly matches their market
value. Then at the end of year 5 the equity in the business is worth
stock + cumulative retained earnings = 2,255. As shown below in
Figure 7.12 and 7.13 the Return on Equity (ROE) is determined:

Know More
Return on equity (ROE) is
the measure of a company’s
net income divided by its
shareholders’ equity. ROE is
Figure 7.12 Calculating the Return on Equity by using Excel function a gauge of a corporation’s
profitability and how efficiently it
generates those profits.

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Figure 7.13 Calculating the Return on Equity (ROE)
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Take note of the fact that this equity returns rises as equity investment
falls in Figure 7.14 and 7.15. If the business first loans 1,500 and the
equity owners put in 600, for example:
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Figure 7.14 Calculating the Return on Equity by using Excel function

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Figure 7.15: Calculating the Return on Equity (ROE)

The accompanying data table and graph demonstrate that the equity
return increases with decreasing initial equity investment as shown
in Figure 7.16:

Figure 7.16: Accompanying Data Table and Graph

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250 FINANCIAL MODELLING

7.10.1 THE ROE IN OUR FIRST FULL MODEL

If we use the mid-year discounting method described in section 5.5 to

value the company as shown in Figure 7.17 and 7.18, we may calculate
the ROE of an investor who purchases the company at date 0 at its
imputed equity valuation, receives 5 years of dividends, and then sells
it at the imputed terminal value of the equity:

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Figure 7.18: Computing the ROE in the First Financial Model

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SELF ASSESSMENT QUESTIONS

10. Which of the following used in pro forma models of this

chapter?
a. Return on equity b. Net profit ratio
c. Gross profit ratio d. None of these

ACTIVITY

Find out the calculation of return on equity.

7.11 TAX LOSS CARRY FORWARDS

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Businesses can use accumulated losses to lower their current tax obli-
gations. We demonstrate how to represent such tax loss carry forwards
IM
in our pro forma model in this section. We modify our fundamental
model in a variety of ways, as shown below:
‰‰ We assume that the firm has a yearly fixed cost component of sales
in addition to costs of goods sold that are a percentage of sales (in
the following Figure 7.19, this value is 440 in cell C6).
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Figure 7.19: Modelling Tax Loss Carry Forwards

‰‰ The business is projected to have a 100 beginning cumulative tax
loss in year zero (cell C11).

We simulate the accumulated tax loss for each year (row 29). If there
was a loss in the year before (for instance, year 1, with a loss of 18), the
total loss rose by that amount (cell D29).

Whenever there is a gain (year 2), the total amount of tax losses car-
ried forward approaches zero (cell D30). Tax losses could be totally
used up (in our case, in year 5) at some time.

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252 FINANCIAL MODELLING

The taxable gains for any particular year are listed in row 30. There is
no tax due if the cumulative tax loss carry forward exceeds the profit
for the year. If not, just the income difference is taxed.

The effective tax rate in row 31 reflects these variations.

The free cash flows are calculated using the effective tax rate, as dis-
played in Figure 7.20:

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Figure 7.20: Free Cash Flows Calculation
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SELF ASSESSMENT QUESTIONS

11. Businesses can use __________ to lower their current tax

obligations.
a. Net profits
b. Accumulated profits
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c. Net losses
d. Accumulated losses

ACTIVITY
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Take the calculation of tax loss carry forwards.

S 7.12 SUMMARY
‰‰ There is no question about the value of financial statement predic-
tions for corporate financial management. Many businesses finan-
cial analyses rely heavily on these projects, often known as pro
forma financial statements.
‰‰ A pro forma financial statement uses hypothetical information or
assumptions about potential values to project performance over a
future period.
‰‰ Financial statement analysis has historically been used to compre-
hend a company’s performance over a specific time period. While
doing so gives information about a company’s past performance,
generating pro forma financial statements is more concerned with
the future.

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‰‰ Pro forma reports are used extensively in decision-making and

strategic planning processes. Pro forma financial statements, for
instance, might be produced to represent the results of three dif-
ferent investment scenarios for your company.
‰‰ Financial statement modelling is the practice of putting a compa-
ny’s costs and profits in a spreadsheet that can be used to estimate
the effects of a choice or event in the future.
‰‰ Financial statement modelling is a way to see how a business has
operated in the past, present and anticipated future. These models
are designed to be instruments for making decisions.
‰‰ Models of financial statements are used to determine a company’s
value or to assess how well a company is performing in comparison
to its competitors. They are also employed in strategic planning

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to evaluate potential outcomes, determine project costs, establish
budgets and distribute resources throughout the organisation.
‰‰ A financial projection displays the anticipated earnings, costs and
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cash flows of a company over a given time frame. This projection
may be provided to other parties or used internally as the founda-
tion for a more thorough budget.
‰‰ A Projected Income Statement is just similar to Income State-
ment or Profit and Loss Statement. The key distinction is that the
projected income statement contains estimates for a future time,
whereas the income statement has actual statistics.
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‰‰ A balance sheet projection is crucial for businesses because it proj-

ects the assets and liabilities that a company will have at a certain
point in time.
‰‰ The cash flow project, which includes the quantity and timing of
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anticipated cash inflows and outflows, might be more crucial for a

new company than the prediction of the income statement.
‰‰ The cash flow statement will demonstrate your peak working cap-
ital needs and emphasise the need for and timing of additional
financing given a level of predicted sales, related costs and capital
expenditure plans over a certain time.
‰‰ The models in this chapter make the assumption that sales deter-
mine the Net Fixed Assets (NFA). This effectively means that we
presume that the depreciation of the fixed assets has real economic
significance and that their after-depreciation value represents
their productive potential.
‰‰ In some circumstances, it may be safe to presume that, with good
maintenance, the present fixed assets can support sustainable lev-
els of future sales.
‰‰ Sensitivityanalysis is a method used in financial modelling to
examine how various independent variable values impact a cer-
tain dependent variable in a given set of circumstances.

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254 FINANCIAL MODELLING

KEY WORDS

‰‰ Cash flow statement: A financial statement that offers total

information on all funds received by and expended by a corpo-
ration
‰‰ Investments: An asset or property acquired with the intention
of earning money or appreciating in value
‰‰ Financial statement: Written documents that detail a compa-
ny’s operations and financial performance
‰‰ Revenues: The revenue produced by regular company activ-
ities, computed as the average sales price multiplied by the
quantity of units sold

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7.13 MULTIPLE CHOICE QUESTIONS
MCQ
1. Models of financial statements are used to determine a
IM company’s value or to assess how well a company is performing
in comparison to it
a. Investors b. Competitors
c. Supplier d. Government
2. Small firms must accurately anticipate their future financial
situation, including a projection of the company’s assets,
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liabilities and capital, in order to project a balance sheet. Which

of the following option is correct regarding the above statement?
a. Consolidated income statement
b. Consolidated balance sheet
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c. Projected income statement

d. Projected balance sheet
3. The sum of your current assets and liabilities is your net working
capital. Which of the following option is correct regarding the
above statement?
a. Project fixed assets
b. Project net working capital
c. Estimate financial debt
d. Project equity position
4. Projecting your cash situation is the last stage in predicting the
balance sheet. Which of the following option is correct regarding
the above statement?
a. Estimate financial debt b. Project equity position
c. Project cash position d. None of these

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5. Which of the following includes the quantity and timing of

anticipated cash inflows and outflows, might be more crucial for
a new company than the prediction of the income statement?
a. Income statement project
b. Retained earnings statement
c. Balance sheet project
d. Cash flow project
6. A pro forma model’s plug will often be one of three financial
balance sheet items and the other two are
a. Cash and marketable securities
b. Debt

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c. Stock
d. All of these
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7. Which of the following terms are included in the calculation of
net profit?
a. Revenues b. Expenses
c. Taxes d. All of these
8. Which of the following terms are included in the calculation of
projected fixed assets?
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a. Fixed assets last year b. Capital expenditure

c. Current assets d. Both a. and b.

7.14 DESCRIPTIVE QUESTIONS

?
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1. What do you mean by pro forma financial statement?

2. Discuss the meaning of financial statements modelling.
3. Describe the modelling and projecting the financial statements.
4. Define the projection of the balance sheet.

HIGHER ORDER THINKING SKILLS

7.15
(HOTS) QUESTIONS
1. Before preparing or deciding on transaction-related events such
as mergers, acquisitions or hypothetical scenarios, corporations
produce statements based on a number of assumptions and
forecasts known as pro forma financial statements. Which of the
following are the Uses of Pro Forma Financial Statements?
a. Projections b. Funding
c. Risk assessment d. All of these

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256 FINANCIAL MODELLING

2. Statements of financial position, statement of operations,

statement of cash flows, and others are among the several
financial statements that a firm generates. In addition to this,
management of the firm may want to handle specific occurrences
for which projections of the financial statements or alternative
assumptions of some items are required. Which of the following
is not an advantage of pro forma financial statements?
a. Helpful in creating risk models, M&A models and budgets.
b. Used to monitor potential business development and make
important decisions.
c. Because of models based on statistics, there is no explicit ref-
erence of qualitative factors.
d. Provide various viewpoints from the participating teams and

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reveal the state of the firm.

7.16 ANSWERS AND HINTS

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ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Meaning of Financial State- 1. a. Financial statement mod-
ments Modelling elling
Modelling and Projecting the 2. c. Financial projection
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Financial Statements
3. a. Projected income state-
ment
How Financial Models Work: 4. a. Sales driven
Theory and an Initial Example
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Alternative Modelling of Fixed 5. a. Present fixed assets

Assets
Sensitivity Analysis 6. b. Extensive Sensitivity
Analysis
Debt as a Plug 7. c. Debt
Incorporating a Target Debt/ 8. c. Debt to equity ratio
Equity Ratio into a Pro Forma
Project Finance: Debt Repay- 9. c. Project financing
ment Schedules
Calculating the Return on 10. a. Return on equity
Equity
Tax Loss Carry Forwards 11. d. Accumulated losses

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Competitors

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Q. No. Answer
2. d. Projected balance sheet
3. b. Project net working capital
4. c. Project cash position
5. d. Cash flow project
6. d. All of these
7. d. All of these
8. d. Both a. and b.

HINTS FOR DESCRIPTIVE QUESTIONS

1. A pro forma financial statement projects performance over
a future period using fictitious data or assumptions about

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probable values. Pro forma financial statements are defined
as “financial statements predicted for future periods” in the
Financial Accounting online course. They may also be known
as financial projections or financial projects. Refer to Section 7.1
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Introduction
2. Financial statement modelling is the practice of putting a
company’s costs and profits in a spreadsheet that can be used to
estimate the effects of a choice or event in the future. For business
leaders, a financial statement model has various applications.
It is most frequently used by financial analysts to assess and
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forecast potential effects of upcoming events or management

choices on a company’s stock performance. Financial statement
modelling is a way to see how a business has operated in the
past, present and anticipated future. These models are designed
to be instruments for making decisions. They could be used by
company leaders to predict the expenses and profitability of a
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proposed new project. Refer to Section 7.2 Meaning of Financial

Statements Modelling
3. A financial projection displays the anticipated earnings, costs
and cash flows of a company over a given time frame. This
projection may be provided to other parties or used internally
as the foundation for a more thorough budget. In the second
scenario, a financial forecast may be used to persuade a bank
to lend money to a company or investors to purchase stock in
the company. A financial prediction is based on a mix of past
performance, anticipated shifts in the relevant market, and other
alterations in the business’s environment such an investment in a
new product line. Refer to Section 7.3 Modelling and Projecting
the Financial Statements
4. A balance sheet projection is crucial for businesses because it
projects the assets and liabilities that a company will have at a
certain point in time. Small firms can use projecting a balance
sheet to determine what they will probably own and owe at

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258 FINANCIAL MODELLING

a future date, which can help them prepare for upcoming

purchases and other crucial business choices. Refer to Section
7.3 Modelling and Projecting the Financial Statements

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. d. All of these
2. c. Because of models based on statistics, there is no ex-
plicit reference of qualitative factors.

7.17 SUGGESTED READINGS & REFERENCES

S
SUGGESTED READINGS
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
IM Bloss, M. and Dirnberger, M., n.d. Financial Modeling.
‰‰ Pfaff,P., 1990. Financial modeling. Needham Heights, Mass.: Allyn
and Bacon.
‰‰ Zivot, E. and Wang, J., 2003. Modeling financial time series with
S-Plus. New York: Springer.
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E-REFERENCES
‰‰ Business Insights Blog. 2022. What Are Pro Forma Financial State-
ments? | HBS Online. [online] Available at: <https://online.hbs.
edu/blog/post/pro-forma-financial-statements> [Accessed 9 Sep-
tember 2022].
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‰‰ Srivastav, A., 2022. Pro Forma Financial Statements. [online]

WallStreetMojo. Available at: <https://www.wallstreetmojo.com/
pro-forma-financial-statements/> [Accessed 9 September 2022].
‰‰ Bragg, S. and Bragg, S., 2022. Pro forma financial statements defi-
nition — AccountingTools. [online] AccountingTools. Available at:
<https://www.accountingtools.com/articles/what-are-pro-forma-
financial-statements.html> [Accessed 9 September 2022].

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 C H A
8 P T E R

PORTFOLIO MANAGEMENT

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CONTENTS

8.1 Introduction
8.2 Turning Your Goals into a Strategy
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Self Assessment Questions
Activity
8.3 Risk-reward Ratio
Self Assessment Questions
Activity
8.4 Investment Risk Pyramid
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Self Assessment Questions

Activity
8.5 Portfolio Strategies
Self Assessment Questions
Activity
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8.6 Building an Investment Portfolio

Self Assessment Questions
Activity
8.7 Risk Reduction in the Stock Portion of a Portfolio
Self Assessment Questions
Activity
8.8 Value Investing
Self Assessment Questions
Activity
8.9 Growth Investing
Self Assessment Questions
Activity
8.10 Summary
8.11 Multiple Choice Questions
8.12 Descriptive Questions

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260 FINANCIAL MODELLING

CONTENTS

8.13 Higher Order Thinking Skills (HOTS) Questions

8.14 Answers and Hints
8.15 Suggested Readings & References

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IM
M
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INTRODUCTORY CASELET

PORTFOLIO MANAGEMENT SOLUTION

ABOUT THE CLIENT

Case Objective
The Client is a US-based private investing company. They have
been in operation since the 1990s and have experience dealing This caselet highlights the
portfolio solution for a digital
with high net worth people, investment companies, pension and
transformation of an asset
profit-sharing plans, non-profits and businesses. management firm.

The Client uses a turnkey asset management platform to access

financial advisers that provide pricey speciality services. The
advisor-strategists construct their clients’ financial portfolios
based on their risk appetite and personal preferences and have
approximately $30 billion in assets. They help with investing and

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money management as well.

BUSINESS CHALLENGE
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The Client formerly offered a third-party off-the-shelf portfolio
management product to advisers. This resulted in ongoing license
expenses and the inability to customise the software’s functional-
ity to perfectly execute client-specific portfolios. The user expe-
rience has to be reconceived by the client as well. It meant that
corporate operations will be digitally transformed, which was not
conceivable with the off-the-shelf product.
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The client made the decision to purchase a proprietary, unique

financial program that could offer advisers the finest customer
engagement capabilities. Advisors requested a business tool with
a customised interface and a full cycle of operation, including
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portfolios. The client intended to raise their capitalisation by add-

ing a new valuable intangible asset through a patented solution
while also eliminating license costs.

SOLUTION

Due to their expertise in creating specialised wealth management

solutions and track record of successfully completing FinTech
projects, the Client selected Devexperts.

Devexperts created the front and back ends of a new portfolio

management program that included the capabilities that advisers
demanded, including:
‰‰ Creation and real-time adjusting of customised portfolios
‰‰ A comparison of the portfolios of the solution and external
accounts (held at any financial institution)
‰‰ Configuration of UI layout for the diversity of portfolio graph-
ics - intelligent customer involvement by allowing customers

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262 FINANCIAL MODELLING

INTRODUCTORY CASELET

to move and modify portfolio information in response to advi-

sor requests

The new proprietary portfolio management solution offers the fol-

lowing capabilities in addition to these ones:
‰‰ Detailed information on the risk-return ratio for evaluat-
ing portfolio results based on factors other than investment
returns.
‰‰ Meeting client needs in accordance with short- and long-term
investments, demonstrating how various investment choices
and market circumstances affect customers’ objectives.

The new program also gives advisors tools for streamlining their

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everyday company operations. They include the first meeting
with the client, continuous talks about financial planning, perfor-
mance, compliance and tax reporting and billing.
IM
RESULTS

Modelling, comparison and analysis tools make up New Client’s

portfolio management solution. The client was able to achieve the
following goals thanks to the reliable proprietary solution:
‰‰ Reducing expenses by doing away with license fees for the
essential business software
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‰‰ Implementing a portfolio management system that can be

adjusted to meet business needs
‰‰ Giving advisors, the Client’s primary customers, the finest ser-
vice possible.
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The Client additionally achieved exceptional financial results as

a consequence of the adoption of the new unique solution. Finan-
cial figures provided by the client show that a year after the solu-
tion was implemented, the company’s CAGR was 17% and its net
flow increased by 245%. The addition of more assets to the plat-
form and the subsequent successful valuation for the Client’s IPO
launch were directly impacted by the new portfolio management
solution.

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 Portfolio Management  263

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Explain the meaning of portfolio management
>> Discuss the concept of risk-reward
>> Describe the investment risk pyramid
>> Analyse the portfolio strategies
>> Develop a portfolio for investing
>> Define the risk reduction in the stock portion of a portfolio

8.1 INTRODUCTION

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In the previous chapter, you studied pro forma financial statements Quick Revision
modelling. Pro forma financial statements are defined as “financial
statements predicted for future periods” in the Financial Account-
ing online course. They may also be known as financial projections
IM
or financial projects. The definition of pro forma financial statements
is “financial statements predicted for future periods” in the financial
accounting.

The process of choosing and managing a set of investments to fulfil

the long-term financial goals and risk tolerance of a customer, a busi-
ness or an institution is known as portfolio management.
M

While people have the option to create and manage their portfolios,
qualified professional portfolio managers act on behalf of customers. NOTE
The ultimate objective of the portfolio manager is to maximise the Portfolio management involves
projected return on the assets while maintaining a reasonable degree building and overseeing a
of risk exposure.
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selection of investments that

will meet the long-term financial
The capacity to evaluate opportunities, dangers and threats across goals and risk tolerance of an
investor.
the complete range of investments is necessary for portfolio manage-
ment. Trade-offs are involved in the decisions, which range from debt
against equity to domestic versus global and growth versus safety.

The management of a portfolio might be passive or active.

‰‰ Passive management is a long-term tactic that may be set and for-
gotten. Investments in one or more Exchange-Traded Funds (ETF)
indexes may be necessary. Common terms for this include index-
ing and index investing. Modern Portfolio Theory (MPT) can be
used by those who construct Indexed portfolios to enhance the
mix.
‰‰ Active management entails actively purchasing and selling specific
stocks and other assets to outperform an index. In general, closed-
end funds are managed actively. Active managers can assess possi-
ble investments using any of a wide range of quantitative or qual-
itative models.

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264 FINANCIAL MODELLING

A portfolio is a group of initiatives or programs that are organised and

managed at the organisational or functional level to maximise opera-
tional effectiveness or strategic advantages. Both organisational and
functional levels can handle them.

Portfolios serve as coordinating structures to support a deployment

by ensuring the best prioritisation of resources to align with strate-
Know More gic intent and achieve the best value. Portfolios serve as coordinating
Active portfolio management structures to enable deployment in situations where projects and pro-
requires strategically buying and grammes are concentrated on the deployment of outputs and, accord-
selling stocks and other assets ingly, results and benefits. The sponsor and portfolio manager seek
in an effort to beat the broader
market. visibility into the plans for the constituent projects and programs to
form the portfolio.

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They then decide how to restructure those constituent parts based on:
‰‰ The company’s capacity to fund the whole portfolio.
‰‰ Any modifications to the strategic direction or pace of execution.
IM
Corporate governance may be completely aligned in a strategic portfo-
lio. Where this is not the case, it is crucial to ensure that the executive
team has a clear grasp of and support for the portfolio prioritisation
process. It is typical in a portfolio for project sponsors to be asked to
give up their project priority for the sake of the larger portfolio.

In this chapter, you will study the meaning of portfolio management,

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risk-reward concept, investment risk pyramid, portfolio strategies,

building an investment portfolio, risk reduction in the stock portion of
a portfolio, value investing, growth investing, etc., in detail.

TURNING YOUR GOALS INTO A

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8.2
STRATEGY
Every approach has effects on performance. The word strategy sug-
gests an intentional attempt to attain stated aims. They want to avoid
taking on too much risk while at least meeting their minimal accept-
able return levels. They desire a relaxing and pleasant retirement.

Results in both the short- and long-term will be determined by the

asset-allocation scheme. Furthermore, asset allocation will have a
much greater impact on risk and returns than stock selection or mar-
ket timing.

We might have discovered that foreign, small-company stocks provided

the best return by looking at the 20-year, asset-class returns. However,
investing the whole Jones family’s wealth in foreign, small-company
equities will not lead to a relaxing and stress-free retirement. Any
asset class will occasionally deviate significantly from its long-term
trend over protracted periods. Additionally, international small-com-

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 Portfolio Management  265

pany stocks’ short-term performance can and frequently do experi-

ence dramatic fluctuations.

SPECIFICATION OF INVESTMENT OBJECTIVES

Investment objectives are typically articulated in terms of income,

growth and stability. Investment objectives may be described more
clearly in terms of return and risk since income and growth are two
ways that return is created, while stability denotes risk minimisation.

CONSTRAINTS

The risk-reward principle, which argues that the potential return on

an investment depends on the level of risk, may be known to you. NOTE

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However, a lot of investors do not know how to figure out how much Passive portfolio management
risk each of their unique portfolios should take. The broad framework seeks to match the returns of the
market by mimicking the makeup
presented in this lesson may be used by any investor to evaluate their of a particular index or indexes.
degree of risk and how that level relates to various assets.
IM
SELF ASSESSMENT QUESTIONS

1. Which of the following suggests an intentional attempt to

attain stated aims?
a. Strategy
b. Goals
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c. Planning
d. Organising
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ACTIVITY

Write a short note on the advantages of portfolio management.

8.3 RISK-REWARD RATIO

The risk/reward ratio shows how much an investor may get from an
investment for every dollar they risk. The predicted rewards of an
investment and the level of risk required to attain those returns are
often compared using risk/reward ratios. Think about the following
instances: A 1:7 risk-reward ratio on investment indicates that the
investor is ready to take on 1 risk in exchange for the chance of receiv-
ing 7. In contrast, a risk/reward ratio of 1:3 indicates that an investor
should anticipate investing 1 with the possibility of getting 3 back.

The ratio is derived by dividing the amount a trader stands to lose if

the price of an asset moves in an unanticipated direction (the risk) by
the amount of profit the trader anticipates to have gained when the

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266 FINANCIAL MODELLING

position is closed. Traders frequently use this method to decide which

trades to place (the reward).

A considerable level of danger comes with investing money in the mar-

kets, hence if you are going to accept that risk, you should be paid. It
might not be worth the risk if someone you only loosely trust requests
for a `50 loan and promises to reimburse you `60 in two weeks, but
what if they promised to pay you `100? It could be alluring to take the
chance of losing 50 for the potential gain of 100.

NOTE That is a 2:1 risk/reward ratio, which attracts the attention of many
expert investors since it allows investors to double their money. The
Risk/Reward is a general
concept underlying anything by ratio would change to 3:1 if the offer had been for 150.
which a return can be expected.
Anytime you invest money Let us now examine this in the context of the stock market. Let us say

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into something there is a risk, you completed your homework and discovered an interesting stock.
whether large or small, that you You note that the price of XYZ stock has dropped from a recent high
might not get your money back. of `29 to `25.
In turn, you expect a return,
which compensates you for
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You think that if you buy now, XYZ will increase to `29 in the not-too-
bearing this risk.
distant future and you may profit. You decide to purchase 20 shares
of this investment with your `500 available. Despite your thorough
investigation, do you know your risk-to-benefit ratio? If an average
individual investor, then you most likely do not.

Example 1: Assume you are paying `700 for 100 shares of a corpora-
tion. You decide to book gains at `720 and set your stop-loss at `690. In
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other words, you may lose `10 on each share, but you could also make
`20.

Solution:
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Formula of calculating risk-reward ratio is:

Risk-reward ratio

= (Entry Price – Stop Loss Price) / (Target Price – Entry Price)

= (700 – 690) / (720 – 700)

= 10 / 20

=1/2

Thus, the risk-reward ratio in this trade is 1:2.

SHARPE RATIO

The Sharpe ratio evaluates the relationship between an investment’s

return and risk. The idea that excess returns over time may indicate
more volatility and risk rather than investment expertise is expressed
mathematically in this way.

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 Portfolio Management  267

As a result of his work on the capital asset pricing model (CAPM),

economist William F. Sharpe introduced the Sharpe ratio in 1966
under the name reward-to-variability ratio. For his work on CAPM,
Sharpe received the economics Nobel Prize in 1990.

The numerator of the Sharpe ratio is the difference over time between
actual or predicted returns and a benchmark, such as the performance
of a certain investment category or the risk-free rate of return. The
standard deviation of returns over the same time period, which is a
gauge of volatility and risk, serves as the denominator.

The portfolio risk premium divided by the portfolio risk is known as

the Sharpe Ratio.

Return on the portfolio – Return on the risk-free rate R p − R f

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Sharpe ratio = =
Standard deviation of the portfolio σp

n on the risk-free rate R p − R f

=
the portfolio σp
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The slope of the capital allocation line is known as the Sharpe ratio, or
reward-to-variability ratio (CAL). The better the asset, the larger the
slope (higher number).

It should be noted that the measure’s restriction is that the risk being
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employed is the portfolio’s overall risk, not its systematic risk. The
portfolio with the greatest performance has the highest Sharpe ratio;
however this statistic is meaningless on its own. The Sharpe ratio for
each portfolio must be calculated in order to rank them.

When the numerators are negative, another restriction comes into

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play. This will lead to inaccurate rankings since the Sharpe ratio will
be less negative for a riskier portfolio.

Example 2: The stock of ABC Corp Plc is the investment which is

the aim. Over the last five years, the stock has generated an average
annual return of 15%. The UK Treasury Bill, which offers an interest
rate of 0.4%, is the risk-free investment. The volatility (standard devi-
ation) of ABC Plc is estimated to be 20%. Calculate the Sharpe ratio.

Solution:

Sharpe Ratio

= (Return of Portfolio – Risk-Free Rate) / Standard Deviation of the

Portfolio’s Excess Return

= (15% – 0.4%) / 20%

= 0.73

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268 FINANCIAL MODELLING

TREYNOR RATIO

The reward-to-volatility ratio, also known as the Treynor ratio, is a

performance indicator for calculating how much extra return a port-
folio created for each unit of risk it assumed.

In this context, an excess return is a return that was obtained beyond

the return that would have been possible from a risk-free investment.
Treasury bills are often employed to represent the risk-free return in
the Treynor ratio, despite the fact that there is no real risk-free invest-
ment.

Systematic risk as determined by a portfolio’s beta is referred to as risk

in the Treynor ratio. The sensitivity of a portfolio’s return to changes
in the return of the whole market is measured by beta.

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The Treynor ratio is a development of the Sharpe ratio that employs
beta or systematic risk as the denominator rather than total risk. This
is thus more appropriate for those with varied portfolios.
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Re turn on the portfolio – Risk-free rate R p − Rf
Treynor ratio = =
Beta of the portfolio Bp

The Treynor ratio, like the Sharpe ratio, needs positive numerators
to provide meaningful comparison findings, thus it is ineffective for
assets with negative beta. Additionally, although both the Sharpe and
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Treynor ratios may rank portfolios, they do not reveal whether or

not the portfolios are superior to the market portfolio or how much a
higher ratio portfolio is preferable to a lower ratio portfolio.

Example 3: Calculate the Treynor ratio. Take a look at the table below,
which includes three assets, their beta levels, and their % returns:
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Investment Beta Value Percentage of Return

Investment A 1.00 10%
Investment B 0.9 12%
Investment C 2.5 22%
Solution:
Investment A:
Treynor ratio for investment A
= (Portfolio Return – Risk-Free Rate) / Portfolio Beta
= (10% – 1%) / 1.0 = 9% or 0.090
Investment B:
Treynor ratio for investment B
= (Portfolio Return – Risk-Free Rate) / Portfolio Beta
= (12% – 1%) / 0.9 = 12.2% or 0.122

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 Portfolio Management  269

Investment C:

Treynor ratio for investment C

= (Portfolio Return – Risk-Free Rate) / Portfolio Beta

= (22% – 1%) / 2.5 = 8.4% or 0.084

From the calculated Treynor ratio numbers, it can be seen that Invest-
ment B has the greatest Treynor ratio, making it the investment with
the lowest beta value. As a result, Investment A’s Treynor ratio is
0.090, Investment B’s is 0.122 and Investment C’s is 0.084. Therefore,
of the three investments examined, Investment B is regarded to have
had the greatest result in this scenario. Similar to that, Investment C
performs the worst out of the three investments, while Investment A

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comes in second.

JENSEN’S ALPHA
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The Jensen’s measure, also known as Jensen’s alpha, is a risk-adjusted
performance metric that measures whether the average return on an
investment or portfolio is higher or lower than the return forecasted
by the capital asset pricing model (CAPM), given the portfolio’s beta
and the market’s overall return. This statistic is also often known by
the name alpha.

Investors who want to appropriately assess the performance of an

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investment manager must consider both the portfolio’s risk and total
return in order to determine if the investment’s return outweighs
its associated risk. If two mutual funds, for instance, both had a 12%
return, a sane investor would choose the less hazardous one. One
method to assess if a portfolio is producing the right return for its
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degree of risk is to use Jensen’s measure.

A portfolio is making excess returns if the value is positive. In other

words, a positive result for Jensen’s alpha indicates that a fund man-
ager outperformed the market via stock selection.

The foundation of Jensen’s Alpha is systematic risk. To calculate a

measure of this systematic risk in a similar way to the CAPM, the daily
returns of the portfolio are regressed against the daily returns of the
market. A measurement of performance in relation to the market is
the discrepancy between the portfolio’s actual return and the pre-
dicted or modelled risk-adjusted return.

αP = Rp – (Rf + βp (Rm – Rf))

A positive number for αp means the portfolio has outperformed the

market, whilst a negative value means the opposite. With the Alpha
serving as a representation of the highest price an investor should pay
for the active management of a portfolio, the values of Alpha may also
be used to rank portfolios or the managers of such portfolios.

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270 FINANCIAL MODELLING

Example 4: The company has beginning portfolio value of `1 Million,

ending portfolio value of `1.2 Million, portfolio beta of 1.2, risk-free
rate of 2% and expected market return of 10%. Calculate the Jensen’s
alpha ratio.

Solution:
Jensen’s alpha

= Portfolio return – [Risk Free Rate + Portfolio Beta × (Market Return

– Risk Free Rate)]

= 20% – [2% + 1.2 × (10% – 2%)]

= 20% – [2% + 9.6%]

S
= 20% – 11.6%

= 8.4%

Working Note:
IM
Portfolio Return

= (Ending Portfolio Value / Beginning Portfolio Value) – 1

= (`1.2 Million / `1 Million) – 1

= 0.20 or 20%
M

SELF ASSESSMENT QUESTIONS

2. Which of the following ratios shows how much an investor

may get from an investment for every dollar they risk?
N

a. Net Profit Ratio

b. Gross Profit Ratio
c. Risk-Reward Ratio
d. All of these

ACTIVITY

Find the calculations of the Risk-reward Ratio.

8.4 INVESTMENT RISK PYRAMID

An investing risk pyramid does not advise you to purchase any spe-
cific stocks or bonds. It serves as a tool for asset allocation. Asset allo-
cation refers to selecting how much of your overall assets should be
invested in lower-risk, secure securities, how much should be invested
in growth opportunities that include some risk and how much you
may invest in high-risk projects.

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 Portfolio Management  271

The pyramid of risk pyramid sometimes referred to as an investment

pyramid, is simply a method that investors employ to build an invest-
ment portfolio. It enables users to choose investments for their portfo-
lio based on the degree of risk associated with certain assets.

The portfolio strategy is pictured as a pyramid with a broad base,

narrowing as it rises and finally ending in a pointed summit. Inves-
tors have properly termed the approach “the risk pyramid” since it is
depicted in the shape of a pyramid and because it deals with the risk
levels of various investment assets.

Having trouble visualising? The risk pyramid is illustrated in

Figure 8.1:

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High-risk investments:
Commodities, futures and options,
cryptocurrencies, penny stocks and TOP
precious metals and gems

Medium-risk investments:
Income stocks, growth stocks, real estate,
IM MIDDLE RISK
mutual funds and index funds

Low-risk investments:
Money market instruments, Treasury
bills, government bonds, cash and cash BASE
equivalents and Certificates of Deposit

Figure 8.1: The Risk Pyramid

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The risk pyramid contains three distinct layers, the base, the centre
and the summit, as seen in the above diagram. The relative danger
levels of the various stages of the pyramid are even colour-coded in
this illustration. Let us examine the pyramid’s three components in
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more detail, beginning with the base.

1. THE BASE

The lowest-risk investment possibilities are represented by the base of

the risk pyramid, which serves as its base. The following are examples Know More
of money market instruments: cash and cash equivalents, Treasury It’s no secret that throughout
history common stock has
bills, government securities, certificates of deposits, bonds and other outperformed most financial
financial products. instruments. If an investor plans
to have an investment for a
The likelihood of default risk or any other risk for that matter, affect- long period of time, his or her
ing these assets is extremely minimal. These investment alternatives portfolio should be comprised
are therefore regarded as the safest of the bunch. However, because mostly of stocks. Investors who
don’t have this kind of time
there is no risk involved, these investments typically have poor rates
should diversify their portfolios
of return as well. by including investments other
than stocks.
The method simply recommends that a sizable portion of your portfo-
lio be made up of these low-risk investment alternatives because the
pyramid’s base is the biggest.

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272 FINANCIAL MODELLING

2. THE MIDDLE

Moderately risky investment alternatives are represented in the cen-

tre of the risk pyramid. The assets that make up the centre of the risk
pyramid are nevertheless seen as being pretty safe, while not being as
secure as the investments at the pyramid’s base. Investments includ-
ing real estate, index funds, growth firms and dividend shares, among
others, frequently make up the middle tier of the pyramid. This cat-
egory of investment opportunities often provides steady returns and
strong long-term capital growth. The method essentially supports a
reasonable degree of portfolio allocation for these assets because this
tier of the pyramid is less than the base but greater than the summit.

3. THE TOP

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Finally, we have the pyramid’s summit. The riskiest investing alter-
Know More natives are represented in this section. Among other asset types, it
The underlying principle of asset covers futures, options, commodities and penny stocks.
allocation is that the older a
IM
person gets, the less risk he or The ability to deliver extraordinarily large profits is one of these asset
she should take on. After you types’ major attributes. However, the significant risk is offset by the
retire, you may have to depend profit. The likelihood of an investor losing a significant portion of their
on your savings as your only
investment capital is substantial when using these sorts of products.
source of income. It follows
that you should invest more
conservatively because asset
The top rung of the risk pyramid is the lowest of the three particularly
preservation is crucial at this for this reason. The approach fundamentally supports allocating the
M

time in life. smallest percentage of the portfolio to various investment products.

Additionally, it indicates that you should only invest money that you
deem disposable or money that you are prepared to lose.

SELF ASSESSMENT QUESTIONS

N

3. Which of the following does not advise you to purchase any

specific stocks or bonds?
a. Portfolio strategy
b. Building an investment portfolio
c. Value investing
d. Investing risk pyramid
4. The lowest-risk investment possibilities are represented by the
base of the risk pyramid, which serves as its base. Which of the
following options is correct regarding the above statement?
a. Middle
b. Top
c. Base
d. None of these

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 Portfolio Management  273

ACTIVITY

Identify and categorise (10/100) stocks/assets as per the investment

risk pyramid.

8.5 PORTFOLIO STRATEGIES

One rule governs investing for Warren Buffett, probably the best stock
picker in the world: Never lose money.

This does not imply that you should dump your investments as soon
as they begin to decline. However, you should continue to pay close
attention to their whereabouts and the losses you are prepared to
accept. Even while you want your investments to bear fruit and grow,

S
long-term investing success depends on capital preservation. When
investing in the markets, it is hard to eliminate risk, but these six mea-
sures may help safeguard your account.
IM
1. DIVERSIFICATION

Diversification is one of the tenets of Modern Portfolio Theory (MPT).

MPT adherents think that in a bear market, a diversified portfolio will Know More
perform better than a concentrated one. By holding a sizable number Active Portfolio Strategies - If
you are an investor with a view
of assets in more than one asset class, investors build deeper and more to beating any benchmarks
extensively diversified portfolios, lowering unsystematic risk. This is of returns, you will think of
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the risk involved in investing in a certain business. Some financial an active strategy. A range of
gurus claim that stock portfolios with 12, 18 or even 30 stocks may assumptions and forecasts are
completely remove unsystematic risk. used to find out what securities
are reliable purchases. Thus,
investors are active, making
2. NON-CORRELATING ASSETS frequent trades moving wealth
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consistently for long- term gains.

Systematic risk, or the risk connected with investing in the markets If you don’t mind risks, this is a
generally, is the reverse of unsystematic risk. Regrettably, the sys- good strategy.
temic risk exists constantly. There is a solution to lessen it, however,
diversify your portfolio’s holdings among non-correlating asset types
including bonds, commodities, currencies and real estate. 3 Non-cor-
relating assets respond to market fluctuations differently than equities
do; often, they move in the other direction. Another asset rises as one
falls. They thereby reduce the total value of your portfolio’s volatility.

In the end, using non-correlating assets reduces performance highs

and lows, resulting in more even returns. That is, at least, the theory.

3. PUT OPTIONS

The S&P 500 fell 24 times out of 84 years, or more than 25% of the
time, between 1926 and 2009. Investors often take profits off the table
to safeguard future gains. This is a sensible decision sometimes. But
often, rising stock prices are just winning stocks taking a break before

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274 FINANCIAL MODELLING

moving higher. You do not want to sell in this situation, but you do
want to lock in part of your profits. How is this accomplished?

There are several possible approaches. The most typical is to purchase

put options, which is a wager that the price of the underlying stock
will decrease. The put provides you with the choice to sell at a certain
price at a specific moment in the future, unlike shorting the stock.

Let us say you hold 100 shares of Company A, which has increased
Know More by 80% in only one year and is now trading at `100. Although you
Passive Strategies - Contrasting are certain of its bright future, you believe that the stock has grown
with active strategies, passive too rapidly and will probably lose value shortly. You purchase a single
strategies monitor weighted put option from Company A with a strike price of `105, or just in the
indexes in the market. Believing
in the way the market flows, money, with an expiry date six months in the future to secure your
investors believe that markets gains. You may purchase this option for `600 or `6 per share, entitling

S
are efficient. you to sell 100 shares of Company A for `105 at any point before the
option’s expiration in six months.

The price to purchase the put option will have increased dramatically
IM
if the stock falls to `90. To make up for the drop in the stock price, you
now sell the option for a profit. Long-term Equity Anticipation Secu-
rities (LEAPS) with durations as long as three years are available to
investors seeking longer-term protection.

It is crucial to keep in mind that you’re primarily concerned with pre-

venting losses from occurring rather than necessarily wanting to ben-
M

efit from the options. Investors may purchase index LEAPS, which
function similarly if they want to cover their whole portfolio rather
than a specific stock.

4. STOP LOSSES
N

Stop-loss orders shield investors from declining share prices. 5 Stops

come in a variety of forms that you might use. Hard stops include
causing the selling of a stock at a constant set price. For instance, if
you purchase shares of Company A for `10 each with a hard stop of `9,
the stock will be instantly sold if the price falls to `9.

Different from other stops, a trailing stop may be set in terms of dol-
lars or percentages and goes along with the stock price. Let us say you
establish a 10% trailing stop using the prior example. The trailing stop
will increase from the initial `9 to `10.80 if the price gains `2. You will
continue to hold the shares even if the price drops to `10.50 utilising
a hard stop of `9. If a trailing stop is used, your shares will be sold at
a price of `10.80. Which is better depends on what occurs next. The
trailing stop comes out on top of the stock price eventually falling to `9
from `10.50. The hard halt, though, is the best option if it rises above
`15.

Stop-loss advocates contend that they shield you from quickly shifting
market conditions. Hard stops and trailing stops, according to their

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 Portfolio Management  275

critics, both make transitory losses permanent. Stops of any type must
be carefully scheduled because of this.

5. DIVIDENDS

The least well-known method of safeguarding your money is probably

investing in dividend-paying equities. In the past, dividends have con-
tributed significantly to the overall performance of a company. It may
sometimes stand in for the total sum.

The best way to get profits that are above average is to own depend-
able businesses that pay dividends. Studies have demonstrated that Know More
firms that pay significant dividends tend to expand profits quicker Aggressive Strategies - As you
than those that do not, in addition to the investment income. Bigger may be able to tell by the name,
share prices, which in turn provide higher capital profits, are often a these strategies are used by

S
result of faster growth. extreme risk-takers. The aim
of this strategy is to maximise
How does this safeguard your portfolio, then? In essence, by boosting profits by taking a lot of risks.
your total return. Dividends provide a safety net for risk-averse inves-
IM
tors during periods of decreasing stock prices, which often reduces
volatility.

Dividends are a useful inflation hedge in addition to acting as a cush-

ion in a down market. You may provide your portfolio protection that
fixed-income investments, except Treasury Inflation-Protected Secu-
rities (TIPS), cannot match by investing in blue-chip corporations
M

that both pay dividends and have pricing power.

Additionally, if you invest in “dividend aristocrats,” or businesses that

have increased their dividends for 25 years running, you can almost
certainly count on them to do so even when bond payments stay the
same. The last thing you need as you approach retirement is for a
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period of strong inflation to deplete your buying power.

6. PRINCIPAL-PROTECTED NOTES

Principal-protected notes with equity participation rights can be an

option for investors who are concerned about keeping their principal
intact. Similar to bonds, these are fixed-income investments that will
return your principal investment if you hold them until maturity. The
equity participation that goes along with the main guarantee is where
they diverge.

Let us imagine, for instance, that you want to purchase `1,000 worth
of principal-protected notes linked to the S&P 500. In five years, these
sounds will become mature. The issuer would pay less than face value
for zero-coupon bonds that mature around the same time as the notes.
Until they are redeemed at face value at maturity, the bonds would
not pay any interest. In this instance, `800 is spent on the `1,000 in
zero-coupon bonds, with the remaining `200 going toward S&P 500
call options.

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276 FINANCIAL MODELLING

Earnings would be distributed when the bonds matured based on the

NOTE participation rate. If the index rose by 20% over the course of this time
Defensive Strategies - period and participation rates were 90%, you would receive your ini-
Conservative in their approach tial investment of `1,000 plus earnings of `180. Otherwise, you would
to investment, these strategies
lose `20 in earnings. However, let’s say the index declines 20% over
are employed by investors who
are very careful when they five years, you would still receive your initial `1,000 investment back
invest in the stock market. They but an investment directly in the index would be down by `200.
study trends in the market and
do a strong technical analysis Principal-protected notes will be appealing to risk-averse investors.
before formalising a portfolio. But before you get on board, you should research the creditworthi-
Such investors are averse to
ness of the bank guaranteeing the principal, the nature of the notes’
risk, but don’t mind a fairly good
rerun on investment. underlying investment and the costs involved in purchasing them.

SELF ASSESSMENT QUESTIONS

S
5. Which of the following is one of the tenets of Modern Portfolio
Theory (MPT)?
a. Stop Losses
IM
b. Put Options
c. Non-Correlating Assets
d. Diversification
6. Systematic risk, or the risk connected with investing in
the markets generally, is the reverse of unsystematic risk.
M

Which of the following options is correct regarding the above

statement?
a. Non-correlating assets
b. Out options
N

c. Diversification
d. Stop losses

ACTIVITY

Identify few portfolio strategies of leading investors across globe.

8.6 BUILDING AN INVESTMENT PORTFOLIO

Those who are just starting their investing journey may find the pro-
cess of building an investment portfolio overwhelming. Budgeting
for numerous bills including rent, Equivalent Monthly Instalments
(EMIs) for automobiles and other commitments might make it diffi-
cult to put aside enough money each month. But the sooner you start
investing, the more time your portfolio has to develop and expand.

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The smart investment ensures that you can prepare for your short-
and long-term objectives while taking into consideration your existing
costs. The balance between growth potential and dangers is the most
crucial component of portfolio construction. The secret is to develop a
diversified portfolio while being aware of your risk tolerance.

Here are a few strategies for creating a strong investment portfolio.

‰‰ Asset allocation: Investing in a variety of assets, such as stocks,
bonds, government securities, real estate, commodities and cash,
is the first rule of portfolio construction. A prudent asset mix might
be essential for protecting your portfolio against a decline in a cer-
tain asset or market. Your financial objectives, investment horizon
and risk tolerance are the three main factors you must take into
account while allocating assets.

S
‰‰ Financial goals: Consider your short-, mid- and long-term finan- NOTE
cial objectives before you start constructing your portfolio. Goals The asset allocation decision
that can be completed in less than three years include trips and refers to the allocation of
home renovations. Mid-term objectives may be set for a period of
IM portfolio assets to broad asset
three to 10 years and might include things such as paying for the markets; in other words, how
much of the portfolio’s funds are
college education of your children. Long-term objectives such as to be invested in stocks, how
saving for retirement or purchasing a home might take more than much in bonds, money market
10 years to complete. Therefore, your asset allocation should be in assets, and so forth.
line with these objectives.
‰‰ Investment horizon: This is the length of time that you plan to
M

keep an investment. Your financial objectives should guide the

choice of the different assets in your portfolio’s investment hori-
zon. Assets that will mature in time for your short-, mid- and long-
term objectives should be in your portfolio.
‰‰ Risk tolerance: Risk tolerance is the amount of risk you can toler-
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ate and it is influenced by your income, spending and risk-taking

propensity. It may vary from one individual to the next and alter
over time. Your risk tolerance, for instance, can rise as your pay
rises and falls if your dependents and costs rise. Age might also
affect risk tolerance, as persons who are getting near retirement
could be less ready to endure high risk.
‰‰ Risk diversification: One of the foundational principles of wise
investment is risk diversification. Based on the idea that various
assets have varying degrees of risk, it entails investing across a
range of assets to lessen the effect of risks related to any one asset
class. Investments with little risk often have poor returns, while
those with significant risk frequently have larger returns.

You may balance your risk and security by investing in a variety of

asset types. Each asset type must also be subject to diversification. By
reducing the harm, diversifying your investments across several sec-
tors and businesses protects your portfolio against a sudden decline
in these areas. According to risk diversification, low-risk, low-return

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278 FINANCIAL MODELLING

assets such as market securities or bonds must be used to offset the

NOTE risks of investing in high-growth companies to get the best returns.
Each investor must determine
which of these major categories Following is the example of the portfolio return in figure 8.2
of investments is suitable for
him/her. The next step, as
discussed in the preceding
section on asset allocation, is to
determine which percentage of
total investable assets should
be allocated to each category
deemed appropriate. Only then
should individual securities be
considered within each asset
class.

Figure 8.2 Portfolio return

S
SELF ASSESSMENT QUESTIONS

7. Investing in a variety of assets, such as stocks, bonds,

IM
government securities, real estate, commodities and cash, is
the first rule of portfolio construction. Which of the following
options is correct regarding the above statement?
a. Financial goals
b. Investment horizon
c. Risk tolerance
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d. Asset allocation
8. Assets that will mature in time for your short-, mid- and long-
term objectives should be in your portfolio. Which of the
following options is correct regarding the above statement?
N

a. Investment Horizon
b. Risk Tolerance
c. Risk Diversification
d. None of these

ACTIVITY

How investment portfolio is useful for the growth of the firm.

RISK REDUCTION IN THE STOCK

8.7
PORTION OF A PORTFOLIO
It is time to start investing after you have paid off all of your high-in-
terest personal debt, including any credit card debt and established
an emergency fund.

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 Portfolio Management  279

Even though you have a plethora of investing alternatives at your

disposal, including crowdsourcing websites, real estate, bonds and
bonds, stocks are a simple place to start with high average returns.

To take advantage of the many advantages that stocks provide inves-

tors, try these 12 risk-reduction strategies instead of opting for low-re-
turn investments.

1. DOLLAR-COST AVERAGING

Dollar-cost averaging is an investment strategy that is used most often

with mutual funds. An investor will allocate a specific dollar amount
that is used to periodically purchase shares of one or more specific
funds.

S
Because the price of the fund(s) will vary from one purchase period to
the next, the investor is able to lower the overall cost basis of the shares
because fewer shares will be purchased in a period when the fund
price is higher and more shares are bought when the price declines.
IM
Dollar-cost averaging is the practice of investing the same quantity of
money regularly, such as once a month, once every three months or
Know More
once every other regular period.
Assume that every risk factor
in a security portfolio is
Imagine that you inherit $50,000, for instance. You might either invest
independent. This portfolio’s
it all at once in a mutual fund or over time, gradually. By making peri- exposure to any one source
odic drip investments, you lower the danger of making bad timing
M

of risk decreases when more

investments just before a market downturn. securities are added to it. The
law of big numbers states that
On the other hand, you may invest $1,000 per month for the following the likelihood that the sample
mean will be relatively near
50 months rather than $50,000 all at once. Or $2000 per month for the
to the population’s predicted
next 25 months, or any other split you prefer. You must stretch out the
N

value increases with sample

investment over time. size. The insurance principle, so
named because it holds that an
In this manner, you invest at a price that is closer to the long-term insurance firm decreases its risk
average price when the share price of the company or fund varies. by issuing numerous policies
against many separate sources
The price changes result in you purchasing more shares when the of risk, can be thought of as
risk reduction in the case of
price is lower and fewer shares when the price is higher since you are independent risk sources.
investing the same amount of money. To rapidly provide an example,
let us assume you put $1,000 each month into SWPPX, an index fund
that follows the S&P 500.

A hypothetical example of how dollar-cost averaging may look over

the first five months is shown below:
‰‰ Month 1 Price: $30. $1,000/$30 = 33.3 shares
‰‰ Month 2 Price: $25. $1,000/$25 = 40 shares
‰‰ Month 3 Price: $27. $1,000/$27 = 37 shares

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280 FINANCIAL MODELLING

‰‰ Month 4 Price: $31. $1,000/$31 = 32.3 shares

‰‰ Month 5 Price: $33. $1,000/$33 = 30.3 shares

You would have invested $5,000 and owned 172.9 shares after five
months of dollar-cost averaging, at an average cost of $29 per share.

Pros & Cons of Dollar-Cost Averaging

Investors should be aware of other benefits and drawbacks of dol-

lar-cost averaging outside its main benefit of spreading the risk over
time.

Investments can be automated and this is a good thing. You may set up
automatic repeating purchases to occur on the same day each month
after you know what stock or fund you want to buy and how much you

S
want to spend each month. It takes place in the background without
your involvement or consideration. Using these financial automation
apps, you can even combine automated investing and savings.
IM
Because you can automatically transfer funds from your checking
account to your investing account, Betterment is one of your favou-
rites. Betterment does not charge for each trade or transfer, which is
its strongest feature.

You do not have to worry about attempting to time the market, which
is another benefit. Professional financial advisers often fall short of
M

properly predicting market gyrations, which speaks to your chances

of doing the same.

One drawback needs to be mentioned. Dollar-cost averaging, which

by definition looks for the same average cost per share, will not enable
N

financial amateurs who track equities markets faithfully beat the long-
term average. Therefore, although dollar-cost averaging will aid in
avoiding returns that are below average, it also prevents returns that
are above normal.

2. INDEX FUNDS

The cost of actively managed funds is high.

Investor fees are higher for these products since the fund manager
actively manages them to outperform the typical market returns.
Investor returns are diminished by these costs.

Actively managed funds often underperform rather than outperform

the overall market, in part because of these higher costs and in part
because of human mistakes. 95% of actively managed mid-cap funds
underperformed mid-cap stock indices, according to a U.S. News &
World Report survey. The results for small- and large-cap funds were
not much better (more on market capitalisation shortly).

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 Portfolio Management  281

A passively managed index fund, on the other hand, just replicates a

stock index, such as the Russell 2000 or the 500. Additionally, no work
is needed from compensated fund managers.

As a result, these index funds have much lower expense ratios, some-
times one-tenth or one-twelfth of what actively managed funds charge.
This allows you to invest more of your money, which will grow over
time.

3. DIVERSIFICATION ACROSS MARKET CAPS

Diversification, or placing your metaphorical eggs in more than one

basket, is a popular strategy for lowering risk. And among the several
types of diversification, market cap diversification is one.

S
The entire value of all publicly traded shares for a certain firm is
referred to as market capitalisation. To put it simply, a company’s mar-
ket capitalisation (market cap) is `500,000 if it has 100,000 outstanding
shares and a share price of `5.
IM
This is one alternative to using the number of workers to describe a
company’s size. After all, businesses with fewer people may neverthe-
less generate millions of dollars in revenue annually and have a high
market value, but businesses with more employees may see little to
no profit.

On the other hand, small-cap businesses often have far lower profit-
M

ability and staff counts than large-cap businesses. The stock prices of
large-cap businesses also tend to be more stable, with slower growth
and a lesser danger of a price crash.

Smaller businesses have more potential to expand and may swiftly

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increase in value. However, they are also just as swift to fall.

You may balance the stability of large-cap firms with the potential
development of small-cap companies by distributing your assets
across small-, mid- and large-cap index funds. For instance, the Rus-
sell 2000 represents 2000 smaller-cap U.S. firms, whereas the S&P 500
represents 500 of the biggest U.S. corporations. To target certain mar-
ket size and area, you may invest in index funds that resemble these
indices (such as the one stated above, SWPPX), as well as any other
index worldwide.

4. DIVERSIFICATION ACROSS REGIONS

Investors may distribute risk across various market capitalisations, as

well as among various geographical areas and nations.

As developed economies, the U.S. and European markets often do not

expand as swiftly as developing markets. Emerging countries with
economies attempting to catch up to advanced nations such as Japan

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282 FINANCIAL MODELLING

and the U.S., such as Brazil or Vietnam, have the opportunity for rapid
expansion. They may, however, also fall apart fast as a result of politi-
cal unrest or financial crises.

Similar to market caps, dividing money across funds active in several

locations will allow you to strike a balance between risk and growth.
I strive for a 50/50 split of domestic and foreign capital, but there is
no foolproof formula for success. Generally speaking, the potential for
development and the danger of rapid losses increases with the econo-
mies of the places where you invest being less developed.

5. DIVERSIFICATION ACROSS SECTORS

Some industries tend to have larger risks and potential rewards than

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others, just as some locations may see quicker growth or losses.

For instance, the technology industry often experiences phenomenal

growth. Look no further than the 78% fall of the tech-heavy NASDAQ
IM
index from 2000 to 2002 to see examples of its horrific disasters.

In comparison, some industries seem to be far more stable. Consider

utility stocks as a prime example of a “defensive” investment sec-
tor—a haven when other industries start to seem unstable and dan-
gerous. Everyone still needs power, after all, regardless of the state of
the economy.
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6. REAL ESTATE INVESTMENT TRUST (REITS)

Purchasing real estate investment trusts or REITs is an additional

method of stock portfolio diversification.
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A REIT is a firm that invests in real estate or real estate-related ser-

vices, but they are traded on the stock market as stocks and ETFs
(such as mortgage REITs). Investors may indirectly participate in real
estate in this manner without having to learn how to flip homes or
how to manage a rental property.

Keep in mind that the stock market and the real estate market often
move in separate directions. Although both the housing and stock
markets crashed during the Great Recession, this was not always the
case. Investors may further diversify their portfolios by placing money
in both stock indices and real estate-related ventures.

7. BOND FUNDS

Similar to this, investors may purchase bonds on the stock market by

purchasing funds that do so. For instance, the Vanguard Total Bond
Market Index Fund (VBMFX) from Vanguard invests in around 70%
U.S. business bonds and 30% U.S. government bonds.

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Bonds are known for being low-risk and low-return investments that
help balance a portfolio of risky stocks. Of course, if you prefer, you
can decide to invest in high-risk, high-return bond funds.

As you get closer to retirement, think about using bond funds as a tool
to reduce the risk associated with the sequence of returns.

8. ONLY SPECULATE WITH MONEY YOU CAN AFFORD TO LOSE

An investment involves purchasing an index fund that closely resem-

bles the Russell 2000, such as the Vanguard Russell 2000 ETF (VTWO).
It essentially enables you to own shares in 2000 firms, the majority of
which are expanding and profitable. Additionally, you may examine
decades of history to support your investment decision.

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Early in your financial career, educate yourself on the differences
between investing and speculating. A generally steady, verifiable and
quantifiable asset is what investing entails while speculating is taking
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a high-risk wager in exchange for the chance of huge rewards.

Take two real estate ventures as yet another illustration. Investing

involves purchasing a rental property that is already occupied by a
dependable tenant and can be inspected, its price compared to similar
properties, its current rent compared to adjacent market rates and its
cash flow projected. As an alternative, speculating is purchasing an
inexpensive plot of property in the hopes that it may one day become
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very valuable.

Speculating is not always a bad thing. A lot of early investors who

purchased bitcoin or other cryptocurrencies gained incredible sums
of money. However, the secret to risk management is to only speculate
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with money you’re willing to lose.

By all means, save 1%, 5% or 10% of your portfolio for high-risk, specu-
lative investments — securities you purchase “just for fun,” which
may see their value plummet or soar.

Just be sure that if they do fail, you will not be brought to ruin along
with them.

9. REINVEST DIVIDENDS

When you purchase a stock or fund, you may opt to reinvest dividends
to help compound your investment returns. Reinvesting dividends
may also assist you to avoid opportunity costs and losses from infla-
tion, as opposed to letting the money accumulate in your brokerage
account as cash.

In addition, it aids in your efforts to save it. Dollar-cost averaging can

also take the form of reinvested dividends. Whenever dividends are

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284 FINANCIAL MODELLING

paid out, they are immediately reinvested in the purchase of further

shares of the fund at the current share price.

10. MAKE DEFENSIVE MOVES BEFORE A CRASH

You should not feel compelled to leave your money in high-risk indus-
tries or areas if you are a worried investor and begin tossing and
turning over reports of an impending crisis. Put money in defensive
sectors, bonds, precious metals or, if you are feeling nervous while
equities prices are still high, you may just sit on big sums of cash.

Just remember not to sell everything when the market has already
plummeted out of fear.

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11. THINK TWICE BEFORE SELLING DURING CORRECTIONS

Of course, the issue is that the majority of investors do not begin to

worry until the market decline is already well underway.
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You have made investments in fundamentally good funds that will
recover if you have adhered to the other risk-mitigation strategies on
this list. Investors get into problems when they sell after a market col-
lapse and at a loss, then timidly hold off on repurchasing until the
recovery is well underway.

They are so purchasing at a premium.

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When everyone around you is in a panic, that is when you should pur-
chase instead of sell. If you’re using dollar cost averaging, stick with
your plan and keep purchasing to bring down your average per-share
base price.
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Your speculative investments are the exception to this rule; if you

can see the writing on the wall with them, you should sell and deduct
your losses. Also keep in mind that you are just speculating with “fun
money,” so no matter what happens, you will not lose everything.

12. HIRE AN EXPERT (OCCASIONALLY)

The risk-reducing investment techniques described above are

designed to be easy enough for anybody to use without professional
assistance. But it does not imply that you should never ask a profes-
sional for help.

Financial aspirations and circumstances vary from person to person.

To gain feedback, discuss ideas and ensure you’re on the right track, it
might be helpful to meet for an hour or two now and then with a qual-
ified financial planner. Even though a lot of financial planners may
want to upsell you on a recurring service plan, you can start by only
paying them for the hour for a single consultation.

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Hiring an investment adviser on an hourly basis will provide you with

more detailed recommendations on what to invest in. Make it clear
before the meeting that you want a one-time session for individualised
counsel to avoid sales pitches for their continued services.

RISKS INVOLVED IN INVESTMENT PORTFOLIO BUILDING

Any investment has some level of risk. Even the most reliable asset
could have an unanticipated setback. Sovereign risk, principal loss
risk and inflation risk are the three main categories into which portfo-
lio risks may be classified.

When a government or nation is unable or unwilling to honour its obli-

gations or loan arrangements, sovereign hazards arise. This might put

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safe assets like government securities in danger.

Loss of primary refers to the possibility of losing all or a portion of the

investor’s initial investment. To reduce the danger of principle loss,
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many cautious investors choose to invest in low-risk securities. It’s
crucial to realise that every asset has this particular danger.

The possibility that an investment portfolio’s returns would fall short

of its anticipated value owing to inflation is known as an inflation risk.
It affects the rate of actual returns on an investor’s assets and is most
often related to bonds and fixed income products.
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MINIMISING PORTFOLIO RISKS

A portfolio will always include risks. In order to reduce an investor’s

exposure to risks via risk diversification, wise investing emphasises
risk management. It is regarded as the best tactic for managing all
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three risk categories.

By making sure that your portfolio doesn’t rely primarily on govern-

ment assets for stability, you may reduce your exposure to sovereign
risks. While bonds and mutual funds are designed to balance the like-
lihood of principal loss, diversifying into equities also reduces the dan-
ger of inflation. Investors must simultaneously watch for changes in
the market. Stop-loss orders are one kind of strategy that is used to
reduce losses when they are inevitable.

The regular evaluation and rebalancing of a portfolio is another cru-

cial component of risk management. Depending on your age, income
and circumstances, your risk tolerance may alter over time. For
instance, you won’t be as eager to take chances when you have kids or
are getting close to retirement. It’s critical to analyse your portfolio to
discover how much of it is made up of low-risk, low-return assets like
bonds or fixed-income securities and high-risk, high-return invest-
ments like equities.

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To monitor your assets and the annual development of your portfo-

lio, frequent reviews are also required. With time, you may develop a
more in-depth understanding of how your portfolio behaves and the
best ways to enhance it. But more crucially, it guarantees that your
portfolio adapts to your shifting needs.

SELF ASSESSMENT QUESTIONS

9. Investor fees are higher for these products since the fund
manager actively manages them to outperform the typical
market returns. Which of the following options is correct
regarding the above statement?
a. Diversification across sectors
b. Diversification across regions

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c. Dollar-cost averaging
d. Index funds
IM10. Which of the following is an additional method of stock
portfolio diversification?
a. REITs
b. Bond funds
c. Both a. and b.
d. None of these
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ACTIVITY

Find out the advantages of the stock portion.

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8.8 VALUE INVESTING

Value investing is a kind of investing that makes money by finding
NOTE undervalued stocks. The foundation of it is the notion that each stock
Value investing style of investing has an intrinsic value, or what it is worth.
termed as conservative
investing. In the case of value You may ascertain what this inherent worth of a firm is by performing
investing, bargains are often a fundamental study on it. Buying stocks that sell for a sizable dis-
measured in terms of market
prices that are below the
count to their inherent worth is the goal of value investing (i.e., they
estimated current economic are cheaper than their true value). Once you purchase a cheap stock,
value of tangible and intangible the price of the stock ultimately increases to its intrinsic value, gener-
assets. ating a profit for us.

Choosing stocks that appear to be trading for less than their intrinsic
or book worth is part of the value investing technique. Value investors
hunt out stocks that they believe the stock market is undervaluing.
They contend that the market overreacts to both positive and nega-
tive news, causing stock price fluctuations that are inconsistent with

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a company’s long-term fundamentals. The overreaction presents a

chance to make money by purchasing equities at a discount—on sale.

The most well-known value investor today is arguably Warren Buffett,

but there are many others as well, including Seth Klarman, a mul-
tibillionaire hedge fund manager, David Dodd, Charlie Munger and
another Graham pupil, Christopher Browne.

The fundamental idea of daily value investing is simple: If you know

the real worth of something, you may save a lot of money when you
purchase it at a discount. Most people would concur that you receive
the same TV with the same screen size and picture quality whether
you get a new TV on sale or at full price.

Similar to how stocks operate, a company’s stock price may fluctuate

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even if its value or valuation has not changed. Similar to TVs, stocks Know More
experience periods of high and low demand, which causes price vola- Shares are purchased by value
tility, but this does not affect the value you receive for your investment. investors at enticingly low
prices. They are distinguished
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Value investors believe that stocks behave similarly to smart consum- by keeping a portfolio of assets
ers who would say that it makes no sense to buy full price for a TV such as real estate, machinery,
other financial stakes in
because TVs go on sale frequently throughout the year. Naturally, subsidiaries or other businesses,
unlike televisions, stocks will not be on sale during cyclical periods and market underperformers.
such as Black Friday and their discount pricing will not be publicised. Deep-value investors are value
investors who exclusively
Value investing is the practice of conducting research to identify these choose inexpensive, seldom
traded shares.
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covert stock sales and purchasing them at a discount from their mar-
ket value. Investors may receive hefty payouts for long-term purchases
and holdings of certain value equities.

SELF ASSESSMENT QUESTIONS

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11. Which of the following is a kind of investing that makes money

by finding undervalued stocks?
a. Growth investing
b. Investment risk pyramid
c. Building an investment portfolio
d. Value investing

ACTIVITY

Write a short note on the advantages of value investing.

8.9 GROWTH INVESTING

Growing an investor’s money is the main goal of the investment style
and technique known as growth investing. Growth stocks, or young or
tiny businesses whose profits are anticipated to expand at an above-av-

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erage pace relative to their industry sector or the broader market, are
the type of securities that growth investors often invest in.

Many investors find growth investing to be very appealing since pur-

chasing shares in developing firms may result in substantial profits (as
long as the companies are successful). But because they have not been
tested, these businesses frequently carry a significant level of risk.

Value investment and growth investing can be compared. Choosing

stocks that appear to be trading for less than their intrinsic or book
worth is part of the value investing technique.

Growth investors often seek investments in fast developing areas (or

even whole industries) that are home to emerging products and ser-
vices. Profits from capital appreciation, or the gains they will obtain

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when they sell their shares, are sought after by growth investors (as
opposed to dividends they receive while they own it). In reality, rather
than providing dividends to its shareholders, the majority of growth-
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stock businesses reinvest their profits back into the company.

These businesses often have great promise but are tiny and young.
They can also be new public corporations that have recently begun
trading. The underlying assumption is that as the business grows
and prospers, better earnings or revenues would ultimately result in
higher stock values. Therefore, growth stocks may trade with a high
Price-to-Earnings (P/E) ratio. They might not be making money right
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now, but they should in the future. This is due to the possibility that
they possess patents or have access to technology that provides them
with an advantage over rivals in their field. They reinvest the money
to create even more cutting-edge technology to stay one step ahead of
rivals and they pursue patents to guarantee longer-term growth.
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Since investors strive to maximise their capital returns, growth

NOTE investing is also frequently referred to as a capital growth strategy or
Growth investors consider a capital appreciation approach. It is important to first comprehend
several factors to identify what growth investing is and is not. The strategy involves purchas-
superior performing securities ing stocks linked to companies that possess desirable qualities that
for purchase. Some of the
factors that are looked into
their competitors do not. These may include items that are simple to
are short run and long run high measure, including sales and/or earnings growth rates that outper-
growth rates from sales and form the market. They can also contain higher-quality elements such
EPS, high profit margin and as solid client loyalty, a valued brand.
notable increase in projected
earnings for both three and five Growth stocks frequently occupy attractive positions in developing
years.
industrial areas with wide lanes for future growth. A growth stock is
valued at a premium that represents the confidence investors have
in the firm due to the attractive future and the exceptionally great
performance the business has had recently. As a result, the easiest
method to tell if a stock is a growth stock is to see if its valuation, typi-
cally measured by its price-to-earnings ratio, is high in comparison to
the overall market and its competitors in the same sector.

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This strategy is in contrast to value investing, which concentrates on

stocks that have lost Wall Street favour. These equities have lower
values, which correspond to more pessimistic sales and profit projec-
tions. Both investment approaches can be successful if used consis-
tently, but most investors favour one approach over the other.

Now that you are aware that growth investing is suited to you, let us
examine the procedures for maximising the technique.

STEP 1: PREPARE YOUR FINANCES

As a general guideline, you should not invest in stocks with funds that
you anticipate using within the next five years, at the very least. That
is because, despite the market’s long-term tendency to increase, it reg-
ularly experiences abrupt declines of 10%, 20% or more. Setting your-

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self up to be compelled to sell stocks during one of these downturns is
one of the worst blunders an investor can make. Instead, you should
be prepared to purchase equities when most people are selling them.
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STEP 2: GET COMFORTABLE WITH GROWTH APPROACHES

As you go forward with building up your funds, it is essential to equip

yourself with yet another potent tool: education. You may opt to use a
variety of growth investment techniques, after all.

For instance, you could limit your search to big, established companies
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with a track record of making money. Your strategy may be based on

quantitative indicators such as operating margin, return on invested
capital and compound annual growth that are compatible with stock
screeners. However, many growth investors place less emphasis on
share prices and instead want to invest in the best-performing compa-
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nies, as seen by their constant increases in market share.

It frequently makes sense to concentrate your purchasing on markets

and businesses you are particularly familiar with. Having expertise in,
for instance, the restaurant industry or working for a company that
provides cloud software services may help you assess investments as
prospective buy prospects. Knowing a lot about a select group of firms
is typically superior to knowing little to nothing about a diverse range
of enterprises.

But if you want to maximise your profits, you must consistently imple-
ment the plan you decide on and resist the urge to switch to a different
strategy just because the current one appears to be more effective.
That technique is called “chasing returns,” and it’s a proven way to
underperform the market over the long run.

Learn the principles of this stock market investment technique to

avoid that destiny. Reading a few classic growths investing books is a
terrific place to start, and then educate yourself with the professionals
in the area.

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T. Rowe Price, for instance, is recognised as the originator of growth

investing and even though he left the industry in 1971, his impact can
still be seen today. At a period when equities were viewed as cyclical,
short-term investments, Price helped popularise the concept that a
company’s profits growth could be projected out over several years.

Although Warren Buffett is typically thought of as a value investor,

several aspects of his strategy are growth-oriented. Buffett once said,
“It’s far better to purchase a fabulous firm at a fair price than a fair
company at a wonderful price.” This is a famous expression of philos-
ophy. In other words, while the price is a crucial component of any
investment, the strength of the company may be equally as significant
as or even more so.

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STEP 3: STOCK SELECTION

It’s time to get ready to start investing right away. Choosing the exact
amount of money you want to put toward your development investing
plan is the first step in this process. It can make sense to start modest
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with, say, 10% of the assets in your portfolio if you’re brand-new to the
strategy. This percentage may increase as you become more accus-
tomed to the volatility and gain experience investing through various
market conditions (rallies, slumps and everything in between).

Risk also plays a significant factor in this decision since growth equi-
ties are viewed as being more aggressive and volatile than defen-
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sive stocks. Because of this, a longer time horizon typically gives you
greater freedom to skew your portfolio in favour of this investment
approach. If your portfolio gives you anxiety, that may be a sign that
your growth stock allocation is too high. Reduce your exposure to
specific growth stocks in favour of more varied choices if you start to
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worry about future losses or previous market declines.

SELF ASSESSMENT QUESTIONS

12. Choosing the exact amount of money you want to put toward
your development investing plan is the first step in this
process. Which of the following options is correct regarding
the above statement?
a. Get comfortable with growth approaches
b. Prepare your finances
c. Stock selection
d. None of these

ACTIVITY

Find out the disadvantages of growth investing.

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8.10 SUMMARY S
‰‰ The process of choosing and managing a set of investments to fulfil
the long-term financial goals and risk tolerance of a customer, a
business or an institution is known as portfolio management.
‰‰ The capacity to evaluate opportunities, dangers and threats across
the complete range of investments is necessary for portfolio man-
agement.
‰‰ A portfolio is a group of initiatives or programs that are organised
and managed at the organisational or functional level to maximise
operational effectiveness or strategic advantages. Both organisa-
tional and functional levels can handle them.
‰‰ Portfolios serve as coordinating structures to support a deploy-

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ment by ensuring the best prioritisation of resources to align with
strategic intent and achieve the best value.
‰‰ Investment objectives are typically articulated in terms of income,
growth and stability.
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‰‰ The risk/reward ratio shows how much an investor may get from
an investment for every dollar they risk. The predicted rewards of
an investment and the level of risk required to attain those returns
are often compared using risk/reward ratios.
‰‰ An investing risk pyramid does not advise you to purchase any
specific stocks or bonds. It serves as a tool for asset allocation.
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Asset allocation refers to selecting how much of your overall assets

should be invested in lower-risk, secure securities, how much
should be invested in growth opportunities that include some risk
and how much you may invest in high-risk projects.
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‰‰ The lowest-risk investment possibilities are represented by the

base of the risk pyramid, which serves as its base. The following
are examples of money market instruments, namely cash and cash
equivalents, Treasury bills, government securities, certificates of
deposits, bonds and other financial products.
‰‰ Those who are just starting their investing journey may find the
process of building an investment portfolio overwhelming. Bud-
geting for numerous bills including rent, Equivalent Monthly
Instalments (EMIs) for automobiles and other commitments might
make it difficult to put aside enough money each month.
‰‰ Value investing is a kind of investing that makes money by finding
undervalued stocks. The foundation of it is the notion that each
stock has an intrinsic value or what it is worth.
‰‰ Growing an investor’s money is the main goal of the investment
style and technique known as growth investing. Growth stocks,
or young or tiny businesses whose profits are anticipated to grow
at an above-average pace relative to their industry sector or the

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292 FINANCIAL MODELLING

broader market, are the type of securities that growth investors

often invest in.

KEY WORDS

‰‰ Portfolio: A group of financial investments, including securi-

ties, cash, bonds, commodities and cash equivalents
‰‰ Prioritisation: Determining the relative significance or urgency
of an item or things through action or procedure
‰‰ Risk-reward: The link between the return on investment and
the level of risk that was assumed during that investment
‰‰ Moderately: Not completely or extremely to a moderate degree
or extent

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8.11 MULTIPLE CHOICE QUESTIONS
MCQ 1. Which of the following is typically articulated in terms of income,
IM
growth and stability?
a. Company objectives
b. Investment objectives
c. Both a. and b.
d. None of these
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2. Which of the following frequently uses this method to decide

which trades to place (the reward)?
a. Investors
b. Traders
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c. Government
d. Both b. and c.
3. Moderately risky investment alternatives are represented in
the centre of the risk pyramid. Which of the following options is
correct regarding the above statement?
a. Top
b. Base
c. Middle
d. All of these
4. The ability to deliver extraordinarily large profits is one of these
asset types’ major attributes. Which of the following options is
correct regarding the above statement?
a. Top
b. Middle

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c. Base
d. Both a. and b.
5. Which of the following orders shield investors from declining
share prices?
a. Put options
b. Stop loss
c. Dividends
d. None of these
6. Which of the following with equity participation rights can be
an option for investors who are concerned about keeping their
principal intact?

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a. Principal-protected notes
b. Dividends
c. Put options
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d. Diversification
7. Which of the following is the amount of risk you can tolerate,
and it is influenced by your income, spending and risk-taking
propensity?
a. Risk diversification
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b. Risk tolerance
c. Investment horizon
d. None of these
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8. Which of the following are known for being low-risk and low-
return investments that help balance a portfolio of risky stocks?
a. Index funds
b. Bonds
c. REITs
d. None of these
9. Growing an investor’s money is the main goal of the investment
style and technique known as
a. Building an Investment Portfolio
b. Value investing
c. Growth investing
d. Investment risk pyramid
10. As a general guideline, you should not invest in stocks with funds
that you anticipate using within the next five years, at the very

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294 FINANCIAL MODELLING

least. Which of the following options is correct regarding the

above statement?
a. Get comfortable with growth approaches
b. Prepare your finances
c. Stock selection
d. None of these

8.12 DESCRIPTIVE QUESTIONS

? 1. What do you mean by portfolio management?
2. Discuss the value investing.
3. Describe the concept of growth investing.

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HIGHER ORDER THINKING SKILLS
8.13
(HOTS) QUESTIONS
IM
1. Which of these is a wager on an unknown future to potentially
win money?
a. Investment
b. Gambling
c. Financing
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d. Portfolio
2. Which of the following is a technique used to assess a security’s
value by looking at its financial information?
a. Security analysis
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b. Fundamental analysis
c. Performance analysis
d. None of these
3. Which of the following describes typical mistakes in managing
investments?
a. Not having a clearly defined investment plan
b. Investors often overdose themselves on information
c. Both a. and b.
d. None of these
4. Which of the following characteristics is necessary for a wise
investor?
a. Smart investor invest consistency
b. Smart investors are important

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c. Smart Investors are emotionally tied to their investment po-

sition
d. All of these

8.14 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Turning Your Goals into a Strategy 1. a. Strategy
Risk-reward Ratio 2. c. Risk-reward Ratio
Investment Risk Pyramid 3. d. Investing risk pyramid
4. c. Base

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Portfolio Strategies 5. d. Diversification
6. a. Non-correlating assets
Building an Investment Portfolio 7. d. Asset allocation
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8. a. Investment Horizon
Risk Reduction in the Stock Por- 9. d. Index Funds
tion of a Portfolio
10. a. REITs
Value Investing 11. d. Value Investing
Growth Investing 12. c. Stock Selection
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Investment Objectives
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2. b. Traders
3. c. Middle
4. c. Base
5. b. Stop loss
6. a. Principal-protected notes
7. b. Risk Tolerance
8. b. Top
9. c. Growth Investing
10. b. Prepare your Finances

HINTS FOR DESCRIPTIVE QUESTIONS

1. The process of choosing and managing a set of investments
to fulfil the long-term financial goals and risk tolerance of a
customer, a business or an institution is known as portfolio
management. Refer to Section 8.1 Introduction

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296 FINANCIAL MODELLING

2. Value investing is a kind of investing that makes money by finding

undervalued stocks. The foundation of it is the notion that each
stock has an intrinsic value, or what it is worth. Refer to Section
8.8 Value Investing
3. Growing an investor’s money is the main goal of the investment
style and technique known as growth investing. Growth stocks,
or new or tiny businesses whose profits are anticipated to grow
at an above-average pace relative to their industry sector or the
broader market, are the type of securities that growth investors
often invest in. Refer to Section 8.9 Growth Investing

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

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Q. No. Answer
1. b. Gambling
2. b. Fundamental analysis
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3. b. Both a. and b.
4. a. Smart investor invest consistency

8.15 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
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‰‰ Stewart, S., Piros, C. and Heisler, J., n.d. Portfolio Management.

‰‰ Institute, P., 2014. The Standard for Portfolio Management - Third
Edition. Newtown Square, PA: Project Management Institute.
‰‰ 2010. Portfolio management. New York: McGraw-Hill Higher Edu-
N

cation.

E-REFERENCES
‰‰ Apm.org.uk. 2022. [online] Available at: <https://www.apm.org.uk/
resources/what-is-project-management/what-is-portfolio-manage-
ment/> [Accessed 19 September 2022].
‰‰ Managementstudyguide.com. 2022. Portfolio Management -
Meaning and Important Concepts. [online] Available at: <https://
www.managementstudyguide.com/portfolio-management.htm>
[Accessed 19 September 2022].
‰‰ Moneycontrol.com. 2022. Portfolio Management - Mutual Fund
Investment, Asset Allocation, Stock Portfolio – Moneycontrol.
[online] Available at: <https://www.moneycontrol.com/portfo-
lio-management/portfolio-investment-signup.php?classic=true>
[Accessed 19 September 2022].

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 C H A
9 P T E R

INTEGRATED RISK MODELLING

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CONTENTS

9.1 Introduction
9.2 Meaning of Risk Modelling
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Self Assessment Questions
Activity
9.3 The Model
9.3.1 General Risk
9.3.2 Credit Risk
9.3.2 Operational Risk
M

9.3.3 Market Risk

Self Assessment Questions
Activity
9.4 Implementation
9.4.1 Simulation Procedure
N

9.4.2 Simulation Variability

Self Assessment Questions
Activity
9.5 Empirical Results
Self Assessment Questions
Activity
9.6 Summary
9.7 Multiple Choice Questions
9.8 Descriptive Questions
9.9 Higher Order Thinking Skills (HOTS) Questions
9.10 Answers and Hints
9.11 Suggested Readings & References

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INTRODUCTORY CASELET

INTEGRATED RISK MODELLING

Organisations nowadays find it challenging to understand the

Case Objective relationships between different risks and decide on the best risk
This caselet discusses why modelling strategies due to the sheer complexity and volume of
organisations need integrated the risk environment. As a result, organisations fall short of the
risk management. goals and success markers they have established. Because efforts
are solely focussed on risk reduction without delivering any value
to the organisation, risk modelling exercises can be pointless and
costly.

Consequently, it is crucial to incorporate risk modelling efforts

across the whole organisational structure. A coordinated method
for the evaluation, control and monitoring of hazards in an organ-

S
isation is created using an integrated risk modelling framework.

Questions like these are addressed with the aid of the Integrated
Risk Modeling technique:
IM
‰‰ How can one plan actions to minimise risks?
‰‰ What factors influence the value of integrated risk modelling?
‰‰ What possible consequences may be there if the risk is not
managed?
‰‰ How can an integrated risk mitigation strategy assist to mini-
M

mise failure and increase success?

The conventional method of risk modelling entails the identifica-

tion of various risks and the delegation of those risks to various
risk specialists who then address them using various methods.
N

However, because the risk modelling process functions in silos,

resulting in a limited view of risk reduction, this method fails to
bring value to organisations.

By taking into account all risks and methodologies used, imple-

menting a thorough approach to risk modelling, such as Inte-
grated Risk Modelling (IRM), helps align risk modelling across
various departments.

Organisations may now change the focus of risk modelling from

examining each risk in isolation to assessing the collective expo-
sure to risks of the organisations by combining several risk mod-
elling functions into an operating risk framework.

To determine how risks interact with one another, an integrated

approach to risk modelling is crucial. After evaluating how the
organisational structure will be impacted overall by these risks
and accompanying changes, expert teams may then build strate-
gies for risk mitigation.

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INTRODUCTORY CASELET

Integrating the risk modelling procedures will expand the market

and boost the likelihood of success. A programme for integrated
risk modelling is also required for an organisation to succeed in a
global economy.

S
IM
M
N

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LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Discuss the meaning of risk modelling
>> Explain the concept of general risk
>> Classify operational risks
>> Describe the simulation procedure
>> Express simulation variability
>> Discuss empirical results

9.1 INTRODUCTION

S
Quick Revision
In the previous chapter, you studied about portfolio management. The
process of choosing and managing a set of investments to fulfil the
long-term financial goals and risk tolerance of a customer, a business
or an institution is known as portfolio management. While people
IM
have the option to create and manage their portfolios, professional
portfolio managers act on behalf of customers. The ultimate objective
of the portfolio manager is to maximise the projected return on the
assets while maintaining a reasonable degree of risk exposure.

Security and risk requirements for an information system, or the pro-

cess of designing such a system, are typically mapped out in security
M

and risk models. It is also used to predict and model the behaviour of
such systems in order to understand the specifics of changes that are
expected to take place when the system is operating.

In some industries, including financial services and energy, where

N

taking measured risk is essential to the business, risk modelling has

been common for years. A wide range of risk models and simulations
have lately started to be adopted by companies in both the public and
private sectors in order to begin tackling strategic, operational, com-
pliance, geopolitical and other sorts of risk.

Many different types of risk can be assessed using risk models. Under-
standing the risk associated with attaining broad strategic objectives
or providing highly detailed answers may be desirable. Perhaps you
want to assess the geopolitical risks of joining a developing market or
comprehend how an adaptable opponent (such a hacker or terrorist)
can strike you. Once risk models have been created, they can be used
to assess a system’s behaviour in both real-world situations and specu-
lative “what if” scenarios. This aids organisations in assessing their
level of risk tolerance and how to make their systems more resilient so
they can endure a variety of shocks.

The notion that risk models are innately very expensive and take
months or even years to construct is a widespread one. In a matter of

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weeks to a few months, with the aid of numerous new tools and accel-
erators, it is now possible to build even pretty sophisticated models.
In this chapter, you will study the meaning of risk modelling, credit
risk, operational risk, market, risk, simulation procedure, simulation
variability empirical results, etc., in detail.

9.2 MEANING OF RISK MODELLING

Risk modelling is the systematic and holistic approach to risk manage-
ment, especially compared to more traditional methods, such as only
buying insurance to protect your business. Risk modelling is about
creating effective risk analyses, magnifying how efficient insurance
can be, and taking a more comprehensive approach to risk research
and solutions.

S
Risk modelling is about modelling and quantifying risk. For the finan-
cial sector, credit risk cases are specifically essential for quantifying
potential losses. Operational risk or the quantification of potential
IM
losses due to process errors, is a relevant topic for all forms of organ-
isations. The approach to risk modelling pays particular attention
to systemic risk in complex systems. Recent topics covered include
operational risk analysis, with particular attention to process inter-
dependencies, and credit risk analysis in interdependent corporate
portfolios. Risk modelling explains the intermittent nature of market
dynamics in terms of interacting prices.
M

The situations of credit risk estimating possible losses due to, for
example, debtor bankruptcy or market risk quantifying potential
losses owing to adverse movements of a portfolio’s market value is
of special significance to the financial sector. Operational risk, which
N

involves estimating possible losses brought on by failed procedures, is

a pertinent problem for every kind of firm.

A systemic risk in complex systems is given special consideration in

the approach to risk modelling. The study of operational risks, with a Know More
focus on the interdependence of processes, and the analysis of credit Risk modeling uses a variety
risks in portfolios involving mutually dependent enterprises are con- of techniques including
temporary topics you have looked at and it also put forward models market risk, value at risk (VaR),
that use interacting prices to explain how market dynamics are spo- historical simulation (HS), or
extreme value theory (EVT) in
radic. order to analyse a portfolio and
make forecasts of the likely
The large-scale blackouts that affected the northeastern US and losses that would be incurred
parts of Canada in August 2003, as well as the significant blackouts for a variety of risks.
in London, Denmark and the southern part of Sweden, as well as a
nationwide one in Italy in the same month, serve as rather spectacu-
lar recent examples illustrative of the predictions regarding the pos-
sibility of first-order phase transitions to a catastrophic breakdown in
systems of interacting processes.

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302 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

1. Which of the following goal is to predict and quantify risk?

a. Risk modelling
b. Implementation
c. Empirical results
d. None of these
2. Which of the following in complex systems is given special
consideration in the approach to risk modelling?
a. Operational risk
b. Credit risk

S
c. Systemic risk
d. Market risk
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ACTIVITY

Write some advantages of risk modelling.

9.3 THE MODEL

M

A model is a framework, quantitative method or strategy that is pred-

icated on hypotheses and uses mathematical, economic, statistical or
financial theories and methods. The model converts the supplied data
into a quantitative estimate.
N

Models are used by financial organisations and individuals to deter-

mine the hypothetical worth of stock prices and discover trading
opportunities. Models can be helpful tools for investment research,
but they can also be vulnerable to several risks, including the use of
faulty data, programming mistakes, technological faults and incorrect
interpretation of the model’s conclusions.

9.3.1 GENERAL RISK

Know More
The goal of risk modeling is The combination of a wide range of hazards is one of the key tech-
to predict and quantify risk. nological challenges in risk management for a financial institution. A
The situations of credit risk
estimating possible losses
financial institution’s annualised loss total is T.
due to, for example, debtor
bankruptcy or market risk T = C + O + M (1)
quantifying potential losses
owing to adverse movements Where C, O and M represent the annual losses brought on by credit,
of a portfolio’s market value are operational and market risk, respectively. Typically, the risk manager
of special significance to the
financial sector.
is concerned with the combined distribution or the distribution of all
hazards together and has some knowledge of the marginal distribution

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of each risk category. Technically, aggregating these hazards is fairly

difficult. It is important to do a numerical integration or simulation to
convolve the underlying risk distributions for each risk category since
they do not all necessarily follow the same distributional pattern.

There are not many methods in the literature for combining credit,
market and operational risk. Under risk modelling all hazards are
assumed to be jointly normally distributed, which greatly simplifies
the method. The use of copulas to connect the marginal to the joint
distribution is another technique that has lately gained a lot of popu-
larity in finance.

Choosing a common time horizon for all the different risk categories
is another difficulty in integrated risk management. Usually, a market

S
risk is calculated daily. Both operational risk and credit risk are gen-
erally calibrated to one year. The practice for modelling risks are fol-
lowed and evaluating capital in banks, which is to employ a one-year
horizon. An institution may access the markets for additional capital
IM
within a one-year time horizon, which is also the one, utilised in the
New Basel Accord. It also corresponds to the internal capital alloca-
tion and budgeting cycle.

The simulation is utilised to convolve the marginal distributions in

terms of the aggregate of risk kinds. After taking samples of P’s simul-
taneous distributions C, O and M (C, O, M) it create the total loss T by
M

(1). The combined probability of the credit, market and operational

losses P (C, O, M), according to the multiplication law of probability
from conventional statistical theory, may be broken down as follows:

P (C, O, M ) = P (C) P (O|C) P (M |C, O). (2)

N

Due to its dominance in the financial organisation under consider-

ation, credit risk is chosen as the basic risk to which all other risk
categories are connected. Be aware that (2) does not mean that you
attempt to forecast the operational loss and market loss based on the
credit loss. (2) is clarified by assuming that:

P (M |C, O) = P (M |C), (3)

This demonstrates the conditional independence between market and

operational losses. In other words, once the credit loss is established,
no amount of operational loss proof alters the perception of the mar-
ket loss. Combining (3) and (2) results in:

P (C, O, M) = P (C) P (O|C) P (M |C). (4)

The combined distribution of risk categories will be able to determine

if you can simulate using the three probability distributions on the
right.

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9.3.2 CREDIT RISK

The risk of losses brought on by the inability of DnB’s financial coun-

NOTE terparties to fulfil their commitments is known as credit risk. The DnB
credit model currently in use, which is distinct from other credit risk
Credit risk is the possibility of a
loss resulting from a borrower’s systems but comparable to the methodology employed by Ward &
failure to repay a loan or meet Lee. The following may be used as a summary. First, 10 kinds of credit
contractual obligations. obligations are created depending on the likelihood of default. Both
financial and non-financial elements, such as management features,
are used to categorise obligations.

Estimating exposure, or how much would need to be paid back to the

bank in the event of a failure, is the next stage. Each commitment’s
estimated loss is determined by multiplying the projected default fre-

S
quency, exposure at default and loss ratio. The estimated loss for the
portfolio is then calculated by adding the obligations.

The risk level in the portfolio is influenced by how losses are distrib-
IM
uted about one another. By assuming a link between each loan’s com-
mitment and the total credit losses, the credit model describes how
each loan affects the overall risk.

It is feasible to calculate the credit portfolio’s standard deviation

based on these connections. In this scenario, the inputs and outputs
for the credit component of the overall risk are, respectively, produced
by DnB’s credit management systems.
M

The whole distribution is required, not just the mean and standard
deviation, to simulate the model. The credit loss rate R is used in the
DnB model, whereby is the institution’s overall credit loss C divided
by its entire exposure. It has decided to utilise a beta distribution to
N

represent the portfolio of linked loans, using the same logic as that
shown below.
The probability density of R is more specifically:
Γ(α + β ) α −1
b( r) = r (1 − r)β −1 , 0 < r < 1, (5)
Γ(α )Γ(β )

where, the Gamma function Γ (α) is defined by,

∞
Γ(α ) = ∫0
tα −1 e− t dt

for α > 0

The two parameters define the beta distribution. The following equa-
tions may be used to get these from the expectation µJ = µ/e and stan-
dard deviation σJ = σ/e of the loss ratio R.
2
 µ' 
α = (1 − µ ')   − µ '
σ ' 

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 Integrated Risk Modelling  305

And

α
β= −α.
µ'

9.3.3 OPERATIONAL RISK

The operational risk of DnB originates from both direct and indirect
losses brought on by external occurrences like natural catastrophes
and criminal activity as well as internal causes like insufficient or inef-
ficient internal procedures and systems. Some of these losses happen
regularly but are only of little worth, whereas others happen very sel-
dom yet are extremely substantial.

S
Based on expert judgement and arbitrary decisions since the amount
and quality of DnB’s information on operational losses do not permit NOTE
the accurate calculation of the parameters in an EVT model. The size Operational risk summarises
of the most frequent loss, the risk-adjusted capital needed to cover the chances and uncertainties
IM a company faces in the course
operational risk (here, the institution follows an international industry
of conducting its daily business
benchmark, which has also been acknowledged by the Basel Commit- activities, procedures and
tee and let operational risk represent around 20% of overall capital systems.
requirement) and the correlation between operational and credit risk
were three quantities on which the risk managers felt they had a rea-
sonably clear opinion. The latter is assumed to be true because opera-
tional mistakes related to credit activity often do not show up until the
M

credit risk manifests.

Risk-adjusted capital may be connected to the 99.97% quantile and

the operational loss distribution’s mode, m, respectively. The former
is connected to the evaluation of an S&P rating of “AA” for the insti-
N

tution, for instance equates to an average default chance of the insti-

tution of 0.03%. In light of this, a suitable distribution for operational
loss is heavy-tailed, defined by the mode and the 99.97% quantile and
that can be conveniently connected to the beta distribution for credit
risk. It was discovered that the lognormal distribution was a sensible
option.

One method recommended by the Basel Committee BIS is to simulate

the frequency of operational loss events over a year from a Poisson
distribution and the severity of these events from a lognormal distri-
bution, then add the individual events to calculate the annual operat-
ing loss as a whole. This method distributes the entire operating losses
as a sum of lognormal. It is a rough approximation to approximate this
distribution using another lognormal distribution.

By converting C and O to standard normal variables X and Y, defin-

ing a correlation between these variables and then re-transforming to
the appropriate distributions, it is possible to establish the connection

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306 FINANCIAL MODELLING

between operational and credit losses. This phenomenon is known as

copula technique. Although a normal copula implies independence
(correlation breakdown) in the tails, this is farther out in the tail than
the 99.97% quantile that does not preclude it from being used in the
calculation of capital at risk because it is further out in the tail than
the 99.97% quantile. The correlation between C and O will be lower
using this method but this may be made up for by increasing the cor-
relation between X and Y.

The modelling is broken out as follows. The credit loss C represented

in 9.3.1 Credit Risk

C = e B−1{Φ(X)}(6)

S
When X is a standard normal variable, Φ (.) is the cumulative standard
normal distribution function, and B−1 (.) is the inverse cumulative
beta distribution. Additionally, it is possible to write the lognormally
distributed operational loss O.
IM
O = exp (ξ + τ Y), (7)

Where Y is an additional normal variable and are the lognormal dis-

tribution’s parameters. O and C becomes dependent when an X and Y
connection is specified.

It is still necessary to declare the variables ξ and τ in (7). In the absence

M

of suitable historical data, the parameters are calculated by solving

the equation using a subjective evaluation of the 99.97% quantile op
and the mode m.

m = exp(ξ − τ 2)(8)
N

And

op = exp{ξ + τ Φ−1(p)}, (9)

Where Φ−1(p) is the 99.97% quantile of the standard normal distribu-

tion.

The technique for modelling an operational risk given in this study

must be seen as preliminary due to the scarcity of data on previous
losses. DnB has begun the process of creating a database for oper-
ational losses and creating risk indicators for use in tracking opera-
tional risk (perhaps in coordination with other financial institutions).
As soon as it is determined that the data material is big enough and of
high enough quality, the present model will be improved.

NOTE 9.3.4 MARKET RISK

Market risk is the risk of losses
on financial investments caused A market risk is a result of the financial institution’s open positions
by adverse price movements in the capital, interest rate and foreign exchange markets and it is

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 Integrated Risk Modelling  307

correlated with changes in market prices and exchange rates. The

equities, foreign currency, interest rate and commodities markets all
represent distinct forms of market risk. DnB’s overall market risk is
made up of hazards connected with 15 different instruments and it is
handled by limitations for each category. The financial institution’s
brokerage operations, which primarily include the interest rate and
currency markets, are distinguished by DnB from banking activi-
ties, where investments are made with a longer-term view, such as
in-stock instruments. Out of a total of around 3000 MNOK for the
whole market portfolio, the trading books’ portion barely accounts for
50 MNOK.

Based on the assumption that market liquidity would always be ade-

quate to enable positions to be closed off with a minimum loss, market
risk is commonly quantified using VaR on a short time horizon, such

S
as 10 days. VaR is beneficial in short-term trading environments but
loses some of its effectiveness when used to assess the market risk
brought on by long-term activities. Four arguments are provided by
IM
Hickman for why VaR is inadequate as a long-term measure. One of
the reasons is that the impact of management intervention rules, such
as stop-loss restrictions, which may significantly reduce the cumula-
tive effect of losses in a catastrophic downside scenario, are not well
reflected by VaR.

By setting a holding time for each market item, it considers the like-
lihood that an intermediate loss would be realised in this model to
M

reduce the risk of big losses. The annual loss is determined by using
the worst-case change that happened throughout these holding peri-
ods. The holding durations range from two days for holdings in the
most liquid currencies to 250 days for equity investments (because
the great bulk of the financial institution’s stock investments are long-
N

term).

Let ∆i represent the instrument’s value on day t and I represent the

holding time for instrument i and Pti .
Next, the definition of the change in instrument i on day t is:

Pti − Pti+∆i
Lti = E i ,
Pti
Know More
Where Ei is the instrument’s positional limit. The total of the changes
Market risk is the risk of
in all the instruments, or the change in the whole market portfolio on losses in positions arising from
day t: movements in market variables
like prices and volatility.
LtM = ∑L.
i
i
t

The worst daily change, or market loss over a year, is described as:
M = max LtM .
t

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308 FINANCIAL MODELLING

However, it should be noted that any definition of a market loss that is

based on the prices of the instruments is compatible with the method
given below for tying market and credit risk together.

To simulate the daily price variations, Pti go with the traditional

option, the model of geometric Brownian motion.

Pti = Pti −1 exp(dti ),

Where the innovation dti is Gaussian and temporally uncorrelated.

It is a presumption that the innovations at the time t for various instru-

ments are connected. It has computed average daily correlations in its
application. However, this can cause the projected economic capital to
be biassed lower.

S
Numerous research published recently, have demonstrated that mar-
ket returns are more correlated during times of world unrest. There-
fore, one may adopt a model where the correlation changes over time,
IM
as the multivariate GARCH-model proposed by Bollerslev.

As an alternative, one may utilise fixed extreme correlations, which

are the correlations between returns that are very far out in the mul-
tivariate market distribution. Such models may be unstable and chal-
lenging to apply in an operational system.
M

The average correlations might be substituted in the model with

exceptional correlations discovered by utilising the portions of the
1983–2000 period that are characterised by a 5% or greater weekly
decline in the Standard & Poor 500 Index. The correlation between
the Norwegian Stock Market Index (TOTX) and the Standard & Poor
500 Index over these sub-periods was about 50% greater than the
N

overall average correlation. Since the concentration is on unpleasant

occurrences, it is not a concern that constantly use extreme correla-
tions, which causes us to overstate returns in “good times.”
NOTE
The term market risk, also known As shown in (4), the model assumes a link between a market loss M
as systematic risk, refers to the and a credit loss C. This does not mean that it predicts the market
uncertainty associated with any losses from the credit losses. It could equally well have modelled P
investment decision.
(C M) instead of P (M C). The model links a given credit loss to the
observed situation in the market the same year.

There may be a linkage between credit and market losses and the
same macroeconomic causes. It might be challenging to put this strat-
egy into effect. To evaluate how credit and market losses rely on cer-
tain macroeconomic conditions, one must first identify the relevant
macroeconomic parameters. To get around these issues, a straight-
forward strategy is used in which the extent of the credit losses are
allowed to determine the expectation and standard deviation of each
market instrument’s distribution.

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 Integrated Risk Modelling  309

To be more precise, the annual credit loss C is allowed via the pre-
dicted daily geometric return µi and volatility σi of each instrument i
rely on,

µ i = α i C + β i (10)

And

σ i = γ i C + δ i (11)

Figure 9.1 shows the Credit Loss Ratio:

S
Mean daily geometric return

IM
-0.002
-0.004

M
-0.006

0.0 0.01 0.02 0.03 0.04

N

Figure 9.1: Credit Loss Ratio

DnB’s credit loss ratios in the period 1984–1999, plotted against the
mean daily geometric return of FINX in the same years. Regression
lines are superimposed.

Empirically established values are used for the parameters αi, βi, γi
and δi. For selected equities, currencies, interest rates and oil prices
from 1984 to 1991, the annual geometric returns and related standard
deviations, as well as the annual credit loss ratios, were historical data
that was accessible. The credit loss ratios for DnB for the years 1984
to 1999 are displayed in Figure 9.1 against the mean daily geometric
return of FINX for the same years, and they are presented against the
daily geometric return standard deviation for the same years in Fig- NOTE
ure 9.2, respectively. The mean returns and volatilities were used as Market risk is a measure of
response variables and the credit loss ratios as explanatory variables all the factors affecting the
in a linear least squares regression analysis to estimate the parame- performance of financial
ters αi, βi, γi and δi in (10) and (11). markets.

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310 FINANCIAL MODELLING

The plots now have the resultant lines placed on them. Figure 9.1
shows that the fit is not particularly strong, but there is a tendency for
substantial credit losses to coincide with FINX’s poor returns. Figure
9.2 shows that although market volatility seems to be low for years
with minor credit losses, it is greater for years with larger credit losses:

0.025
Standard Deviation of daily geometric returns

0.020
0.015

S
0.010

IM
0.0 0.01 0.02 0.03 0.04

Figure 9.2: DnB’s credit loss ratios in the period 1984–1999, plotted
against the standard deviation of the daily geometric returns of
FINX in the same years. Regression lines are superimposed.
M

SELF ASSESSMENT QUESTIONS

3. Which of the following is concerned with the combined

distribution or the distribution of all hazards together, and
has some knowledge of the marginal distribution of each risk
N

category?
a. Product manager
b. Sales manager
c. Deputy manager
d. Risk manager
4. Choosing a common time horizon for all the different risk
categories is another difficulty in ____________.
a. Integrated risk management
b. Financial management
c. Both a. and b.
d. None of these

ACTIVITY

Discuss the limitations of credit risk.

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9.4 IMPLEMENTATION
The main learning from allied disciplines in public services, such as
Change Management, Project Management, Improvement Science,
Quality Improvement, Knowledge Translation and Organisational
Development, is coupled to and built upon during implementation.

Although implementation is still in its early stages, interest in it has

grown over the past ten years. A growing corpus of research has iden-
tified key elements in effective implementation and has documented
instances of employing implementation to assist the provision of ser-
vices, notably in the health, education, social and community contexts.

9.4.1 SIMULATION PROCEDURE

S
Only via simulation can the intricate distribution of the total loss be
determined. Following the decomposition on the right of the model Know More
(4), sampling from the model produces realisations T1,...., TN of the Market risk can be defined as
total loss (4).
IM the risk of losses in on and off-
balance sheet positions arising
As mentioned in Section 9.3.2 Credit Risk, the credit loss ratios Rj is from adverse movements in
first drawn from the beta distribution to sample the credit losses Cj. market prices.
Using the procedure described in Section 9.3.3 Operational Risk to
simulate operational losses Oj from the distribution P(OjC), and third,
the market losses Mj are drawn dependent on Cj as outlined in Sec-
tion 9.3.4 Market Risk.
M

After sampling each marginal distribution, the total losses Tj = Cj +

Mj + Oj are calculated. An illustration of the DnB group’s total loss
distribution is shown in Figure 9.3:
N
0.0003

95% -quantile 99.97% -quantile

Probability density

4691 MNOK 14585 MNOK

0.0002

99% -quantile
0.0001

7353 MNOK
0.0

0 5000 10000 15000 20000 25000

Total loss (MNOK)

Figure 9.3: The Estimated Total Loss Distribution for the DnB Group

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312 FINANCIAL MODELLING

9.4.2 SIMULATION VARIABILITY

Our aim is the economic capital Kp for tiny percentiles p, as stated in

Section 9.3.1 General Risk. Using a Monte Carlo estimate Kp based on
N simulations. An approximate formula for the standard error due to
sampling is:

1 p(1 − p)
se( Kˆ p ) = , (12)
f(K p) N

Where N is the number of runs and f(·) is the probability density func-
tion for Kp. A density estimation approach may be used to estimate
the unknown factor f(Kp) from the simulations. A kernel-density
smoother was used.

S
One may determine how many simulations are necessary by using (12)
? DID YOU KNOW to assess the Monte Carlo error in the reported estimations of the eco-
Simulation is traditionally used to nomic capital.
reduce errors and their negative
IM
consequences.
The 99.97% quantile for the DnB group (p = 0.9997) is of special sig-
nificance since it relates to the financial institution’s official rating.
Getting a “AA” rating from the top rating agencies is DnB’s stated
objective.

To maintain a “AA” rating, the institution has mandated that risk-ad-

M

justed capital must cover 99.97% of probable losses over a one-year

timeframe.

The coefficient of variation, or se(Kp)/Kp, for various sample sizes for

this quantile as well as the 95% and 99% quantiles are shown in Table
N

9.1.

DnB determined that 500,000 simulations (about one hour on a nor-

mal PC) represented a suitable compromise between accuracy and
computing cost based on the findings in Table 9.1.

Table 9.1 demonstrates that with this many simulations, the upper and
lower 95% confidence bonds (±2se(Kp)) deviate from the expected
99.97% quantile by no more than 2%:

TABLE 9.1: THE COEFFICIENT OF VARIATION ASSOCI-

ATED WITH QUANTILES OF THE TOTAL LOSS DISTRIBU-
TION FOR A DIFFERENT NUMBER OF SIMULATIONS.
Number of Simulations
Quantile
50,000 100,000 200,000 500,000 1,000,000
95.00% 0.005 0.004 0.003 0.0017 0.0001
99.00% 0.009 0.006 0.004 0.0028 0.0020
99.97% 0.029 0.021 0.015 0.0092 0.0065

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 Integrated Risk Modelling  313

SELF ASSESSMENT QUESTIONS

5. Only via simulation can the intricate distribution of the total

loss be determined. Which of the following option is correct
regarding the above statement?
a. Simulation procedure
b. Simulation variability
c. Empirical results
d. None of these
6. One may determine how many simulations are necessary
by using (12) to assess the Monte Carlo error in the reported

S
estimations of the economic capital. Which of the following
option is correct regarding the above statement?
a. Empirical results
IM
b. Simulation procedure
c. Simulation variability
d. Both a and c

ACTIVITY
M

Write a short note on the process of simulation variability.

9.5 EMPIRICAL RESULTS

N

When compared to techniques based on the notion of perfect correla-

tion, the modelling methodology proposed in this study results in sig-
nificant reductions in economic capital. The reductions at the 95% and
99% quantiles are 11% and 12%, respectively, while the drop at the
99.97% quantile is 20% lower than it would have been if the separate
capital needs had been included. This demonstrates that significant
cost savings and improved competitiveness may be realised by mod-
elling the connections across risk classes in a more accurate manner.
Comparing the outcomes of diversification to the actual relationships
between risk classes is intriguing. Table 9.2 displays the associations
in this model. All of the correlations are positive, however, they are all
much lower than 1:

TABLE 9.2: CORRELATIONS BETWEEN DIFFERENT RISK

SOURCES
Credit Market Operational
Credit 1.00 0.30 0.44

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314 FINANCIAL MODELLING

Credit Market Operational

Market 0.30 1.00 0.13
Operational 0.44 0.13 1.00

SELF ASSESSMENT QUESTIONS

7. When compared to techniques based on the notion of perfect

correlation, the modelling methodology proposed in this study
results in significant reductions in economic capital. Which of
the following option is correct regarding the above statement?
a. Simulation variability
b. Empirical results

S
c. Simulation procedure
d. All of these
IM 8. Comparing the outcomes of diversification to the actual
relationships between risk classes is ____________.
a. Simulation variability
b. Simulation procedure
c. Empirical results
d. Intriguing
M

ACTIVITY

Find some advantages and disadvantages of integrated risk mod-

N

elling.

S 9.6 SUMMARY
‰‰ Larger businesses and several financial institutions have created
established procedures to manage risk. Typically, capital reserving
is done for each category of risk separately, and then the buffer for
the whole business is increased.
‰‰ Through combined modelling of risk classes and their relation-
ships, this research aims to establish a framework for these more
grounded assumptions. Simple correlations between risk pair,
empirical modelling and Monte Carlo simulations as the technical
instrument are key components of this method.
‰‰ The integration of several hazards to determine the overall risk
is the main topic of this essay. The majority of banks are outfitted
with cutting-edge risk assessment tools for the minimal evaluation
of credit and market risk.

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 Integrated Risk Modelling  315

‰‰ In some areas, including financial services and energy, where tak-

ing measured risk is essential to the business, risk modelling has
been used for years.
‰‰ A wide range of risk models and simulations have lately started to
be used by companies in both the public and commercial sectors
to begin tackling strategic, operational, compliance, geopolitical
and other sorts of risk.
‰‰ Modelling is becoming more useful due to increased data acces-
sibility and advanced analytical tools, while also becoming more
valuable due to the necessity to manage an environment that is
becoming more dangerous.
‰‰ The goal of risk modelling is to predict and quantify risk. The sit-
uations of credit risk estimating possible losses due to, for exam-

S
ple, debtor bankruptcy or market risk quantifying potential losses
owing to adverse movements of a portfolio’s market value is of spe-
cial significance to the financial sector.
‰‰ Systemic
IM
risk in complex systems is given special consideration
in this approach to risk modelling. The study of operational risks,
with a focus on the interdependence of processes, and the analysis
of credit risks in portfolios involving mutually dependent enter-
prises are contemporary topics.
‰‰ A model is a framework, quantitative method or strategy that is
predicated on hypotheses and uses mathematical, economic, sta-
M

tistical or financial theories and methods. The model converts the

supplied data into a quantitative estimate.
‰‰ The combination of a wide range of hazards is one of the key tech-
nological challenges in risk management for a financial institution.
N

‰‰ The risk of losses brought on by the inability of DnB’s financial

counterparties to fulfil their commitments is known as credit risk.
‰‰ The risk level in the portfolio is influenced by how losses are dis-
tributed about one another. By assuming a link between each
loan’s commitment and the total credit losses, the credit model
describes how each loan affects the overall risk.
‰‰ The operational risk of DnB originates from both direct and
indirect losses brought on by external occurrences like natural
catastrophes and criminal activity as well as internal causes like
insufficient or inefficient internal procedures and systems.
‰‰ Market risk is a result of the financial institution’s open positions
in the capital, interest rate and foreign exchange markets, and it is
correlated with changes in market prices and exchange rates.
‰‰ When compared to techniques based on the notion of perfect cor-
relation, the modelling methodology proposed in this study results
in significant reductions in economic capital.

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316 FINANCIAL MODELLING

KEY WORDS

‰‰ Credit Risk: A potential loss brought on by a borrower’s inabil-

ity to make loan payments or fulfil contractual commitments
‰‰ Integration: An act or practice of successfully merging two or
more items
‰‰ Market Risk: A risk of financial ventures losing money due to
unfavourable pricing changes
‰‰ Operational Risk: A possibility of suffering financial loss as a
result of internal systems, personnel, procedures or other fail-
ures that might obstruct corporate operations
‰‰ Risk Modelling: A risk type that develops when a financial

S
model is used to assess quantitative data, such as a company’s
market risks or value
IM9.7 MULTIPLE CHOICE QUESTIONS
MCQ 1. ___________ in complex systems is given special consideration in
this approach to risk modelling.
a. Empirical results
b. Large-scale blackouts
M

c. Implementation risk
d. Systemic risk
2. The combination of a wide range of hazards is one of the key
technological challenges in risk management for a:
N

a. Financial institution
b. Government
c. Investors
d. Both c. and d.
3. Once __________ is established, no amount of operational loss
proof alters the perception of the market loss.
a. Operational loss
b. Credit loss
c. Market loss
d. None of these
4. Which of these is the risk of losses brought on by the inability of
DnB’s financial counterparties to fulfil their commitments?
a. Market risk
b. Operational risk

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 Integrated Risk Modelling  317

c. Credit risk
d. Both a. and b.
5. Which of the following in the portfolio is influenced by how losses
are distributed about one another?
a. Risk level
b. Market level
c. Both a. and b.
d. None of these
6. Which among the following of DnB originates from both direct
and indirect losses brought on by external occurrences like nat-
ural catastrophes and criminal activity?

S
a. Credit risk
b. Operational risk
c. Market risk
IM
d. Both b. and c.
7. The technique for modelling operational risk is seen as prelimi-
nary due to the scarcity of data:
a. Previous profits
b. Current profits
c. Current losses
M

d. Previous losses
8. Which of these is a result of the financial institution’s open posi-
tions in the capital, interest rate and foreign exchange markets?
N

a. Market risk
b. Operational risk
c. Credit risk
d. None of these
9. Which of the following is determined by using the worst-case
change that happened throughout these holding periods?
a. Quarter loss
b. Half-yearly loss
c. Annual loss
d. All of these
10. Which among the following is based on the prices of the
instruments and is compatible with the method given below for
tying market and credit risk together?
a. Credit loss
b. Market loss

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318 FINANCIAL MODELLING

c. Both a. and b.
d. None of these

9.8 DESCRIPTIVE QUESTIONS

? 1. Discuss the meaning of risk modelling.
2. Describe the concept of the model.
3. Explain the meaning of operational risk.
4. What do you mean by market risk?

HIGHER ORDER THINKING SKILLS

9.9
(HOTS) QUESTIONS

S
1. Being in charge of something as huge and complicated as risk
modelling is challenging, yet in just a few weeks, businesses
worth hundreds of billions of dollars have collapsed due to a
lack of awareness of key risks and slow response time to possible
IM
losses. Which of the following techniques are used in some of
the world’s biggest financial and economic crises that have been
brought on by corporations’ failure?
a. Capital budgeting techniques
b. Risk modelling techniques
c. Financial techniques
M

d. None of these
2. Which of the following is frequently a problem since it affects
the organisational level; as a result, it must be resolved before
deploying an integrated risk modelling system?
N

a. Data ownership
b. Degree of uncertainty
c. Risk data
d. Business unit-specific risks

9.10 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Meaning of Risk Modelling 1. a. Risk modelling
2. c. Systemic risk
The Model 3. d. Risk manager
4. a. Integrated risk management
Implementation 5. a. Simulation procedure

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 Integrated Risk Modelling  319

Topic Q. No. Answer

6. c. Simulation variability
Empirical results 7. b. Empirical results
8. d. Intriguing

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. d. Systemic risk
2. a. Financial institution
3. b. Credit loss
4. c. Credit risk

S
5. a. Risk level
6. b. Operational risk
7. d. Previous losses
IM
8. a. Market risk
9. c. Annual loss
10. b. Market loss

HINTS FOR DESCRIPTIVE QUESTIONS

1. In some areas, including financial services and energy, where
M

taking measured risk is essential to the business, risk modelling

has been used for years. A wide range of risk models and
simulations have lately started to be used by companies in both
the public and commercial sectors to begin tackling strategic,
operational, compliance, geopolitical and other sorts of risk.
N

Refer to Section 9.2 Meaning of Risk Modelling

2. A model is a framework, quantitative method or strategy that
is predicated on hypotheses and uses mathematical, economic,
statistical or financial theories and methods. The model converts
the supplied data into a quantitative estimate. Refer to Section
9.3 The Model
3. The operational risk of DnB originates from both direct and
indirect losses brought on by external occurrences like natural
catastrophes and criminal activity as well as internal causes like
insufficient or inefficient internal procedures and systems. Refer
to Section 9.3 The Model
4. Market risk is a result of the financial institution’s open positions
in the capital, interest rate and foreign exchange markets, and it
is correlated with changes in market prices and exchange rates.
The equities, foreign currency, interest rate and commodities
markets all represent distinct forms of market risk. Refer to
Section 9.3 The Model

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320 FINANCIAL MODELLING

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. b. Risk modelling techniques
2. a. Data ownership

9.11 SUGGESTED READINGS & REFERENCES

SUGGESTED READINGS
‰‰ BIS (1995), ‘An internal model-based approach to market risk cap-
ital requirements’. Basle Commitee on Banking Supervision.

S
‰‰ BIS (2001), ‘Working paper on the regulatory treatment of opera-
tional risk’. Basle Com- mitee on Banking Supervision.
‰‰ Bluhm, C., Overbeck, L. & Wagner, C. (2002), An Introduction to
Credit Risk Modeling, CRC Press.
IM
‰‰ Bock, J. (2000a), ‘A capital idea’, Risk Professional 2(9), xx–xx.
‰‰ Bock, J.T. (2000b), ‘Efficient allocation of economic capital’,
MKIRisk, discussion paper.

E-REFERENCES
M

‰‰ Metricstream. 2022. The Comprehensive Guide To Integrated Risk

Management. [online] Available at: <https://www.metricstream.
com/integrated-risk-management.html> [Accessed 27 September
2022].
‰‰ O’Reilly Online Learning. 2022. Business Risk and Simulation
N

Modelling in Practice: Using Excel, VBA and @RISK. [online]

Available at: <https://www.oreilly.com/library/view/business-risk-
and/9781118904053/c04.xhtml> [Accessed 27 September 2022].
‰‰ Docs.openquake.org. 2022. IRMT: Integrated Risk Modelling Tool-
kit — Integrated Risk Modelling Toolkit 3.1.0 documentation.
[online] Available at: <https://docs.openquake.org/oq-irmt-qgis/
v3.1.0/> [Accessed 27 September 2022].

NMIMS Global Access - School for Continuing Education

 CASE STUDIES
7 TO 9

CONTENTS

Case Study 7 Rajart and Associates — Financial Alternatives

Case Study 8 Building a Recession-Proof Investment Portfolio
Case Study 9 Risk Modelling Techniques

S
IM
M
N

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322 FINANCIAL MODELLING

CASE STUDY 7

RAJART AND ASSOCIATES — FINANCIAL ALTERNATIVES

George Thomas was finishing some weekend reports on a Friday

Case Objective afternoon in the downtown office of Wishart and Associates, an
This case study familiarises investment-banking firm. Since Monday, Meenda, a partner with
with different types of the business, had not been in the New York office. He was trav-
securities as per the elling through Pennsylvania, meeting with five potential clients
requirements of different who were exploring securities floatation with Wishart and Asso-
companies.
ciates’ help. Meenda had called George’s secretary on Wednesday
and said he would cable his ideas on Friday afternoon. George
was anticipating the arrival of the cable.

Meenda would be recommending different types of assets to each

of the five clients to fulfil their specific demands, George under-

S
stood. He also knew Meenda wanted him to phone each of the cli-
ents over the weekend to discuss the recommendations. As soon
as the cable came, George was ready to make these calls. George
was prepared to make these calls as soon as the cable arrived. At
IM
4:00 p.m. a secretary handed George the following telegramc

George Thomas, Wishart and Associates STOP Taking advantage

of offer to go skiing in Poconos STOP Recommendations as fol-
lows:
1. Common stock
M

2. Preferred stock
3. Debt with warrants
4. Convertible bonds
5. Callable debentures
N

George understood as he picked up the phone to make the first

call that the potential clients were not matched with the invest-
ment options. George discovered folders on each of the five firms
seeking funding in Meenda’s office. Meenda had scribbled some
handwritten notes on Monday before he departed, and they were
in the front of each folder. George went over each of the notes one
by one.

API, INC

API, Inc. currently requires $8 million and will require $4 million

in four years. In the tri-state area, a packaging company with a
high growth rate. Over-the-counter (OTC) trading is how common
stocks are traded. The stock is currently low, but it is expected to
rise in the next 12 to 18 months. Any sort of security is acceptable
to me. Growth is expected to be mild. Profits should skyrocket
as a result of the new machinery. Debt of $7 million was recently

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 Case study 7: Rajart and Associates — Financial Alternatives  323

CASE STUDY 7

paid off. Except for short-term responsibilities, he has essentially

no debt left.

SANDFORD ENTERPRISES

$16 million is required. The stock price has dropped, but it is pre-
dicted to rise. In the following two years, excellent growth and
profitability are expected. Low debt-to-equity ratio, owing to the
company’s history of paying off debt before it matures. The ma-
jority of earnings are retained, while dividends are paid in small
amounts. Management is adamant about not handing over voting
power to outsiders. Money will be utilised to purchase plumbing
materials and machinery.

S
SHARMA BROTHERS., INC.

To expand its cabinet and woodworking operations, it will need

$20 million. Originally a family firm, it now employs 1,200 people,
IM
generates $50 million in revenue, and is traded over the counter.
He is looking for a new shareholder, but he is not willing to stock
at a discount. Straight debt cannot raise more than $12 million.
There are good growth opportunities. Earnings are excellent.
Banks may be prepared to lend money to meet long-term require-
ments.
M

SACHEETEE ENERGY SYSTEMS

The liberal investment community in the Boston area holds the

firm in high regard. The stock is currently trading for $16 per
share. Management would prefer to raise $ 28 million by sell-
N

ing common shares at $21 or higher, but this is a distant second

choice. Those who are likely to invest in this company will be at-
tracted by the financing gimmicks and the opportunity to make a
quick profit on their investment.

RANBAXY INDUSTRY

A total of $25 million is required. The company makes boat canvas

covers and needs money to expand. Money for the long future is
required. Ownership that has been tightly maintained for a long
time is reluctant to relinquish control. Without the authorisation
of bondholders and the First National Bank of Philadelphia, it
is impossible to issue debt. Debt-to-equity ratio is relatively low.
Profits are relatively high. Growth prospects are favourable.
Strong management with slight flaws in the areas of sales and
promotion.

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324 FINANCIAL MODELLING

CASE STUDY 7

Meenda’s secretary entered the office as George was going over

the folders. “Did Meenda leave any other stuff here on Monday
other than these notes?” George inquired.

“No, that’s it,” she replied, “but I think those notes will come in
useful.”

Meenda called early this morning to say he had double-checked

the information in the folders. He also stated that he had learnt
nothing new on the trip and that he had essentially squandered
his week, except for the fact that he had been invited to go skiing
at the business lodge up there.

George studied the situation for a while. He could always wait un-

S
til the next week, when he would be certain that he had the prop-
er advice and that he had taken into account some of the factors
that characterised each client’s demands and position. He could
still call the firms by 6:00 p.m. and achieve the initial deadline if
IM
he could figure out which firm fit each recommendation. George
returned to his office and began matching each company with the
proper financing.

QUESTIONS

1. Which type of financing is appropriate to each firm?

M

(Hint: EBIT-EPS (Approach) Analysis)

2. What types of securities must be issued by the firm which
is on the growing stage in order to meet the financial
requirements?
N

(Hint: Trading on equity)

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 Case study 8: Building a Recession-Proof Investment Portfolio  325

CASE STUDY 8

BUILDING A RECESSION-PROOF INVESTMENT PORTFOLIO

David’s 2009 New Year’s resolve was to create an investment port-

folio that could endure a period of market volatility because ana- Case Objective
lysts were predicting hard times. David, a 45-year-old resident of This case study highlights the
the UK, believed that if he could continuously increase his invest- preparation of a recession-
ment over the following five years, he would be able to accumu- proof investment portfolio.
late a comfortable nest fund before retiring.

David had £10,000 to invest, which was at the moment in a high

street account (high street in the UK refers to “quite common”).
High street quick access accounts are regular savings accounts
with the option for customers to withdraw money anytime they
need to, without incurring any fees. This makes it comparable to

S
an Indian savings account. Should a recession hit, he wanted to
safeguard his funds. Additionally, he anticipated a conservative
portfolio with minimal danger to savings and modest room for de-
velopment over the following five years. Here is how David built
IM
his portfolio with the aid of an Independent Financial Adviser
(IFA).

STOCK MARKET VOLATILITY

Normally, stocks would make up a large portion of a well-diver-

sified investment portfolio. The current unrest, however, pres-
M

ents some difficult decisions for investors such as David who are
attempting to create a portfolio from scratch after five years of
equities market success. Equities no longer appear to be such a
fantastic value.
N

The FTSE 100 index of leading UK corporations was at a respect-

able level of 6,500 at the beginning of 2008. By the end of October,
the index had plummeted by 3,000 points. There is currently no
sign that the present market volatility will soon come to an end.

The index reached 4,300 at the end of 2008. During 2008, equity
markets are anticipated to suffer more. David decided to ensure
that less risky assets made up the majority of his portfolio.

When the markets appear to be fairly inexpensive right now, Da-

vid remarked, “I would be more inclined to take on riskier assets
if I were twenty years younger. It’s probably a terrific moment to
be investing.”

“Sadly, I cannot afford to take any chances at my age. Making

sure my money will be available when I need it is what interests
me the most.”

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326 FINANCIAL MODELLING

CASE STUDY 8

INVESTING IN CASH

Cash investments are typically seen as the safest sanctuary during

volatile stock market periods. Cash as an asset class, however, is
starting to appear quite unappealing to savers used to receiving a
rate of interest of 6% or more.

The Bank of England has lowered UK interest rates from 5.25% to

only 1.5% from where they were last year. Because of this, inves-
tors who place their confidence in cash will seldom ever see their
money rise.

Cash investments have a good chance of giving investors no re-

turns at all once inflation and the taxman have taken their respec-

S
tive percentages.

With £10,000 to invest, David determined that he should put £7,200

into a 2008 stocks and shares ISA, putting the entire sum into an
IM
ISA before the 2009 ISA season starts on 6 April 2009.

David would have to wait until after this date to hunt for a Cash
ISA with a higher interest rate, therefore, he would have to retain
£3,000 in his high street immediate access account.

The current cash savings rates are not all that great, but David
noted, “Sometimes peace of mind is more essential than higher
M

profits.” His money will be protected if his bank fails.

INVESTING IN BONDS

David decided to invest in assets that generated a fixed income,

N

such as corporate and government bonds since he knew that some

of his money would have to be held in cash and he wanted the bal-
ance of his portfolio to be able to earn greater consistent returns.

Because they provide investors with a steady stream of payments

(income) and a return on their initial investment at the end of the
investment term, bonds are referred to as fixed-income assets.

Investors can buy shares of a fund that invests in different kinds

of bonds through a bond fund. This has the benefit that the bond
fund is simple to trade and the fund manager may choose the best
investments for you.

DIVERSIFYING BETWEEN DIFFERENT BOND TYPES

David put £5,000 into two different bond funds on the advice of his
IFA. The first investment (£2,000) was made only in government
bonds, the safest kind of investment. David thought that given

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 Case study 8: Building a Recession-Proof Investment Portfolio  327

CASE STUDY 8

the recent volatility of markets, it made sense to retain a decent

amount of his portfolio as secure as possible.

David also decided to put £3,000 into a different fund that was in-
vested in top-notch corporate bonds that were issued by some of
the greatest businesses in the UK and the world.

In comparison to government bonds, corporate bond markets

now provide a competitive rate of income. The risk associated
with investing in businesses is still far higher than it has ever
been, especially in light of recent high-profile bank failures and
the failure of other businesses.

According to David, “There are instances when you don’t want your

S
investments to be overly hazardous or difficult. Bonds are safe and
monotonous, which right now is perfect for me.”

INVESTING IN DEFENSIVE EQUITIES

IM
David decided to invest part of the remaining £2,200 of his 2008
ISA limit in some larger, more “defensive” UK firms through a
fund in the UK equities income sector. His IFA enquired about
his thoughts on making investments outside of the UK and said
that although there is an increased risk, there is great potential
for development in the international markets.
M

David decided that he felt more at ease investing in the UK-based

funds since he thought the prognosis for the rest of the globe was
so unclear. I enjoy the concept of investing in large UK compa-
nies, the kind of businesses I can keep an eye on in the news and
keep track of their success, he continued.
N

David’s IFA suggested that he complement his bond-focused

strategy with an equity-based one. His equities fund would profit
from the shift in market sentiment if stock prices rose. The IFA
advised David to consider a UK equity income fund, which would
seek to produce a consistent income by investing in protective UK
businesses.

David may always choose to retain the investment’s regular in-

come “rolled up” in the fund and see his money grow that way.

Conclusion Before making any investments, David’s IFA was well

informed of his investing goals and risk tolerance. The IFA be-
lieved that the bulk of the portfolio should be placed in low-risk
assets given David’s age and investing horizon, which was be-
tween five and ten years, even though the stock holding present-
ed some possibility for future gain.

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328 FINANCIAL MODELLING

CASE STUDY 8

David clarified: “I’m satisfied with my portfolio and would not

want to have any further investments given how bad the reces-
sion is going this year. Younger investors might not find this type
of portfolio to be sufficiently “racy,” but I have high hopes that it
will fulfil my objectives and provide me with a respectable nest
egg in a few years.”

QUESTIONS

1. Discuss the stock market volatility in this case study.

(Hint: Normally, stocks would make up a large portion of
a well-diversified investment portfolio)
2. Explain the investment in bonds in this case study.

S
(Hint: David decided to invest in assets that generated a
fixed income, such as corporate and government bonds
since he knew that some of his money would have to be
IM held in cash and he wanted the balance of his portfolio to
be able to earn greater consistent returns)
M
N

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 Case study 9: Risk Modelling Techniques  329

CASE STUDY 9

RISK MODELLING TECHNIQUES

Some of the world’s biggest financial and economic crises have

been brought on by corporations’ failure to use risk modelling Case Objective
techniques. Being in charge of something as huge and compli- This case study highlights
cated as risk modelling is challenging, yet in just a few weeks, the financial and economic
businesses worth hundreds of billions of dollars have collapsed crises to use risk modelling
due to a lack of awareness of key risks and slow response time to techniques.
possible losses.

The term “Integrated Risk Modeling” (IRM) refers to any risk

modelling techniques used by an organisation to increase risk
awareness and decision-making in ways that enable it to not only
survive but also benefit from risk.

S
Each business has its risk modelling processes and has designat-
ed different risk teams to handle each significant risk category.
IM
Building a strong IRM process inside a business has several ben-
efits.

Below is a summary of a few business benefits that an organised

IRM program may provide.
‰‰ Integrated Risk Modelling gives users and application systems
reliable, consistent and accurate information.
M

‰‰ Itgives organisations the chance to meet compliance needs

with readily available, dependable and secure data.
‰‰ It offers the flexibility to design and manage new organisational
structures and inter-organisational linkages that may come
from mergers and acquisitions, as well as the capacity to limit
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risks related to data concerns.

‰‰ Integrated risk modelling makes it easier to establish, put
into practice and monitor corporate data quality KPIs and
minimise any delays brought on by data problems when
providing services or goods to consumers.
‰‰ By maintaining the bare minimum levels of operations that are
essential for doing business, integrated risk modelling offers
methods to assist the company in recovering from problems
like work stoppages, severe disasters, etc.
‰‰ It aids in the modelling’s determination of the best alternative
for reducing identified risks by the organisation’s strategy,
objectives and risk tolerance.
‰‰ Itaids leadership teams in maintaining a comprehensive
understanding of how risks may affect the strategic and
operational goals of the company.

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CASE STUDY 9

‰‰ It enables the management of one or more risks by a single

monitoring and modelling system, improving the clarity of
risk assessment at the organisational level, risk management
and understanding of interconnections between various risk
categories.
‰‰ IRM makes managerial actions to decrease risks more
realistically analysed and judged since it also considers
occurrences that occur beyond the examined risks alone.
‰‰ The eight Integrated Risk Modeling components—internal
environment, identification, analysis and risk assessment;
risk treatment; risk control; information; communication; and
monitoring of risks—provide an in-depth understanding of
the risks evaluated.

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‰‰ The IRM method aids in finding opportunities to boost
productivity during the identification, analysis and risk
assessment processes.
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‰‰ By allowing modelling teams to make informed decisions in
activities where the risks are well handled, it helps to assure
better use of the resources that are now available.

Moving toward the implementation of an Integrated Risk Model-

ing approach presents ongoing hurdles for organisations. These
can be generally divided into technical and commercial issues.
M

BUSINESS CHALLENGES
‰‰ Since an Integrated Risk Modelling approach may have
a significant effect on the business as a whole, it may need
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continual executive-level sponsorship.

‰‰ It is very difficult for a company to arrive at true expenses
and critical business indicators since they could be based
on exaggerated assumptions and false outputs, which would
create financial difficulties.
‰‰ Data ownership is frequently a problem since it affects the
organisational level; as a result, it must be resolved before
deploying an integrated risk modelling system.
‰‰ The process of identifying and comprehending inter-
organisational linkages has become more difficult as a result
of new regulatory compliance requirements.
‰‰ The degree of uncertainty around new solutions rises
proportionately as the product market expands. This in turn
raises the possibility of failing to deliver on schedule and
within budget.

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CASE STUDY 9

‰‰ As businesses continue to grow internationally, they must

contend with inconsistent laws, limitations on data transfer
and local legal requirements for accessing, storing and
transferring data.

TECHNICAL CHALLENGES
‰‰ The organisation maintains repositories for risk-related data,
but the consistency and quality of the data may not be suitable
for processing or reporting.
‰‰ The chosen risk modelling approach needs to be dependable,
scalable, adaptable and managed.
‰‰ The risk strategy is intricate and sensitive to recently

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implemented regulatory regulations as well as frequently
shifting connections between businesses and their clients.
‰‰ Risk data is based on internal and external data sources, both
IM
of which may have obsolete or conflicting data.
‰‰ Business unit-specific risks might have an effect on other
divisions within the company and can harm the company’s
reputation in the market. Therefore, Integrated Risk Modelling
solutions have to be flexible enough to adjust when the risk
effect changes.
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Organisations’ sizes, income and global reach all keep expanding.

It can be difficult to establish and sustain a culture of good risk
modelling in a developing firm.

It is important to gather and disseminate knowledge regarding

risks, how they are managed and experiences from various busi-
N

ness units. To ensure the effectiveness of the risk modelling pro-

cess, precise metrics must be timely collected due to the dynamic
nature of regulatory requirements. To successfully incorporate
the risk modelling methods into the current business processes,
training sessions might be done.

For regular and consistent communication with the modelling on

the goal, effectiveness and expense of the risk modelling process,
communication procedures should be created. This will make it
easier to sustain modelling support and persuade managers and
other engaged stakeholders to continue participating in the ongo-
ing risk modelling process. To increase the efficiency of the risk
modelling process, appropriate software tools and methodologies
should be created and implemented. To make the tools more use-
ful for a variety of business modelling activities, they should make
it easier to share risk data with other systems.

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CASE STUDY 9

Your chosen IRM system should enable efficient cross-organisa-

tional communication and link you directly to the strategic plan-
ning procedure, corporate goals, business units and various oper-
ations inside these units.

QUESTIONS

1. Discuss the integrated risk modelling in this case study.

(Hint: The term “Integrated Risk Modeling” (IRM) refers
to any risk modelling techniques used by an organisation
to increase risk awareness and decision-making in ways
that enable it to not only survive but also benefit from
risk)

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2. Discuss the efficiency of the risk modelling process.
(Hint: To increase the efficiency of the risk modelling
process, appropriate software tools and methodologies
IM should be created and implemented)
M
N

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 C H
10 A P T E R

ANALYSING AND CONCLUDING THE MODEL

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CONTENTS

10.1 Introduction
10.2 Revolver Modelling
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10.2.1 How does a revolver work in a 3-statement model?
10.2.2 Revolvers are secured by accounts receivable and inventory
Self Assessment Questions
Activity
10.3 Analysing the Output
Self Assessment Questions
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Activity
10.4 Stress Testing the Model
10.4.1 Error Checking
10.4.2 Types of Stress Testing
Self Assessment Questions
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Activity
10.5 Fixing Modelling Errors
10.5.1 The Model Review Process
10.5.2 Seven Types of Errors
Self Assessment Questions
Activity
10.6 Advanced Modelling Techniques
Self Assessment Questions
Activity
10.7 Using the Model to Create a Discounted Cash Flow (DCF) Analysis
10.7.1 DCF Model Basics: Present Value Formula
10.7.2 How to Build a DCF Model: 6 Step Framework
Self Assessment Questions
Activity
10.8 Summary
10.9 Multiple Choice Questions

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334 FINANCIAL MODELLING

CONTENTS

10.10 Descriptive Questions

10.11 Higher Order Thinking Skills (HOTS) Questions
10.12 Answers and Hints
10.13 Suggested Readings & References

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INTRODUCTORY CASELET

MODEL-BASED ANALYSIS

A model-based analysis is a type of analysis that employs model-

ling to carry out the study, record the findings and convey them. Case Objective
Causal loop diagrams and simulation modelling are the two major
modelling techniques employed for social issues. For the first con- This case highlights the
key instrument, i.e., model-
ceptual attacks on the issue, causal loop diagrams are employed. based analysis for tackling
For the remainder of the task, simulation models are used. System challenging social problems.
dynamics has been chosen by Thwink.org as the best simulation
modelling tool because of its effectiveness, simplicity and focus on
feedback loops.

The model-based analysis is needed to carry out the System

Improvement Process, the method that is currently being imple-

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mented. To answer queries like “What are the dominating feed-
back loops that are now creating issue symptoms”, the procedure
goes through a sequence of phases and a model is created.
IM
The three main tools diagram explains why the three tools are
required. Difficult social problems like sustainability are so dif-
ficult they require all three tools to solve. That these tools have
not been applied to the sustainability problem as a whole explains
why past solutions have failed. The carpenter has been using the
wrong tools for the job.
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A Difficult Social Problem

can be solved only by

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Tool 1
Root Cause Analysis

doing this reliably and efficiently requires

Tool 2
Process Driven Problem Solving

getting this right for this type of problem requires

Tool 3
Model Based Analysis

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336 FINANCIAL MODELLING

INTRODUCTORY CASELET

HOW THE WRIGHT BROTHERS USED MODEL-BASED

ANALYSIS

The Wright brothers made history in 1903 when they flew a heavi-
er-than-air powered plane for an extended period under control
with a pilot inside. Many have attempted earlier with no success
since, in contrast to the Wright brothers, they did not apply enough
model-based analysis.

Orville and Wilbur Wright created a set of models to examine

and resolve their numerous subproblems to find a solution to the
problem of how to fly without killing oneself, which was all too
prevalent at the time:
1. In 1899, wing warping as a means of achieving flight control

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could be tested using a five-foot-long box kite. The wings
of the kite may be bent by strings linked to it. The model
demonstrated how controlled banking to the left or right
IM might result from wing warping.
2. To further investigate wing warping and lift in 1900, a full-
sized glider was utilised as a kite. To benefit from the robust
winds in the region, this was done in Kitty Hawk. With Wilbur
on board, several flights were performed as a genuine glider.
“The brothers were encouraged because the craft’s front
elevator worked well and they had no accidents.”
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3. In 1901, they created a little airfoil and put it in front of a

bicycle to test it. The Wright brothers started developing
their data, which was eventually improved in the wind tunnel
when model testing revealed the unreliability of available lift
data.
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4. After realising that building full-sized glider models required

a lot of money and time, they constructed a six-foot wind
tunnel and started thoroughly evaluating several tiny wing
designs. In their 1902 full-size glider model, the lift, lift-to-
drag ratio and control were all enhanced by the data and
conclusions.
5. They created and tested a brand-new full-sized glider in
1902. There was progress. To increase control, the vertical
rudder was made moveable. There were several model tests
conducted, ranging from 700 to 1000 glides. Roll, pitch and
yaw controls were used to solve all of the lift and steering
concerns. They concluded that they were now prepared to
fly an aeroplane powered by a machine.
6. More wind tunnel testing on propeller models was conducted
at the beginning of 1903. The crucial component of machine-
powered flying, the propeller, was designed using the data.

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 Analysing and Concluding the Model  337

INTRODUCTORY CASELET

To prevent torque, two eight-foot propellers were designed,

one for each side, revolving in the opposite direction. All of
their key subproblems had now been resolved using model-
based analysis.
7. Since they could not find any lightweight motors, shop
technician Charlie Taylor created one in under six weeks. The
first Flyer was put together. It barely weighed 605 pounds.
Four successful flights against a 27-mile-per-hour headwind
were performed on December 17, 1903. In 59 seconds, the
last flight covered 852 feet.

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338 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Discuss revolver modelling
>> Explain output
>> Classify the stress testing of the model
>> Describe fixing modelling errors
>> Express advanced modelling techniques
>> Extent the Discounted Cash Flow (DCF) analysis

10.1 INTRODUCTION

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In the previous chapter, you studied integrated risk modelling. An
Quick Revision
organisation’s security, risk tolerance profile and strategic choices are
all influenced by a set of proactive business-wide processes known as
Integrated Risk Modeling (IRM). IRM places a greater emphasis on
IM
analysing risks in the broader context of company strategy as opposed
to compliance-based risk modelling methodologies. A collaborative
IRM programme should include executives from the business and IT
sectors.

Financial modelling is a tool used by professionals in many different

industries. Public accountants use it for due diligence and valuations,
M

bankers use it for sales and trading, stock research and both commer-
cial and investment banking and institutions use it for private equity,
portfolio management and research.

Financial modelling inaccuracies can result in costly errors. A finan-

cial model could be provided to an outsider as a result to have the data
N

it includes verified.

To reassure the end-user that the calculations and assumptions con-

tained within the model are accurate and that the results produced by
the model are reliable, banks and other financial institutions, project
promoters, businesses looking for funding, equity houses and others
may ask for model validation.

In this chapter, you will study the revolver modelling, stress testing
the model, fixing modelling errors, advanced modelling techniques,
using the model to create a Discounted Cash Flow (DCF) analysis,
etc., in detail.

10.2 REVOLVER MODELLING

The revolving credit line, or “revolver,” serves as a plug in the majority
of 3-statement models to guarantee that debt is automatically pulled
to cover predicted losses.

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 Analysing and Concluding the Model  339

When a surplus is anticipated, cash behaves similarly, to the model

forecasts. NOTE
A revolver refers to a
The model forecasts are discussed below: borrower—either an individual
or a company—who carries a
1. A cash surplus, to calculate the end-of-period cash on the balance balance from month to month,
sheet, the model simply adds the surplus to the preceding year’s via a revolving credit line.
closing cash balance.
2. In a cash deficit, the revolver is used as a plug in the model so
that any cash losses result in further borrowing. This prevents
cash from going negative.

10.2.1 HOW DOES A REVOLVER WORK IN A 3-STATEMENT

MODEL?

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How these plugs function in a model will be shown via a short series
of exercises. A straightforward income statement, balance sheet and
cash flow statement are shown in the following figures 10.1, 10.2, and
10.3.
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All three (income statement, balance sheet and cash flow statement)
propositions connect properly.

Example 1: Is the “plug” cash or the revolver, assuming you intend to

have at least `100 in cash throughout the forecast? Why?

Solution: The “plug” in this case is money, as you can see in

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Figure 10.1. Since there is a surplus, the model just increases the cash
balance after the period by the extra cash earned throughout the time:
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Figure 10.1: Increases the Cash Balance after the period

Example 2: Here, we will increase the expenditure amount on the

income statement from ` 800 to `1,500.

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340 FINANCIAL MODELLING

Is the “plug” cash or the revolver, assuming once again that you desire
to have at least ` 100 in cash throughout the forecast as shown in fig-
ure 10.2

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Figure 10.2: Increase the Expenditure
Amount on the Income Statement

Know More Solution 2: The revolver in this instance serves as the “plug.” This
is because the company suffered large losses and without a revolver,
A revolver can sometimes be
referred to as a revolver loan or cash balances would go negative. Here is the solution as shown in fig-
revolving debt. ure 10.3:
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Figure 10.3: Negative Cash Balances

Although the core logic in the aforementioned example is quite simple,

the Excel modelling necessary to make the plugs function dynamically
is a bit challenging. Let us take a closer look at the revolver formula
on the balance sheet. How does the revolver balance understand that

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 Analysing and Concluding the Model  341

it should increase in a deficit, but decrease in a surplus while never

falling below zero? The following figure 10.4 uses the MIN function to
achieve the following:

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Figure 10.4: Revolver Formula on the Balance Sheet

10.2.2 REVOLVERS ARE SECURED BY ACCOUNTS

RECEIVABLE AND INVENTORY

Of course, it may be wise to review other assumptions if someone con-

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structed a model that shows persistent financial losses that a revolver

is now supporting. This is because businesses often utilise a revolver
to cover short-term working capital gaps rather than to cover ongoing
financial losses.
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Additionally, there are practical restrictions on how much a business

may draw from its revolver. In particular, a “borrowing base” is some-
times used to set a limit on how much money businesses may borrow
from the revolver. The quantity of liquid assets backing the revolver
often accounts receivable and inventories are represented by the bor-
rowing base. The usual calculation is 80% of the “liquidation value” of
the inventory plus 90% of the accounts receivable.

SELF ASSESSMENT QUESTIONS

1. Which of the following serves as a plug in the majority of

3-statement models to guarantee that debt is automatically
pulled to cover predicted losses?
a. Revolver
b. Analysing the output
c. Stress testing the model
d. None of these

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342 FINANCIAL MODELLING

2. Which of the following calculates the end-of-period cash on

the balance sheet, the model simply adds the surplus to the
preceding year’s closing cash balance?
a. Cash deficit
b. Cash surplus
c. Stress testing the model
d. Analysing the output

ACTIVITY

Find some advantages of revolver modelling.

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10.3 ANALYSING THE OUTPUT
The evaluation of financial data to make business choices is known as
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Financial Analysis. Examining past and future profitability, cash flows
and risk are often part of this research. It might lead to the reallocation
of resources from or to a company’s or internal operation specifically.

The following scenarios are especially well suited for this kind of study:
‰‰ Investment decisions by external investors: In this situation, a
financial analyst or investor evaluates a company’s financial state-
M

ments and related disclosures to determine if it makes sense to

lend the organisation money or invest in it. To determine if the
company is adequately liquid and produces a sufficient quantity of
cash flow, he/she often uses ratio analysis. And for creating trend
lines that may be used to project financial outcomes into the future,
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it may also be necessary to combine the data from the financial

statements for many different periods.
‰‰ Investment decisions by internal investors: In this scenario, an
internal analyst examines the anticipated cash flows and other
relevant data on a potential investment (usually for a fixed asset).
The goal is to determine if the anticipated project cash outflows
will provide an adequate return on investment. The decision of
whether to buy, rent or lease an asset may also be the subject of
this analysis.
‰‰ Sources of analysis information: The financial accounts of a
company are the main source of data for financial analysis. These
records are used by the financial analyst to calculate ratios, draw
trend lines and make comparisons to data from similar businesses.
‰‰ Financial analysis outcomes: Any of the following choices might
be the result of financial analysis:
 Deciding whether to invest in a company and how much to pay
each share.

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 Analysing and Concluding the Model  343

 Deciding whether to lend money to a company and, if so, on

what conditions.
 Choosing whether to invest domestically in working capital or
an asset and how to finance it.

One of the most important tools company managers use is to assess

how their firm is doing financial analysis. They often ask the finan-
cial analyst about their company’s profitability, cash flows and other
financial matters as a result.

SELF ASSESSMENT QUESTIONS

3. The evaluation of financial data to make business choices is

known as __________.

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a. Financial analysis
b. Stress testing
c. Fixing model errors
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d. Analysing the output
4. Which of the following examines the anticipated cash flows
and other relevant data on a potential investment (usually for
a fixed asset)?
a. External analyst
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b. Internal analyst
c. Both a. and b.
d. None of these
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ACTIVITY

Discuss how the evaluation of financial data is useful for any firm.

10.4 STRESS TESTING THE MODEL

The resilience of institutions and investment portfolios against poten-
tial future financial scenarios is tested using the computer simulation NOTE
approach known as “Stress Testing.” Such testing is often used by the Stress Testing is a software
financial sector to assess internal procedures and controls, as well as testing technique that
investment risk and asset sufficiency. Regulators have recently man- determines the robustness of
dated that financial institutions conduct stress tests to ensure their software by testing beyond the
limits of normal operation.
capital reserves and other assets are sufficient.

Stress testing is a typical tool used by businesses that manage assets

and investments to assess portfolio risk and implement any hedging
techniques required to protect against potential losses. Their portfo-
lio managers specifically employ in-house, proprietary stress-testing

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344 FINANCIAL MODELLING

methods to assess how well the assets they manage may withstand
certain market developments and outside catastrophes.

Stress testing a financial model is the crucial final stage in prepara-

tion. A valuable talent for raising the caliber of a financial model is
the capacity to stress test one and identify any problems in it. Stress
testing makes sure there won’t be any mistakes once the model has
been given to the last user.

Despite the fact that stress testing a financial model helps to avoid
unhappy customers, managers and executives, this last step is fre-
quently skipped.

Testing the logic of the formulas used into the financial model’s com-
putations is one of the simplest ways to conduct a stress test. If the

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results make sense, it may be determined by doing a quick sanity
check. Filling the formula down or to the right into neighboring cells
and checking to see if the change properly propagates through is a
more robust version of this test. Are the values produced by the filled-
IM
down formula appropriate? If not, there could be a formula reference
that was missed and has to be corrected. One of the statement’s lines
is incorrectly referenced, as may be seen in the figure below. These
faults are found via stress testing are showing in Figure 10.5:
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Figure 10.5: Stress testing a financial model

It is prudent to stress test the formulas relating to the assumptions

because a financial model uses assumptions to calculate projected val-
ues. Check the formula with all likely and conceivable values for the
assumptions. Check to see if the formulas still work when the assump-
tion is decreased, increased, flipped, or set to zero. A closer examina-
tion of the formula logic may be necessary for that particular assump-
tion if, in any event, the formula malfunctions or becomes absurd.

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Verify the output values against each user’s copy or version of the
financial model if multiple users are using it. Do the outcomes exactly
fit the assumptions, and vice versa? Additionally, now is a good time
to check that the model’s new iterations have maintained the correct
formatting.

10.4.1 ERROR CHECKING

It is not too difficult to verify that the data and calculations are accu-
rate due to the core statements’ structure. Just a few of the checks that
can be used in an Excel model to make sure that values are adding up
correctly are listed below:
‰‰ Does the balance sheet add up? Do Assets minus Liabilities minus
Equity equal zero?

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‰‰ Does the change to retained earnings in the current period equal
net income minus dividends?
‰‰ Does the ending cash balance in the cash flow equal the cash bal-
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ance in the balance sheet?
‰‰ Do ending values in the supporting schedules match their corre-
sponding values in the core statements?
‰‰ One master error check to determine whether all of the above are
resulting correctly.
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The user can verify calculations are being made accurately and that
no formula logic has been made incorrectly by including these checks
in a financial model. The financial model is more secure against errors
occurring the more checks there are in place.
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10.4.2 TYPES OF STRESS TESTING

To find hidden weaknesses, stress testing entails conducting simula-

tions. There are several ways to do these exercises identified in the NOTE
literature on corporate governance and company strategy. Stress testing is defined as the
process of testing the hardware
The most common testing are hypotheticals, historical and stimulated or software for its stability under
testing. a heavy load condition.

‰‰ Historical stress testing: In a historical scenario, a simulation

based on a past crisis is conducted for the firm, asset class, port-
folio or individual investment. A few historical crises include the
tech bubble that burst in 1999-2000, the Asian crisis of 1997 and the
stock market crash of October 1987.
‰‰ Hypothetical stress testing: A hypothetical stress test is often
more focused, frequently concentrating on how a single organi-
sation may handle a specific catastrophe. A corporation in Cali-
fornia may do a stress test against a fictitious earthquake, while
an oil company would do so against the start of a Middle Eastern

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346 FINANCIAL MODELLING

conflict. Insofar as just one or a few test variables are changed at

once, stylised situations are a bit more scientific. The stress test,
for instance, may see the Dow Jones index lose 10% of its value in
a single week.
‰‰ Simulated stress testing: Monte Carlo simulation is one of the
most well-known stress test methodologies. For certain variables,
this kind of testing may be used to estimate the likelihood of alter-
native outcomes.
The Monte Carlo simulation, for instance, often takes a variety of
economic factors into account. For different kinds of stress testing,
businesses may also resort to professionally run risk management
and software suppliers. One example of external stress-testing
software that may be used to assess risk in asset portfolios is

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Moody’s Analytics.

SELF ASSESSMENT QUESTIONS

5. Which of the following is often more focused, frequently

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concentrating on how a single organisation may handle a
specific catastrophe?
a. Hypothetical stress testing
b. Simulated stress testing
c. Historical stress testing
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d. None of these
6. The Monte Carlo simulation, for instance, often takes a variety
of economic factors into account. Which of the following option
is correct regarding the above statement?
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a. Historical stress testing

b. Simulated stress testing
c. Hypothetical stress testing
d. None of these

ACTIVITY

Discuss the work process of stress testing the model.

10.5 FIXING MODELLING ERRORS

This idea is crucial and at the heart of examining financial models.
In this piece, we will explain how a model review system works and
break down several fault categories to help you understand how, very
easily, you may lower the “degree of wrongness” to allowable levels.

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 Analysing and Concluding the Model  347

Figure 10.6 shows rationalising a model review system:

You
Professional Model
Auditor
Know More
Modeling error in linear or
nonlinear control systems is
the main issue that should be
addressed in designing model-
2 16 150+ based filtering approaches to
Hours spent reviewing achieve high-accuracy state
estimation.

Figure 10.6: Rationalising a Model Review System

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Observation 1: You have limited time

Professional model auditors must set up a LARGE amount of time for

evaluating financial models.
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In actuality, spending 150+ hours examining a model is not uncom-
mon. This is the end of the scale for stakes.

Let us pretend you have a lot less time—say, between two and sixteen
hours. Given that, we will need to adopt a new strategy to maximise
the use of our time.
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Observation 2: All models contain errors, but they matter to varying

degrees.

As hinted at in the post’s beginning, the objective is to be less incorrect

rather than entirely correct.
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Remember that no amount of review, no matter how thorough, can

guarantee perfection. Single-person code examination only finds 20%
to 40% of all problems, according to Panko [2016].

Note that this rises (to 63%) when inspectors use a technique for the
review, according to different research by the same author (Panko
[1999]).

Your time is limited, so we can make good use of the Pareto distribu-
tion. For our purposes, we can crudely paraphrase this: 20% of the
faults account for 80% of the anticipated output errors.

A quick disclaimer: This is a mind-set, not a policy. I’m not advocat-

ing a 20% tolerance, but rather how to strategically identify the main
sources of mistakes.

This is NOT a “leave no stone unturned” strategy.

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348 FINANCIAL MODELLING

Observation 3: The model is a hierarchy shown in Figure 10.7:

Top down view

IRR, NPV

Cash flow |P&L| B/S

OPS CON DEBT EQ D&T

Bottom up view Timing

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Figure 10.7: Hierarchy Model
IM(Source: https://www.icaew.com/technical/technology/excel-community/excel-community-arti-
cles/2021/intro-to-financial-modelling-part-14)

Where:

OPS = Operations

CON = Construction/expansion
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DEBT = Debt

EQ = Equity

D&T = Depreciation & Taxation

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Every financial model has a goal—or a set of goals—in mind. Examples

include determining the worth of an asset, aiding in decision-making
by analysing potential outcomes and how they could affect important
variables and providing variance analysis between historical data and
the budget. The majority of these essential outputs are found in the
financial statements or at the valuation level (for example, IRR and
NPV) (cash flow, P&L and balance sheet).

The financial statements and the valuation metrics are a hierarchy

that is built up from all of the model’s separate modules. Therefore,
concentrate first on the balance sheet, P&L and cash flow during your
examination and feel free to be intrusive.

Conclusion: Triage your review with a process, not a checklist.

In summary,
1. Due to schedule constraints
2. Aim to make fewer errors by employing

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 Analysing and Concluding the Model  349

3. A method that benefits from the model hierarchy. Sound too

basic? It is far better than utilising an extensive checklist or a
random method.

Although useful, exhaustive checklists are likely to be disregarded.

Nobody has time to analyse a financial model independently or accord-
ing to the 103 things you should accomplish.

10.5.1 THE MODEL REVIEW PROCESS

If you accept the aforementioned assumption, then we should learn

more about the process and discuss the main categories of faults that
the process should highlight as shown in Figure 10.8:

S
• Understand commercials, model flow and turn model to simple
• Row differences (Maps, or Ctrl+\)
• Transition points and Charts (Alt + F1) on Cash flow Items & B/S
Top down view items
IM
• Warnings & Alerts in model (B/S doesn’t balance, CF < 0)

2. Systematic Extreme Value, Founding & Directional

• Connect Cash flow Waterfall//Statement, bring in Scenario Manager
• Create a CF Data table
• Plug in extreme values for major drivers of NPV & record changes.
• Set debt = 100%, equity = 100%, explore known inverse relationship
M

3. Other Checks: Not As Quick Wins

• Trace Dependents around input fields
• Check background items: Name Manager, Macros, Hidden sheets
N

4. Cell By Cell: The Grind

• Similar to Commercial Review but more detailed
• Use Maps, Transition points, Check, Anchoring, Charts
Bottom up view • Use F9/ software tool (e.g. BPM Traverse) to check formula links.

Figure 10.8: Model Review Process

(Source: https://www.icaew.com/technical/technology/excel-community/excel-community-arti-
cles/2021/intro-to-financial-modelling-part-14)

Putting the following technique after analysing financial models from

a variety of angles, including self-review, assessing others’ models
(for things like credit procedures) and acting as a professional model
auditor. This is also the result of several discussions with other model
reviewers, as well as from training and procedure improvement.

Many phases in the picture will be reasonably self-explanatory, but we

will quickly describe each step before adding depth to this framework

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350 FINANCIAL MODELLING

by talking about the kinds of faults that each of these processes will
produce:
Step 1: Using commercial review to isolate errors
An extract from a wind farm model’s financial statement is shown in
Figure 10.9: Can you identify any possible mistakes?

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Figure 10.9: Wind Farm Model’s Financial Statement
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Two obvious things are:
1. Positive numbers are used to indicate expenses. People use
various sign conventions for their financial statements, thus
this may not ALWAYS be inaccurate. To be certain, one must
look at how they are combined.
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2. In comparison to the income of ` 75M, the proportional amount

of the expenses is `4M, which is quite low.

The commercial review should be used as a guide for identifying

non-trivial model issues since it will help identify them.
N

It is obvious that the more you understand a certain business, the

simpler commercial evaluation becomes. Along with that, comes the
capacity to glance at an O&M (Operations & Maintenance) number
for a specific year.

Conducting a row differences exercise is another fast win:

‰‰ Use Ctrl + to indicate any discrepancies in a highlighted compu-
tation row (i.e., where the formula should be consistent). You can
do this by highlighting the calculation columns beginning with
the first calculation on all of the pages at once (in my models, col-
umn J, all the way to the end of the sheet calculations).
‰‰ Verifying the financial statements’ transition points, such as if
there is growth, whether there are any revenue cliffs and whether
the debt is paid off or refinanced as anticipated Charts or spar-
klines may be used to assess these and provide a visual represen-
tation of trends.
‰‰ Examining the model Warnings & Alerts, by this week’s post.

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 Analysing and Concluding the Model  351

Steps 2 through 4

Step 2 includes changing the model’s results by inserting very high or

low numbers.
1. Changes to the scenario manager’s primary value drivers may be
made to do this methodically.
2. Recording the results in a data table to examine how each
extreme result affects the important results separately

In Step 3, further regular checks are performed, such as picking up

mislinked items by employing trace dependencies on input fields.

Similar to step 1, step 4 is a cell-by-cell procedure that works on a row-

by-row basis.

S
10.5.2 SEVEN TYPES OF ERRORS

Once again, even if the model review procedure might assist in isolat-
IM
ing problems, you will need to be aware of the many kinds of errors.

Types of errors may be categorised in several ways. Here, mistake

kinds are organised by “skill type.” To build up a financial model that
meets best practices, one must become proficient in each of these
individual competencies. And every one of them has the same risk of
mistake.
M

The majority of mistakes you will make will be related to these specific
mistakes, which are covered in more depth:
1. Formula Omissions, Extra’s & Linking: The following are the
formulas of omissions, extra’s and linking:
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 Linking: Tying the wrong cell or range together

 Omissions or extras: Units were incorrectly converted; for
instance, they should read % per year rather than % per
quarter. Incorrectly including a conversion may have the
same effect.
2. Anchoring: Unanchored or too anchored ranges.
3. Functions: Using formulas and functions incorrectly.
 LOOKUP – not having sequential data
 MATCH – not using the Type correctly
 IFERROR

 OFFSET

4. Tools: The “Tools” that Excel offers include errors. Among them
are:
 Usage of Named Ranges – double naming cells
 Conditional formatting

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352 FINANCIAL MODELLING

5. Model Infrastructure: Errors may be the consequence of poor

model infrastructure. Examples of candidates include:
 Timing strips that are inconsistent might cause a direct con-
nection of monthly or quarterly calculations to yearly com-
putations.
 Lack of understanding of structural computations, financial
statements, etc., may lead to circularities. These make the
model run more slowly, and sometimes the iterations fail to
converge.
6. Subject Matter Knowledge: Errors in understanding how to do
certain computations, such as:
 Compound escalation techniques

S
 Instead of the dreaded “balance sheet plugs,” how to balance
the balance sheet
IM7. Best Practice: Highest standard Errors often have an impact
on the model’s robustness and transparency, i.e., they make it
difficult or inaccurate to change the calculation logic or inputs.
Examples of this:
 In a cell, there exist hardcodes
 Calculations are not distinct from inputs
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 Improper or irregular formatting

SELF ASSESSMENT QUESTIONS

7. Errors may be the consequence of poor model infrastructure.

N

Which of the following option is correct regarding the above

statement?
a. Subject matter knowledge
b. Model infrastructure
c. Best practice
d. None of these
8. Errors in understanding how to do certain computations,
such as
a. Compound escalation techniques
b. Instead of the dreaded “balance sheet plugs,” how to bal-
ance the balance sheet
c. In a cell, there exist hardcodes
d. Both a. and b.

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 Analysing and Concluding the Model  353

ACTIVITY

Find some more examples in which fixing modelling errors are

founded.

10.6 ADVANCED MODELLING TECHNIQUES

The application designer may incorporate components that are not
by default included in the programme thanks to advanced modelling. Know More
Understanding the application views, dimensions and approval hier- Advanced modeling lets the
archy may be aided by this. Conditional rules are one example of a application designer manually
modelling approach that uses dependencies but is not automatically add objects to an application
design.
processed and recognised. In this case, the application designer may

S
make sure that when the programme is deployed to the distributed
client; those objects are included inside its scope. When an application
is deployed, its included objects are subject to dependency analysis,
but those in the manual dependencies folder are not included. The
IM
approval hierarchy, views and manually added items to the manual
dependencies folder are all listed in full detail in a part of the applica-
tion definition are:
‰‰ Enabling advanced modelling: To be able to add dependencies NOTE
to the manual dependencies folder, advanced modelling must be Advanced Modelling Techniques
enabled. in Structural Design introduces
numerical analysis methods
‰‰ Adding dependencies manually: The application may manually to both students and design
M

add the requirements for deployment. practitioners.

SELF ASSESSMENT QUESTIONS

9. Which of the following is one example of a modelling approach

N

that uses dependencies but is not automatically processed and

recognised?
a. Conditional rules b. Non-conditional rules
c. Random model rules d. None of these

ACTIVITY

Write a short note on the limitations of advanced modelling tech-

niques.

USING THE MODEL TO CREATE A NOTE

10.7 DISCOUNTED CASH FLOW (DCF) The discounted cash flow (DCF)
formula is equal to the sum of
ANALYSIS DCF, MODEL the cash flow in each period
divided by one plus the discount
A financial model known as the “Discounted Cash Flow Model,” or rate (WACC) raised to the power
“DCF Model,” estimates future cash flows for a firm and discounts of the period number.

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354 FINANCIAL MODELLING

them to determine the company’s present value. Both in academics

and practice, DCFs are often utilised. For investment bankers, pri-
vate equity professionals, equity researchers and “buy side” investors,
valuing businesses using a DCF model is seen as a key competency.

A DCF model calculates an organisation’s intrinsic value (the value

based on an organisation’s capacity to produce cash flows) and is often
used to compare an organisation’s intrinsic worth to its market value.

Apple, for instance, has a market value of almost ` 909 billion. Based
on the company’s fundamentals and anticipated future performance
(i.e., its intrinsic worth), is that market price justified? A DCF specif-
ically aims to respond to such a question. DCF Analysis for Apple is
shown in Figure 10.10:

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IM
M

Figure 10.10: DCF Analysis for Apple

The rationale behind the DCF model is that the value of a firm is not
a function of arbitrary supply and demand for that company’s shares,
in contrast to market-based valuation methods like a similar company
analysis. Instead, a company’s worth depends on its potential to pro-
N

vide future cash flow for its owners.

10.7.1 DCF MODEL BASICS: PRESENT VALUE FORMULA

To calculate a company’s current value using the DCF technique, we

NOTE must anticipate its future cash flows and discount them to the present.
Investors can use the concept Investors should be prepared to pay this present value (the company’s
of the present value of money worth). The following formula may be used to explain this (with r to
to determine whether the future represent the discount rate):
cash flows of an investment
or project are greater than the
Cash flow
value of the initial investment. Preset value t=0 =
(1 +γ )t=1

Suppose you decide to spend `800 on the items shown in Figure 10.10.
This may be resolved using the calculation as follows:

1,000
800 =
(1 + 25%)1

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 Analysing and Concluding the Model  355

The identical pitch would be made if I promised ` 1,000 for the next
five years as opposed to only ` 1,000 for the following year. The arith-
metic just becomes somewhat more challenging:
t= n
Cash flowt
Value t=0 ∑
t =1 (1 + r)t

You may determine this using the PV functions in Excel (see

Figure 10.11). However, you must independently discount each cash
flow if it varies from year to year:

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Figure 10.11: DCF Model Basics - Present Value Formula

N

10.7.2 HOW TO BUILD A DCF MODEL: 6-STEP FRAMEWORK

The DCF model is based on the idea that a company’s value is solely
determined by its projected future cash flows. Consequently, defining Know More
and computing the cash flows that a firm produces is the first barrier Present value (PV) is the
current value of a future sum of
in developing a DCF model. There are two typical methods for figur-
money or stream of cash flows
ing out the cash flows that a company produces: given a specified rate of return.
‰‰ Unlevered DCF approach: The operational cash flows are pro-
jected and discounted. You may simply add any non-operating
assets, like cash and deduct any financing-related liabilities, like
debt, once you have a current value.
‰‰ Levered DCF approach: After cash flows to all debt (i.e., non-eq-
uity claims) have been subtracted, forecast and discount the cash
flows that are still available to equity stockholders.

Although it might be challenging to achieve perfect equality, in reality,

both should ultimately result in the same value. Since it is the most
used, the unlevered DCF technique is the main topic of this article.

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356 FINANCIAL MODELLING

There are 6 phases in this method:

‰‰ Forecasting unlevered free cash flows
 After taking into account all operational costs and investments,
step one is to anticipate the cash flows a business produces
from its main activities.
 “Unlevered free cash flows” are the name given to these cash
flows.
‰‰ Calculating the terminal value
 It is impossible to continuously anticipate financial flows.
At some point, you must estimate a lump-sum valuation of
the firm beyond the explicit forecast period to make certain
high-level assumptions regarding cash flows beyond the last

S
explicit forecast year.
 The word “final value” refers to the whole amount.
‰‰ Discounting the cash flows to the present at the weighted aver-
IM age cost of capital
 The Weighted Average Cost of Capital (WACC) is the discount
rate that accounts for the riskiness of unlevered free cash flows.
 All operational cash flows are represented by unlevered free
cash flows, which “belong” to the company’s lenders and own-
ers.
M

 As a result, employing the proper capital structure weights, the

risks of both capital sources (i.e., debt vs. equity) must be tak-
en into account (thus, the phrase “weighted average” cost of
capital).
 The enterprise value is the discounted present value of all un-
N

levered free cash flows.

‰‰ Add the value of non-operating assets to the present value of
unlevered free cash flows
 We must include any non-operating assets, such as cash or in-
vestments, which a firm may have on its balance sheet when
calculating the current value of unlevered free cash flows.
 For instance, if we determine that Apple has unlevered free
cash flows with a present value of `700 billion but also find out
that it has `200 billion in cash lying about, we should add this
cash.
‰‰ Subtract debt and other non-equity claims
 The DCF’s main objective is to seize the equity owners’ prop-
erty (equity value).
 As a result, we must deduct any lenders from the current value
if a corporation has any (or any other non-equity claims against
the organisation).

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 Analysing and Concluding the Model  357

 The equity owners are entitled to any leftovers.

 In our example, the equity value would be determined as fol-
lows if Apple had ` 50 billion in debt commitments at the time
of the valuation.
 ` 700 billion (enterprise value) + ` 200 billion (non-operating
assets) – ` 50 (debt) = ` 850 billion
 Non-operating assets and debt claims are often put togeth-
er to form a single figure known as Net Debt (debt and other
non-equity claims – non-operating assets).
 The following formula is often seen: enterprise value - net debt
equals equity value. The market capitalisation, or how the eq-
uity value is seen by the market, is analogous to the equity val-
ue calculated by the DCF.

S
‰‰ Divide the equity value by the shares outstanding
 The equity value reveals the owners’ overall worth. But how
much is each share worth? We compute this by dividing the eq-
IM
uity value by the outstanding diluted shares of the corporation.
Example of DCF Model is explained in Figure 10.12:
M
N

Figure 10.12: DCF Model

SELF ASSESSMENT QUESTIONS

10. A financial model is known for which of the following estimates

future cash flows for a firm and discounts them to determine
the company’s present value?
a. Stress testing model
b. Analysing the output

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358 FINANCIAL MODELLING

c. Discounted cash flow model

d. Both a. and c.
11. Which of the following should be prepared to pay this present
value (the company’s worth)?
a. Government
b. Creditors
c. Suppliers
d. Investors

ACTIVITY

S
Write some advantages and disadvantages of the DCF Model.

S 10.8 SUMMARY
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‰‰ Financial modelling is a tool used by professionals in many dif-
ferent industries. Public accountants use it for due diligence and
valuations, bankers use it for sales and trading, stock research and
both commercial and investment banking and institutions use it
for private equity, portfolio management and research.
‰‰ Financial modelling inaccuracies can result in costly errors. A
M

financial model could be provided to an outsider as a result to

have the data it includes verified. To reassure the end-user that
the calculations and assumptions contained within the model are
accurate and that the results produced by the model are reliable,
banks and other financial institutions, project promoters, busi-
N

nesses looking for funding, equity houses and others may ask for
model validation.
‰‰ The revolving credit line, or “revolver,” serves as a plug in the
majority of 3-statement models to guarantee that debt is automat-
ically pulled to cover predicted losses. When a surplus is antici-
pated, cash behaves similarly, to the model forecasts.
‰‰ Although the core logic in the aforementioned example is quite
simple, the Excel modelling necessary to make the plugs function
dynamically is a bit challenging.
‰‰ The evaluation of financial data to make business choices is known
as Financial Analysis. Examining past and future profitability,
cash flows and risk are often part of this research. It might lead
to the reallocation of resources from or to a company’s or internal
operation specifically.
‰‰ The resilience of institutions and investment portfolios against
potential future financial scenarios is tested using the computer
simulation approach known as “Stress Testing.”

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 Analysing and Concluding the Model  359

‰‰ To find hidden weaknesses, stress testing entails conducting sim-

ulations. There are several ways to do these exercises identified in
the literature on corporate governance and company strategy.
‰‰ Every financial model has a goal—or a set of goals—in mind.
Examples include determining the worth of an asset, aiding in
decision-making by analysing potential outcomes and how they
could affect important variables and providing variance analysis
between historical data and the budget.
‰‰ The application designer may incorporate components that are
not by default included in the programme thanks to advanced
modelling. Understanding the application views, dimensions and
approval hierarchy may be aided by this. Conditional rules are one
example of a modelling approach that uses dependencies but is

S
not automatically processed and recognised.
‰‰ A financial model known as the “Discounted Cash Flow Model,” or
“DCF Model,” estimates future cash flows for a firm and discounts
them to determine the company’s present value.
IM
KEY WORDS

‰‰ Advanced modelling techniques: The application designer

may incorporate components that are not by default included
in the programme thanks to advanced modelling
‰‰ DCF model: A financial model known as the Discounted Cash
M

Flow Mod, or DCF Model, estimates future cash flows for a firm
and discounts them to determine the company’s present value
‰‰ Historical stress testing: In a historical scenario, a simulation
based on a past crisis is conducted for the firm, asset class, port-
N

folio or individual investment

‰‰ Levered DCF approach: After cash flows to all debt (i.e.,
non-equity claims) have been subtracted, forecast and discount
the cash flows that are still available to equity stockholders
‰‰ Stress testing: The resilience of institutions and investment
portfolios against potential future financial scenarios is tested
using the computer simulation approach

10.9 MULTIPLE CHOICE QUESTIONS

1. Which of the following is the revolver used as a plug in the model MCQ
so that any cash losses result in further borrowing?
a. Analysing the output
b. Stress testing the model
c. Cash deficit
d. Cash surplus

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360 FINANCIAL MODELLING

2. Which among the following is sometimes used to set a limit on

how much money businesses may borrow from the revolver?
a. Accounts receivable
b. Borrowing base
c. Accounts payable
d. None of these
3. Which of these is a typical tool used by businesses that manage
assets and investments to assess portfolio risk?
a. Borrowing base
b. Analysing the tool
c. Cash surplus

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d. Stress testing
4. A simulation based on a past crisis is conducted for the firm,
asset class, portfolio or individual investment.
IM
Choose the correct option regarding the above statement.
a. Hypothetical stress testing
b. Simulated stress testing
c. Historical stress testing
d. None of these
M

5. The financial statements and the valuation metrics are a

hierarchy that is built up from which of these?
a. Schedule constraints
b. Random method
N

c. Stress testing
d. Model’s separate modules
6. Which of the following are the types of errors?
a. Anchoring
b. Tools
c. Model infrastructure
d. All of these
7. After taking into account all operational costs and investments,
step one is to anticipate the cash flows a business produces from
its main activities.
Which among the following option is correct regarding the above
statement?
a. Calculating the terminal value
b. Discounting the cash flows to the present at the weighted
average cost of capital

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 Analysing and Concluding the Model  361

c. Forecasting unlevered free cash flows

d. Subtract debt and other non-equity claims
8. The DCF’s main objective is to seize the equity owners’ property
(equity value). Which option is correct regarding the above
statement?
a. Add the value of non-operating assets to the present value of
unlevered free cash flows
b. Divide the equity value by the shares outstanding
c. Subtract debt and other non-equity claims
d. Calculating the terminal value

10.10 DESCRIPTIVE QUESTIONS

S
?
1. Discuss the concept of revolver modelling.
2. What do you mean by stress testing the model?
IM
3. Explain the Advanced modelling techniques.
4. Describe the DCF Model.

HIGHER ORDER THINKING SKILLS

10.11
(HOTS) QUESTIONS
1. You must estimate a lump-sum valuation of the firm beyond the
M

explicit forecast period to make certain high-level assumptions

regarding cash flows beyond the last explicit forecast year. Which
of the following option is correct regarding the above statement?
a. Calculating the terminal value
N

b. Discounting the cash flows to the present at the weighted

average cost of capital
c. Divide the equity value by the shares outstanding
d. Add the value of non-operating assets to the present value of
unlevered free cash flows
2. We must include any non-operating assets, such as cash or
investments, which a firm may have on its balance sheet when
calculating the current value of unlevered free cash flows. Which
of the following option is correct regarding the above statement?
a. Calculating the terminal value
b. Discounting the cash flows to the present at the weighted
average cost of capital
c. Divide the equity value by the shares outstanding
d. Add the value of non-operating assets to the present value of
unlevered free cash flows

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362 FINANCIAL MODELLING

10.12 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Revolver modelling 1. a. Revolver

2. b. Cash surplus

Analysing the output 3. a. Financial analysis

4. b. Internal analyst

Stress testing the model 5. a. Hypothetical stress

testing

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6. b. Simulated stress testing

Fixing modelling errors 7. b. Model infrastructure

IM
8. d. Both a. and b.

Advanced modelling techniques 9. a. Conditional rules

Using the model to create a 10. c. Discounted cash flow

Discounted Cash Flow (DCF) model
Analysis
M

11. d. Investors

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
N

1. c. Cash deficit

2. b. Borrowing base

3. d. Stress testing

4. c. Historical stress testing

5. d. Model’s separate modules

6. d. All of these

7. c. Forecasting unlevered free cash flows

8. c. Subtract debt and other non-equity claims

HINTS FOR DESCRIPTIVE QUESTIONS

1. The revolving credit line, or “revolver,” serves as a plug in
the majority of 3-statement models to guarantee that debt is
automatically pulled to cover predicted losses. When a surplus is

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 Analysing and Concluding the Model  363

anticipated, cash behaves similarly, to the model forecasts. Refer

to Section 10.2 Revolver Modelling
2. The resilience of institutions and investment portfolios against
potential future financial scenarios is tested using the computer
simulation approach known as “stress testing.” Such testing is
often used by the financial sector to assess internal procedures
and controls, as well as investment risk and asset sufficiency.
Regulators have recently mandated that financial institutions
conduct stress tests to ensure their capital reserves and other
assets are sufficient. Refer to Section 10.4 Stress Testing the
Model
3. The application designer may incorporate components that are
not by default included in the programme thanks to advanced

S
modelling. Understanding the application views, dimensions and
approval hierarchy may be aided by this. Conditional rules are
one example of a modelling approach that uses dependencies but
is not automatically processed and recognised. In this case, the
IM
application designer may make sure that when the programme
is deployed to the distributed client; those objects are included
inside its scope. Refer to Section 10.6 Advanced Modelling
Techniques
4. A financial model known as the “Discounted Cash Flow Model,”
or “DCF Model,” estimates future cash flows for a firm and
discounts them to determine the company’s present value. Refer
M

to Section 10.7 Using the Model to Create a Discounted Cash

Flow (DCF) Analysis DCF Model

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS
N

Q. No. Answer
1. a. Calculating the terminal value
2. d. Add the value of non-operating assets to the present value
of unlevered free cash flows

SUGGESTED READINGS &

10.13
REFERENCES

SUGGESTED READINGS
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
Bloss, M. and Dirnberger, M., n.d. Financial Modeling.
‰‰ Pfaff,
P., 1990. Financial modeling. Needham Heights, Mass.: Allyn
and Bacon.
‰‰ Zivot,E. and Wang, J., 2003. Modeling financial time series with
S-Plus. New York: Springer.

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364 FINANCIAL MODELLING

E-REFERENCES
‰‰ Kubicle.com. 2022. Conclusions and Improvements | Online Finan-
cial Modeling Training | Kubicle. [online] Available at: <https://
kubicle.com/learn/financial-modeling/conclusions-and-improve-
ments> [Accessed 27 September 2022].
‰‰ Vskills Blog. 2022. Business and Financial Modelling - Vskills
Blog. [online] Available at: <https://www.vskills.in/certification/
blog/business-and-financial-modelling/> [Accessed 27 September
2022].
‰‰ Toptal Finance Blog. 2022. Tutorial on How to Make a Financial
Model. [online] Available at: <https://www.toptal.com/finance/
tutorials/what-is-a-financial-model> [Accessed 27 September
2022].

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 C H
11 A P T E R

VARIANCE-COVARIANCE MATRIX

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CONTENTS

11.1 Introduction
11.2 Sample Variance-Covariance Matrix
IM
11.2.1 Fixed-Weight Historical
11.2.2 Exponential Smoothing
11.2.3 Multivariate GARCH
Self Assessment Questions
Activity
11.3 The Correlation Matrix
M

Self Assessment Questions

Activity
11.4 Computing the Global Minimum Variance Portfolio (GMVP)
Self Assessment Questions
Activity
N

11.5 Alternatives to the Sample Variance-Covariance

11.5.1 The Single-Index Model (SIM)
11.5.2 Constant Correlation
11.5.3 Shrinkage Methods
Self Assessment Questions
Activity
11.6 Using Option Information to Compute the Variance Matrix
Self Assessment Questions
Activity
11.7 Summary
11.8 Multiple Choice Questions
11.9 Descriptive Questions
11.10 Higher Order Thinking Skills (HOTS) Questions
11.11 Answers and Hints
11.12 Suggested Readings & References

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366 FINANCIAL MODELLING

INTRODUCTORY CASELET

THE GENETIC VARIANCE-COVARIANCE MATRIX

Although phenotypic correlations between traits can occasion-

Case Objective ally result from environmental factors, it also happens that traits
under some shared genetic controls do not correlate in the phe-
This caselet highlights the notype as a result of opposing environmental factors. Traits that
phenotypic correlations
between traits. share genetic factors are expected to show phenotypic covariance
between trait values. The additive genetic covariance between
characteristics is; therefore, estimated by scientists researching
the development of traits.

Covariance between features that may be handed down to the

next generation is described by additive genetic covariance,
which is similar to additive genetic variance. There are several

S
methods for estimating additive genetic covariance, which need
some understanding of how people are linked; Lynch and Walsh
provide a full explanation of these methods. The P matrix and G
IM
matrix are terms used by biologists to refer to the variance-cova-
riance matrices for phenotypic data.

Researchers also assessed the genetic variance-covariance matrix

for emergency time, maximum height and tiller number in each
population of reed canary grass in the study detailed in the Exer-
cise below. Because they raised collections of plants that were
genetic clones of one another, the researchers were able to deter-
M

mine the G matrix. The population of plants in France has a G

matrix of 0000149.57.6907.6910.27.

There was no genetic covariance with the other two qualities since
there was no genetic variation for emergence time. The genetic
N

covariance between maximal height and tiller number, however,

is somewhat negative. This number implies that plants are geneti-
cally restricted to generate fewer tillers while they grow taller, and
the opposite is also true.

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 Variance-Covariance Matrix  367

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Discuss the sample variance-covariance matrix
>> Explain the correlation matrix
>> Classify the computing of the Global Minimum Variance
Portfolio (GMVP)
>> Describe the alternatives to the sample variance-covariance
>> Express the Single-Index Model (SIM)
>> Extent the using option information to compute the variance
matrix

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11.1 INTRODUCTION
In the previous chapter, you studied the analysis of the model. Finan-
Quick Revision
cial modelling is a tool used by professionals in many different indus-
IM
tries. In addition to being used by institutions for private equity, port-
folio management and research are also used by public accountants
for due diligence and valuations, bankers for sales and trading, stock
research and both commercial and investment banking.

A square matrix called a variance-covariance matrix holds the vari-

ances and covariances related to various variables. The variances of
M

the variables are contained in the matrix’s diagonal elements, while

the covariances of every conceivable pair of variables are contained in
the off-diagonal members.

As an illustration, imagine that you make a variance-covariance

matrix for the three variables X, Y and Z. The variances of X, Y and Z
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are 2.0, 3.4, and 0.82 correspondingly in Table 11.1:

TABLE 11.1: VARIANCES OF X, Y AND Z

Know More
X Y Z
A covariance matrix is a square
X 2.0 -0.86 -0.15 matrix giving the covariance
Y -0.86 3.4 0.48 between each pair of elements
of a given random vector.
Z -0.15 0.48 0.82

This table shown in bold along the diagonal. There is a -0.86 covari-
ance between X and Y.

Because the covariance between X and Y is equal to the covariance

between Y and X, the variance-covariance matrix is symmetric. To
display the covariance for each pair of variables twice in the matrix,
the ith and jth variables’ covariance is presented at places I j) and (j, i).

A covariance matrix, which is a square matrix, shows the variance

displayed by dataset elements as well as the covariance between two

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368 FINANCIAL MODELLING

datasets. Variance, a metric of dispersion, can be characterised as the

spread of data from the dataset’s mean. The calculation of covariance
between two variables is used to assess how the two variables fluctu-
ate collectively.

The definition of a variance-covariance matrix is a square matrix in

which the off-diagonal members stand in for the covariance and the
diagonal elements for the variance. Positive, negative or zero covari-
ance between two variables is all possible. Positive covariance denotes
a positive link between the two variables, whilst negative covariance
denotes a negative association. Two items will show 0% covariance if
they do not fluctuate together.

In this chapter, you will study the variance-covariance matrix, sam-

ple variance-covariance matrix, the correlation matrix, computing

S
the Global Minimum Variance Portfolio (GMVP), alternatives to the
sample variance-covariance, using option information to compute the
variance matrix, etc., in detail.
IM
SAMPLE VARIANCE-COVARIANCE
11.2
MATRIX
The historical covariance technique will likely be a poor estimator
NOTE of the actual variance-covariance matrix, according to the apparent
Covariance matrix is a type of instability of the unconditional covariance matrix. As a result, for pre-
matrix that is used to represent dicting risk exposures, more complicated models of the evolution of
M

the covariance values between

the variance-covariance matrix may be needed.
pairs of elements given in a
random vector.
The equally weighted historical method, exponentially weighted mov-
ing average approach and GARCH approach are the three kinds of
models. Other additional models might be employed. However, we
N

have limited ourselves to the models (and straightforward modifica-

tions of those models) now employed by Australian banks.

The stability analysis in the preceding section was based on com-

mon covariance and correlation metrics that account for the sample
mean of each series throughout each sub-period. The stability analy-
sis assumes that the mean of each series of financial returns is zero.
When calculating market risk exposures, this presumption is a widely
accepted market practice. The variance-covariance matrix estima-
tions may be worsened by the inclusion of an erroneous estimate of
the mean since the mean is theoretically near zero and subject to
estimation error. The addition of the estimated means will not signifi-
cantly alter the results if the conventional method for variances and
covariances is used since the squared return component is 100–1,000
times larger than the mean component.

While some banks update the variance-covariance matrix every day

as part of their VaR model implementation, it is standard practice at
other institutions to only do so once every three months. As a conse-
quence, two sets of projections are taken into account: the forecasts

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 Variance-Covariance Matrix  369

for one day in the future and the anticipated average variances and
covariances for the upcoming quarter.

11.2.1 FIXED-WEIGHT HISTORICAL

The fixed-weight method is based on the supposition that the vari-

ances and covariances of returns are constant across the sample
period. This is an incorrect assumption, as shown by the variance-co-
variance matrix’s instability as observed. On account of its simplicity,
it is commonly employed. This method may be used to express each
component of the variance-covariance matrix as:

1 N −1
σ 2 ij, t + 1 = ∑
N S =0
ri, t − s rj, t − s

S
where ri,t−s represents the market return for asset i between days
t−s−1 and t−s.
IM
11.2.2 EXPONENTIAL SMOOTHING

Exponential smoothing gives greater weight to the most recent data

than it does to earlier ones. JP Morgan made use of this strategy in Know More
their Risk Metrics VaR model to gain popularity (JP Morgan and
Covariance Matrix is a measure
Reuters, 1996). The exponentially weighted moving average method of how much two random
responds more quickly to transient variance and covariance changes. variables change together. It is
M

This quicker response is advantageous if the underlying variances actually used for computing the
and covariances are not consistent over time. On the other side, a covariance in between every
column of data matrix.
smaller sample size results from putting more weight on recent data,
which raises the likelihood of measurement error. In the variance-co-
variance matrix, each element is represented by:
N

σ2ij, t+1= λσ2 ij, t+(1– λ)ri, j rj,t

where 0<λ<1

An exponentially weighted average is made up of two parts on any

given day: the weighted average from the previous day, which weighs,
and the product of returns from the previous day, which weighs (1−λ).
This equation reflects the idea of volatility clustering by using an
autoregressive structure for the variance-covariance. Two strategies
are used in the analysis that comes next. The first is to assume that
is λ fixed at 0.94 by the Risk Metrics definition. The second strategy
involves applying maximum likelihood approaches to estimate λ over
a series of rolling windows (this approach can be referred to as the
dynamic exponentially weighted moving average approach).

The model is developed using maximum likelihood techniques over

the entire dataset to evaluate the accuracy of fixing λ at 0.94 (λ was
restricted to take the same value for all matrix members). This inves-
tigation yielded a value of 0.995 using the foreign exchange covariance
matrix.

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370 FINANCIAL MODELLING

Like the equally weighted method the k-step ahead one-day forecasts
are constant and the quarter-average forecast is equal to σ2ij, t+1. To see
this:

Et(σ2ij, t+k) = Et((1– λ)rij, t+k–1 rj, t+k–1+ λσ2ij, t+k–1)

= (1– λ)σ2ij, t+k–1 + λσ2ij, t+k–1

= σ2ij, t+k–1

11.2.3 MULTIVARIATE GARCH

The ARCH model proposed by Engle is generalised in Bollerslev’s

? DID YOU KNOW (1986) work as the GARCH model (1982). The specification of vari-
MGARCH stands for multivariate ances and covariances refers to stochastic processes that change over

S
GARCH, or multivariate time. Given that volatility clustering can be explicitly simulated, the
generalised autoregressive theory behind these models is conceptually comparable to that of the
conditional heteroskedasticity. exponentially weighted method. However, there are fewer limitations
on how the behaviour of the volatilities may be specified. The GARCH
IM
model is stacked inside the first two models. The model collapses to the
fixed-weight historical model if and α and β in the specification below
are both zero. The model is comparable to the exponentially weighted
model if is equal to zero, α = (1−λ) and β = λ. The zero-mean GARCH
(1,1) model has the following form in a univariate setting:
Rt = rt
M

rt /It-1~ N(0, Ht)

Ht = ω+ αr2t-1 + βHt-1

It is assumed that the vector of innovations or unexpected returns

has a conditional variance of Ht and is conditionally normal. Although
N

the specification of the development of the covariances can get more

involved, the multivariate framework is identical to the univariate in
that the variance-covariance matrix is dependent on historical reali-
sations of covariances of financial returns.

The more basic multivariate models use the assumption that vari-
ances and covariances are dependent on both their past values and
innovations as well as the past values and innovations of other vari-
ables. These generic models have so many parameters that need to
be estimated that as the number of variables rises, computing may
become impossible.

For instance, one of the more generic models requires 243 parameters
to be evaluated for our nine-by-nine foreign exchange matrix. There
is a need for a more frugal parameterisation because the focus is on
a model’s forecasting ability, which necessitates frequent rolling esti-
mates of the models.

Two models are applied to this goal. The first model is the Bollerslev’s
constant correlation multivariate GARCH model (1990).

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 Variance-Covariance Matrix  371

The model’s benefit is that it reduces the number of parameters that

must be estimated to 3p + p(p1)/2, where p is the total number of
financial returns. Variances are calculated using the straightforward
GARCH (1,1) formula:
σ2ij, t+1 = ωi+ αir2i, t + βiσ2i, t
The covariances are formulated as:
σij, t+1 = ρij σi, t+1 σj, t+1

The variance parameters must be subject to non-negativity require-

ments to guarantee that the conditional variance estimates are always
positive. Since the system is recursive, stationarity demands that αi +
βi < 1 for all i.

S
The model’s parameters are calculated using maximum likelihood
methods. The maximum likelihood estimator is asymptotically nor- Know More
mal when there is standard regularity. Using the Bernt, Hall, Hall and MGARCH allows the
Hausman (1974) method, the log-likelihood is maximised. The itera- conditional-on-past-history
IM
tion method takes a very long time because of the log-very likelihood’s covariance matrix of the
dependent variables to follow a
non-linear nature. Rolling estimate is computationally infeasible even
flexible dynamic structure.
after the constant correlation assumption is applied to the model due
to the total of 63 parameters in the whole system (for the nine-by-nine
foreign exchange variance-covariance matrix). The strategy used is
to estimate independent bivariate systems for each pair of financial
returns to allow rolling estimation. Seven parameters for each of these
M

36 systems need to be calculated.

The whole variance-covariance matrix may be created from these

bivariate systems. Estimates derived by pair-wise estimation may be
inaccurate and skewed to the degree that covariances are in reality
jointly determined. The covariance matrix’s positive definiteness can-
N

not be guaranteed by this method, but it does make forecasting pos-

sible and tractable. This approach provides only one estimate of each
covariance, but ρ−1 estimate for the ω, α and β parameters for each
variance. The average of the ρ−1 forecasts of each variance is used.

The constant correlation GARCH model’s one-day-ahead GARCH

variance forecast is provided by:

σ 2 i, t + 1 = ω + α i r2 i,t + β iσ 2 i,t
ωi r
= + α i ∑ β i j r 2 i, t − j
1 − βi j =0

T represents the length of data used in the estimation. It follows that

the k-step ahead forecast has the form:

ωi
σ 2 i,t + k / t = ωi + (α i + β i )k−1 (σ 2 i,t +1 − ωi ) where ωi =
1 − α i − βi

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372 FINANCIAL MODELLING

and hence, are not constant in k. Given these variances in forecast

functions the average one-day forecast over a quarter (containing N
days) is:

1 2  1 − (α i + β i ) N 
σ Ai
2
= ωi + (σ i, t +1 − ωi )   if α i + β i ≠ 1
N  1 − α i − βi 

Given the constant correlation assumption, the covariance predic-

tions are straightforward functions of these variance forecasts and the
parameters pij.

The Babba, Engle, Kraft and Kroner (BEKK) parameterisation is the

second multivariate GARCH model that is employed for forecasting.
This model was developed by Engle and Kroner (1995), whose qua-

S
dratic form ensures that the conditional covariance matrix would be
positive definite. The model has the form:

Ht+1 = C'C +B'HtB + A'RtR'tA

IM
The parameter matrices that must be estimated are A, B and C. A vec-
NOTE tor of returns for time t is called Rt. The calculated variance-covari-
GARCH is a statistical model ance matrix at time t is called Ht. Once more, using the unconstrained
that can be used to analyse a
number of different types of
BEKK model would need too much computing time for this forecast-
financial data, for instance, ing experiment.
macroeconomic data. Financial
M

institutions typically use this The parameter matrices are given a diagonal shape to improve tracta-
model to estimate the volatility bility and eliminate cross-market impacts. The required non-negativ-
of returns for stocks, bonds and
market indices.
ity requirements are automatically imposed by the model. The entire
model is estimated as opposed to generating estimates pair by pair.
N

The GARCH parameters are substituted with squared parameters in

the BEKK model, which results in variance forecasts that have the
same structure as those from the GARCH constant correlation model.

The constant correlation assumption is relaxed for the covariance

predictions in the BEKK model, which have the same specification as
the constant correlation GARCH variance equations.

SELF ASSESSMENT QUESTIONS

1. Which of the following called a variance-covariance matrix

holds the variances and covariances related to various
variables?
a. Square matrix
b. Diagonal matrix
c. Both a. and b.
d. None of these

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 Variance-Covariance Matrix  373

2. Which of the following gives greater weight to the most recent

data than it does to earlier ones?
a. Multivariate GARCH
b. Fixed-weight historical
c. Exponential smoothing
d. Both a. and b.

ACTIVITY

Find out the advantages of the covariance matrix.

S
11.3 THE CORRELATION MATRIX
Simply said, a correlation matrix is a table that shows the correlation
IM
coefficients for various variables.

The matrix depicts the correlation between all the possible pairs of
values in a table. It is an effective tool for compiling a sizable data-
set and for locating and displaying data patterns. The variables are
shown in rows and columns of a correlation matrix. The correlation
coefficient is contained in each cell of a table.
M

The correlation matrix is commonly used with other kinds of statis-

tical analysis as well. It could be useful, for instance, when analysing Know More
numerous linear regression models. A correlation matrix is
“square”, with the same
N

Keep in mind that the models include several independent variables. variables shown in the rows
In a model for multivariate linear regression, the correlation matrix and columns.
determines the correlation coefficients between the independent vari-
ables.

HOW TO CREATE A CORRELATION MATRIX IN EXCEL?

Let us look at the next example to better understand the processes

required to create a correlation matrix in Excel. You work as an
investment bank stock analyst. Recently, your boss instructed you to
examine the price correlations of the equities that may be added to the
portfolio. The equities of the following corporations are then exam-
ined: NVIDIA, Ford, Shell and Alphabet.

Making a correlation matrix is the most effective technique to exam-

ine the relationships between the stock prices of the firms stated
above. To do it, download the information into Excel and sort it into
the appropriate columns.

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374 FINANCIAL MODELLING

The stock prices of several companies are shown in each column for
the given period (from December 2015 to November 2018) as shown in
Figure 11.1:

S
IM
M

Figure 11.1: Correlation Matrix in Excel

The following are the procedure to create the correlation matrix in

excel:
1. Select the Data Analysis button under the Analse group in the
NOTE
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Data tab.
Most correlation matrixes use
Pearson’s Product-Moment The Data Analysis dialog box appears.
Correlation (r). It is also common
2. Select the Correlation option in the Data Analysis dialog box.
to use Spearman’s Correlation
and Kendall’s Tau-b. Both 3. Click the OK button.
of these are non-parametric
correlations and less susceptible The Correlation dialog box appears.
to outliers than r.
4. Type in the input range including the company names and stock
values.
5. Select the Columns radio button for the Grouped By: option
(because our data is arranged in the columns).
6. Select the Labels in First Row checkbox (the first rows of each
column contain the names of the companies).
7. Select the preferred output choice (i.e., the location on the
spreadsheet where the correlation matrix will appear).
8. Press the OK button.

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 Variance-Covariance Matrix  375

Your matrix should look like as shown in Figure 11.2:

Figure 11.2: Matrix

SELF ASSESSMENT QUESTIONS

3. The correlation matrix establishes the correlation coefficients

between the independent variables in a model for

S
a. Multivariate linear regression
b. Exponential smoothing
c. Fixed-weight historical
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d. None of these

ACTIVITY

Discuss some limitations of the correlation matrix.

M

COMPUTING THE GLOBAL MINIMUM

11.4
VARIANCE PORTFOLIO (GMVP)
The Global Minimum Variance Portfolio (GMVP) and efficient port-
folios are the two most common applications of the variance-covari-
N

ance matrix. Consider a scenario where N assets each have an S vari-

ance-covariance matrix. The GMVP is the portfolio with the lowest
variance out of all viable portfolios, x = {x 1, x 2, …, x N}. The mini- Know More
mum variance portfolio is defined by: The global minimum variance
portfolio (GMVP) allocates a
1row ⋅ S −1 given budget among n financial
XGMVP = {xGMVP,1 , xGMVP,2 ,..., xGMVP, N } = assets such that the variance
1row ⋅ S −1 ⋅ 1Trow
of the portfolio return is
1row ⋅ S −1 minimised.
where 1row = {1, 1,..., 1} =
 Sum ( numerator)
↑
N-dimensional
row vector of 1s

 xGMVP, 1  1
  1
 xGMVP, 2  S −1 1column  
xGMVP =  = T −1
, where 1column =  
   1column ⋅ S ⋅ 1column  
x  1
 GMVP, N  
↑
N −dimensional
column vector of 1s

S −1 1column
=
Sum( numerator) NMIMS Global Access - School for Continuing Education
 Sum ( numerator)
↑
N-dimensional
row vector of 1s

 xGMVP, 1  1
  1
376 FINANCIAL MODELLING  xGMVP, 2  S −1 1column  
xGMVP = = T −1
, where 1column =  
   1column ⋅ S ⋅ 1column  
x  1
 GMVP, N  
↑
N −dimensional
column vector of 1s

S −1 1column
=
Sum( numerator)

This formula is due to Merton.

The particular fascination of the minimum variance portfolio is that it

is the only portfolio on the efficient frontier whose computation does
not require the asset’s expected returns. The mean μGMVP and the vari-
NOTE ance σ2GMVP of the minimum variance portfolio are given by:
The global minimum variance
portfolio lies to the far left of the μGMVP = xGMVP .E(r), σ2GMVP = xGMVP .S. x2GMVP
efficient frontier and is made up
of a portfolio of risky assets that
produces the minimum risk for EXHIBIT
an investor.

S
Excel’s MMULT function to solve for Portfolio Variance

Only if the portfolio has 2 or 3 stocks it is possible to use a formula

to determine portfolio variance. When a portfolio has more than
IM
three stocks, utilising that method to solve the problem becomes
difficult and time-consuming. This makes utilising Excel’s MMULT
function to account for portfolio variance perfect. Two matrices
can be multiplied using this function. Having stated that, one must
comprehend the fundamentals of matrices before discussing the
MMULT function. From a matrix perspective, portfolio variance is
M

expressed as:

Wt × (Covariance Matrix) × W

In the above equation, W refers to the column vector of stock weights.

N

It is the third matrix that consists of a single column. Meanwhile,

Wt refers to the transpose of stock weights (row vector). It is the
first matrix that consists of a single row. Finally, covariance matrix
refers to all the possible pairs of covariances. Keep in mind that the
order mentioned in the above equation is important - first matrix
is the row vector of stock weights, second matrix is the covariance
matrix, and third matrix is the column vector of stock weights.

So, σ p2 = W t *×Covariance
CovarianceMatrix
Matrix* ×
WW

 Cov1,1 Cov1,2 Cov1,3 … Cov1, n   W1 

 Cov Cov2,2 Cov2,3 … Cov2, n   W2 
 2,1  
= [W1 W2 W3 … Wn]× 
* Cov3,1 Cov3,2 Cov3,3 … Cov3, n ×*  W3 
   
         
Covn Covn Covn,3 … Covn, n  Wn 
 ,1 ,2

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 Variance-Covariance Matrix  377

Above, the 1st matrix is multiplied by the second matrix. This

resulting product is then multiplied by the 3rd matrix.

The number of rows in matrix two must match the number of col-
umns in matrix one when multiplying two matrices. To ensure that
the number of columns in the weight matrix and the number of
rows in the covariance matrix match, the first stock weights matrix
is transposed. Let’s use the straightforward, hypothetical example
of two equities to better grasp this.

The weight is represented on the left side, and the covariance

matrix is shown on the right side as shown in figure 11.3:

S
IM
Figure 11.3: Covariance Matrix

When expressed in form of a matrix, the above tables would like the
ones below:

40%   0.021 0.0012 

M

60%  0.0012 0.015 

   
Above, in case of the matrix on the left, there are two rows and one
column. As such, this is a 2 by 1 (or 2×1) matrix. Meanwhile, in case
of the matrix on the right, there are two rows and two columns.
N

As such, this is a 2 by 2 (or 2×2) matrix. Keep in mind, a matrix is

expressed in the form M by N, where M refers to the number of
rows and N refers to the number of columns. So:
‰‰ Matrix 1 = 2×1 matrix
‰‰ Matrix 2 = 2×2 matrix

When multiplying two matrices, the number of columns in matrix 1

must equal the number of rows in matrix 2. Above, however, matrix
1 consists of 1 column while matrix 2 consists of 2 rows. Because of
this mismatch, there is a need to transpose matrix 1, so that it then
becomes a 1x2 matrix and can then be multiplied with matrix 2.

Rather than doing manually (which can get quite laborious and
time consuming), this calculation can be quickly done in Excel
using the =MMULT(A,B) function, where A represents array 1 (the
1st matrix) and B represents array 2 (the 2nd matrix).

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378 FINANCIAL MODELLING

Let us do that below figure 11.4:

Figure 11.4: Calculation of Covariance using MMULT Function

S
Before we explain the above image, here is an important thing to
keep in mind.

If you are using the latest version of Microsoft Office 365, you can
IMdirectly hit enter after inputting all the required arrays in the
MMULT function to generate the output.

However, if you are using any other version of Microsoft Office, you
may need to press Shift + Control + Enter to generate the output.

Now, in the above image, notice the highlighted cell E6 and the for-
mula that was used to calculate this, in cell F6. As you can see, there
M

is an error (#VALUE!). The reason why there is an error is because

the number of columns in the weight matrix (1) did not match with
the number of rows in the covariance matrix (2).

Hence, there is a need to transpose the weights, so that the matrix

N

changes from a 2x1 to a 1x2 matrix. So, the calculation of covari-

ance shown in figure 11.5:

Figure 11.5: Calculation of Covariance using

MMULT Transpose Function

The result of the product of the two matrices has been calculated
in cell E6 and the formula that was used to calculate this has been
written in cell G6.

Notice that multiplying a [1×2] matrix with a [2×2] matrix results

in a [1×2] matrix, as can be seen in the highlighted cells E6 and F6.

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 Variance-Covariance Matrix  379

Now, this resulting product must be multiplied by the third matrix

(which is the column vector of stock weights) to get the value of the
portfolio variance, as shown in figure 11.6:

Figure 11.6: Calculation of Portfolio Variance

using MMULT Function

In the above image, notice the highlighted cell E8 and the formula
that was used to calculate this in cell F8. See that the resulting

S
product (E6#), which is a [1×2] matrix (E6:E7), is multiplied by the
column vector of stock weights, which is a [2×1] matrix.

Notice that multiplying a [1×2] matrix with a [2×1] matrix results

IM
in a [1×1] matrix, as can be seen in the highlighted cell E8. This
value, 0.010536, is nothing but the portfolio variance.

Instead of using the function MMULT twice, one can further

shorten the work by nesting an MMULT within another MMULT.
To understand how to do this, as shown in figure 11.7:
M

Figure 11.7: Calculation of Portfolio Variance using Twice MMULT

N

Transpose Function

In the above image, notice the highlighted cell E6 and the formula
that was used to calculate this in cell F6. Notice how MMULT has
been nested inside another MMULT, to directly generate the port-
folio variance.

SELF ASSESSMENT QUESTIONS

4. Which of the following are the two most common applications

of the variance-covariance matrix?
a. Global Minimum Variance Portfolio (GMVP) and efficient
portfolios
b. Global Minimum Variance Portfolio (GMVP) and risk port-
folios
c. Efficient portfolios and risk portfolios
d. All of these

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380 FINANCIAL MODELLING

ACTIVITY

Write some uses of the global minimum variance portfolio.

ALTERNATIVES TO THE SAMPLE

11.5
VARIANCE-COVARIANCE
The covariance values between adjacent pairs of elements in a ran-
dom vector are represented by a particular sort of matrix known as a
Covariance Matrix.

The variance-covariance matrix is another name for the covariance

matrix. This is due to the variance of each element being represented

S
along the matrix’s primary diagonal.

A square matrix is a covariance matrix. It is also symmetric and pos-

itive semi-definite. In stochastic modelling and principle component
IM
analysis, this matrix is highly helpful.

11.5.1 THE SINGLE-INDEX MODEL (SIM)

The Single-Index Model (SIM) was developed to reduce the number

of complicated computations required to calculate the variance-cova-
riance matrix.
M

The SIM’s fundamental premise is that each asset’s returns may be

linearly regressed on a market index x:

ri = α i + βi rx + ε i
N

where the correlation between εi and εj is zero. Given this assumption,

it is easy to establish the following two facts:

‰‰ E (ri ) = α i + βiE (rx )

βi β jσ x2 when i ≠ j
‰‰ σ ij = 
 σx when i = j
2

In essence, the SIM includes modifications to covariance estimates

NOTE but not sample variance.
The single-index model (SIM) is
By using some VBA code, one can automate the process of computing
a simple asset pricing model to
measure both the risk and the the SIM:
return of a stock.
Function sim(assetdata As Range, marketdata As Range) _
As Variant
Dim i As Integer
Dim j As Integer
Dim numcols As Integer

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 Variance-Covariance Matrix  381

numcols = assetdata.Columns.Count
Dim matrix() As Double
ReDim matrix(numcols - 1, numcols - 1)
For i = 1 To numcols
For j = 1 To numcols
If i = j Then
matrix(i - 1, j - 1) = Application. _
WorksheetFunction.Var_S(assetdata.Columns(i))
Else
matrix(i - 1, j - 1) = _
Application.WorksheetFunction.Slope(assetdata. _
Columns(i), marketdata) * _
Application.WorksheetFunction.Slope(assetdata. _
Columns(j), marketdata) * _
Application.WorksheetFunction.Var_S(marketdata)
End If
Next j

S
Next i
sim = matrix
End Function
IM
The asset returns and market returns make up this function’s two
parameters.

Using this code in the illustration as shown in Figure 11.8:

M
N

Figure 11.8: Computation of the Single-Index

Variance-Covariance Matrix

EXHIBIT

Visual Basic for Applications (VBA) Function

The legacy program Visual Basic from Microsoft Corporation (NAS-

DAQ: MSFT) includes Visual Basic for Applications (VBA). VBA is
a programming language that may be used to create applications
for the Windows operating system and is supported by Microsoft
Office (MS Office, Office) programs including Access, Excel, Pow-
erPoint, Publisher, Word and Visio.

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382 FINANCIAL MODELLING

Beyond what is typically possible with MS Office host apps, VBA

enables users to modify.

VBA is an event-driven tool, so you can use it to instruct the com-

puter to start doing a single operation or a series of related tasks.
You create bespoke macros—a.k.a. macroinstructions—by entering
commands into an editing module to do this.

A macro is simply a string of letters that, when entered, produces a

different string of characters as its output, carrying out a certain set
of computational operations.

Because VBA is the version of Visual Basic that comes with Micro-
soft Office, you don’t need to buy the VBA program.

S
VBA is not an independent application. Instead, it gives users the
ability to interact with GUI elements including toolbars, menus,
conversation boxes and forms. User-defined functions (UDFs),
Windows application programming interfaces (APIs), and the auto-
IMmation of particular computer operations and computations are all
possible with VBA.

VBA in Excel

Each software in the Office suite may incorporate VBA code to

improve the product. All of the Office suite programs use a common
programming language.
M

VBA has worked better with Excel than other Office suite tools
because of the repetitive nature of spreadsheets, data analytics and
data organisation.

The usage of macros is frequently the foundation of the connection

N

between VBA and Excel.

VBA is used in Excel to execute macros, while it can also be used

for non-macro tasks.

11.5.2 CONSTANT CORRELATION

By assuming that the variances of the asset returns are sample returns
and that all covariances are related by the same correlation coeffi-
cient, typically taken to be the average correlation coefficient of the
assets in question, the constant correlation model of Elton and Gruber
Know More (1973) computes the variance-covariance matrix.
The constant correlation model
is a mean-variance portfolio Since Cov(ri,rj) = σij = ρijσiσj, this means that in the constant correla-
selection model where, for a tion model:
given set of risky securities, the
correlation of returns between  σ ij = σ i2 when i = j
any pair of different securities σ ij = 
is considered to be the same. σ ij = ρσ iσ j when i ≠ j

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 Variance-Covariance Matrix  383

The data for the 10 stocks can be used to put the constant correlation
model into practice.

One can begin by calculating the correlations between each stock as

shown in Figure 11.9:

S
Figure 11.9: Estimating the Constant Correlation Variance-Covari-
ance Matrix

Below is a VBA function to compute this matrix from the return data:
IM
Function constantcorr(data As Range, corr As Double) _
As Variant
Dim i As Integer
Dim j As Integer
Dim numcols As Integer
numcols = data.Columns.Count
numrows = data.Rows.Count
M

Dim matrix() As Double

ReDim matrix(numcols - 1, numcols - 1)
If Abs(corr) > = 1 Then GoTo Out
For i = 1 To numcols
For j = 1 To numcols
N

If i = j Then
matrix(i - 1, j - 1) = Application. _
WorksheetFunction.Var_S(data.Columns(i))
Else
matrix(i - 1, j - 1) = corr * jjunk(data, i) * _
jjunk(data, j)
End If
Next j
Next i

Out:

If Abs(corr) > = 1 Then constantcorr = VarCovar(data) _

Else constantcorr = matrix
End Function

11.5.3 SHRINKAGE METHODS

Recently, a third category of techniques for calculating the vari-

ance-covariance matrix has grown in favour.

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384 FINANCIAL MODELLING

The variance-covariance matrix is a convex combination of the sam-

ple covariance matrix and another matrix, according to so-called
shrinkage methods.

Shrinkage variance-covariance matrix = λ×Sample var-cov + (1+ λ)×

Other matrix

In the example, as follows, the “other” matrix is a diagonal matrix of

only variances, with zeros elsewhere.

The shrinkage estimator λ = 0.3 (cell B20) as shown in Figure 11.10:

S
IM
M
N

Figure 11.10: Estimating the Variance-Covariance Matrix Using the

Shrinkage Approach

There is little theory about choosing the proper shrinkage estimator.

Our suggestion is to choose a shrinkage operator λ so that the GMVP

is wholly positive

SELF ASSESSMENT QUESTIONS

5. The variance-covariance matrix is a convex combination of

the sample covariance matrix and another matrix, according
to so-called
a. Shrinkage methods b. Correlation methods
c. Both a. and b. d. None of these

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 Variance-Covariance Matrix  385

ACTIVITY

Find out some advantages of the Single-Index Model (SIM).

USING OPTION INFORMATION TO

11.6
COMPUTE THE VARIANCE MATRIX
Utilising data from the options market is another method for comput-
ing the variance matrix.

One can calculate the variance matrix using constant correlation and
the implied volatility for each of the equities from them at-the-money

S
call options:

 σ2i, implied if i = j
σ ij = 
ρσ i, implied σ j, implied if i ≠ j
IM
Here’s an example of our 10-stock case as shown in Figure 11.11:
M
N

Figure 11.11: Comparing Implied and Historical Volatility

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386 FINANCIAL MODELLING

One can now use the implied volatilities as the basis for a constant
correlation variance-covariance matrix as shown in Figure 11.12:

S
IM
Figure 11.12: Constant Correlation Matrix with Implied Volatilities

The programming of the ImpliedVolVarCov is similar to previous

VBAs in this chapter:
M

Function ImpliedVolVarCov(varcovarmatrix As _
Range, volatilities As Range, corr As Double)
As Variant
Dim i As Integer
N

Dim j As Integer
Dim numcols As Integer
numcols = varcovarmatrix.Columns.Count
numrows = numcols
Dim matrix() As Double
ReDim matrix(numcols - 1, numcols - 1)
If Abs(corr) > = 1 Then GoTo Out
For i = 1 To numcols
For j = 1 To numcols
If i = j Then
matrix(i - 1, j - 1) = volatilities(i) ∧ 2
Else
matrix(i - 1, j - 1) = corr * _
volatilities(i) * volatilities(j)
End If
Next j
Next i
Out:
If Abs(corr) > = 1 Then ImpliedVolVarCov = _
"ERR" Else ImpliedVolVarCov = matrix
End Function

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 Variance-Covariance Matrix  387

SELF ASSESSMENT QUESTIONS

6. Utilising data from which of the following market is another

method for computing the variance matrix?
a. Options market
b. Derivative market
c. Warrant market
d. Both b. and c.

ACTIVITY

Find some features of the variance matrix with the help of the inter-

S
net.

11.7 SUMMARY S
IM
‰‰ A square matrix called a variance-covariance matrix holds the
variances and covariances related to various variables. The vari-
ances of the variables are contained in the matrix’s diagonal ele-
ments, while the covariances of every conceivable pair of variables
are contained in the off-diagonal members.
‰‰ The variance-covariance matrix is calculated by many statistical
M

programs for parameter estimators in statistical models. Standard

errors of estimators or functions of estimators are frequently cal-
culated using this method.
‰‰ A covariance matrix, which is a square matrix, shows the variance
N

displayed by dataset elements as well as the covariance between

two datasets.
‰‰ The definition of a variance-covariance matrix is a square matrix
in which the off-diagonal members stand in for the covariance and
the diagonal elements for the variance.
‰‰ A correlation matrix is a table that shows the correlation coeffi-
cients for various variables. The correlation between all potential
pairings of values in a table is shown in the matrix. It is an effective
tool for compiling a sizable dataset and for locating and displaying
data patterns.
‰‰ The correlation matrix is commonly used with other kinds of sta-
tistical analysis as well. It could be useful, for instance, when ana-
lysing numerous linear regression models.
‰‰ The Global Minimum Variance Portfolio (GMVP) and efficient
portfolios are the two most common applications of the vari-
ance-covariance matrix.

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388 FINANCIAL MODELLING

‰‰ The covariance values between adjacent pairs of elements in a ran-

dom vector are represented by a particular sort of matrix known
as a covariance matrix.
‰‰ The Single-Index Model (SIM) was developed to reduce the num-
ber of complicated computations required to calculate the vari-
ance-covariance matrix.
‰‰ By assuming that the variances of the asset returns are sample
returns and that all covariances are related by the same correla-
tion coefficient.
‰‰ The variance-covariance matrix is a convex combination of the
sample covariance matrix and another matrix, according to
so-called shrinkage methods.

S
‰‰ Utilising data from the options market is another method for com-
puting the variance matrix.

KEY WORDS
IM
‰‰ Covariance matrix: A square matrix giving the covariance
between each pair of elements of a given random vector
‰‰ Correlation: A method for determining the connections
between two variables
‰‰ Fascination: The state of being greatly interested in or delighted
by something
M

‰‰ Portfolio: A collection of financial investments, including closed-

end funds and exchange-traded funds (ETFs), that include
equities, bonds, commodities, cash and cash equivalents
‰‰ Square matrix: A matrix that has an equal number of rows and
N

columns

11.8 MULTIPLE CHOICE QUESTIONS

MCQ 1. The covariance between X and Y is equal to the covariance
between Y and X, the variance-covariance matrix is
a. Asymmetric
b. Symmetric
c. Both a and b
d. None of these
2. Which of the following, which is a square matrix, shows the
variance displayed by dataset elements as well as the covariance
between two datasets?
a. Diagonal matrix
b. Square matrix

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 Variance-Covariance Matrix  389

c. Covariance matrix
d. None of these
3. Which of the following will likely be a poor estimator of the
actual variance-covariance matrix, according to the apparent
instability of the unconditional covariance matrix?
a. Square matrix technique
b. Diagonal matrix technique
c. Historical covariance technique
d. Both a and c
4. The stability analysis assumes that the mean of each series of

S
financial returns is
a. Infinite
b. Finite
IM
c. Zero
d. Both a. and b.
5. Which of the following is based on the supposition that the
variances and covariances of returns are constant across the
sample period?
M

a. Fixed-weight historical
b. Exponential smoothing
c. Multivariate GARCH
d. All of these
N

6. The ARCH model proposed by Engle is generalised in Bollerslev’s

(1986) work as the GARCH model (1982). Which of the following
option is correct regarding the above statement?
a. Exponential smoothing
b. Multivariate GARCH
c. Fixed-weight historical
d. Both a. and b.
7. Which of the following is a table that shows the correlation
coefficients for various variables?
a. Diagonal matrix
b. Square matrix
c. Covariance matrix
d. Correlation matrix

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390 FINANCIAL MODELLING

8. Which of the following was developed to reduce the number of

complicated computations required to calculate the variance-
covariance matrix?
a. Exponential smoothing
b. Fixed-weight historical
c. Single-Index Model (SIM)
d. None of these

11.9 DESCRIPTIVE QUESTIONS

?
1. Discuss the square matrix.
2. Explain the sample variance-covariance matrix.

S
3. Describe the correlation matrix.
4. Interpret sample variance-covariance.

HIGHER ORDER THINKING SKILLS

IM
11.10
(HOTS) QUESTIONS
1. Which of the following claims about an endogenous variable is
true in the context of simultaneous equations modelling?
a. Endogenous variables’ values are decided outside of the sys-
tem
M

b. The system can have fewer equations than endogenous vari-

ables.
c. No endogenous variables will appear on the right-hand side
of reduced form equations.
N

d. Only endogenous variables will be present on the RHS of re-

duced form equations.
2. The covariance is:
a. A measure of the strength of the relationship between two
variables.
b. Dependent on the units of measurement of the variables.
c. An unstandardised version of the correlation coefficient.
d. All of these

11.11 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Sample Variance-Covariance 1. a. Square matrix
Matrix

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 Variance-Covariance Matrix  391

Topic Q. No. Answer

2. c. Exponential smoothing
The Correlation Matrix 3. a. Multivariate linear
regression
Computing the Global Minimum 4. a. Global Minimum Vari-
Variance Portfolio (GMVP) ance Portfolio (GMVP)
and efficient portfolios
Alternatives to the Sample Vari- 5. a. Shrinkage methods
ance-Covariance
Using Option Information to Com- 6. a. Options market
pute the Variance Matrix

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

S
Q. No. Answer
1. b. Symmetric
2. c. Covariance matrix
IM
3. c. Historical covariance technique
4. c. Zero
5. a. Fixed-weight historical
6. b. Multivariate GARCH
7. d. Correlation matrix
M

8. c. Single-Index Model (SIM)

HINTS FOR DESCRIPTIVE QUESTIONS

1. A square matrix called a variance-covariance matrix holds the
N

variances and covariances related to various variables. The

variances of the variables are contained in the matrix’s diagonal
elements, while the covariances of every conceivable pair of
variables are contained in the off-diagonal members. Refer to
Section 11.1 Introduction
2. The historical covariance technique will likely be a poor
estimator of the actual variance-covariance matrix, according to
the apparent instability of the unconditional covariance matrix.
As a result, for predicting risk exposures, more complicated
models of the evolution of the variance-covariance matrix may
be needed. Refer to Section 11.2 Sample Variance-Covariance
Matrix
3. The correlation between all potential pairings of values in a
table is shown in the matrix. It is an effective tool for compiling
a sizable dataset and for locating and displaying data patterns.
The variables are shown in rows and columns of a correlation
matrix. The correlation coefficient is contained in each cell of a
table. Refer to Section 11.3 The Correlation Matrix

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392 FINANCIAL MODELLING

4. The covariance values between adjacent pairs of elements in

a random vector are represented by a particular sort of matrix
known as a covariance matrix. The variance-covariance matrix
is another name for the covariance matrix. This is due to the
variance of each element being represented along the matrix’s
primary diagonal. Refer to Section 11.5 Alternatives to the
Sample Variance-Covariance

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. c. No endogenous variables will appear on the right-hand

S
side of reduced form equations.
2. d. All of these
IM SUGGESTED READINGS &
11.12
REFERENCES

SUGGESTED READINGS
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
Bloss, M. and Dirnberger, M., n.d. Financial Modeling.
M

‰‰ Pfaff,P., 1990. Financial modeling. Needham Heights, Mass.: Allyn

and Bacon.
‰‰ Zivot, E. and Wang, J., 2003. Modeling financial time series with
S-Plus. New York: Springer.
N

E-REFERENCES
‰‰ Cuemath. 2022. Covariance Matrix - Formula, Examples, Defini-
tion, Properties. [online] Available at: <https://www.cuemath.com/
algebra/covariance-matrix/> [Accessed 3 October 2022].
‰‰ Stattrek.com. 2022. Covariance Matrix. [online] Available at:
<https://stattrek.com/matrix-algebra/covariance -matrix>
[Accessed 3 October 2022].
‰‰ Smartmoney.angelone.in. 2022. The variance and covariance
matrix. [online] Available at: <https://smartmoney.angelone.in/
chapter/the-variance-and-covariance-matrix/> [Accessed 3 Octo-
ber 2022].

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 C H
12 A P T E R

RECRUITING, INTERVIEWING AND SELECTION

S
CONTENTS

12.1 Introduction
12.2 Recruiting and Interviewing
IM
Self Assessment Questions
Activity
12.3 Financial Institutions and Investment Banks
Self Assessment Questions
Activity
12.4 Process of Interviewing
M

12.4.1 General Interviewing Overview

12.4.2 Qualitative/fit Questions
12.4.3 Technical Questions
12.4.4 Post Interview
12.4.5 Following up
N

12.4.6 Selecting a Firm

12.4.7 Selecting a Group
Self Assessment Questions
Activity
12.5 Investment Banking
Self Assessment Questions
Activity
12.6 Selection
12.6.1 How to Hire Financial Advisors?
Self Assessment Questions
Activity
12.7 Summary
12.8 Multiple Choice Questions
12.9 Descriptive Questions
12.10 Higher Order Thinking Skills (HOTS) Questions
12.11 Answers and Hints
12.12 Suggested Readings & References

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394 FINANCIAL MODELLING

INTRODUCTORY CASELET

SINGER INDUSTRIES LIMITED

Suresh Kumar was production manager for Singer Industries

Case Objective Limited, a Noida based electrical appliances company near Delhi.
This caselet highlights Singer Suresh had to approve the hiring of new supervisors in the plant.
Industries Limited, a close-by The HR manager performed the initial screening.
manufacturer of electrical
goods. Anil Dhavan, Singer’s HR Director, called Suresh on Friday in the
late afternoon. He said “Suresh, I just spoke with a recent engi-
neering graduate from a local engineering college who would be
the perfect fit for the supervisor position you asked me about.
Despite earning a lower pay, he has some decent job experience
with a global company in Pune. He wants to travel to Noida to visit
his folks.” “Well, Anilji, I will take care of the boy,” Suresh replied.

S
“He is currently at my office, and if you are free, I will send him
to you”, said Anil. Before responding, Suresh was silent for a time
“Great Sir, I am undoubtedly busy today, but I also can’t afford to
IM
offend you. Sir, immediately send him, please.”

The new candidate, Ranga Rao, entered Suresh’s office shortly

after and introduced himself. Suresh urged Rao to enter his cabin
and said “I have a few critical phone calls to make, but I will be
right there with you.” Suresh ended the calls after fifteen min-
utes and started interrogating Rao. Suresh was astonished as the
candidate’s ability was demonstrated by the merit certificates, the
M

best idea prize from a prior international company and his swift
reactions. Meanwhile, a supervisor shouted, “We have a tiny prob-
lem on line number 5 and need your aid,” and opened Suresh’s
door.
N

Suresh returned fifteen minutes later and the conversation pro-

ceeded for a few minutes before a series of phone calls once again
stopped him. Suresh said, “Excuse me for a minute, Rao.”

For the following forty minutes, there were further interruptions

in the same pattern. Inconveniently, Rao glanced at the watch and
said, “Sorry, Suresh, but I have to leave right away. The train to
Pune leaves at nine o’clock.”

As the phone rang once again, Suresh answered, “Sure, Rao.”

“Call me in a week”.

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 Recruiting, Interviewing and Selection  395

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

>> Discuss recruiting and interviewing
>> Explain the financial institutions and investment banks
>> Classify the process of interviewing
>> Describe the general interviewing overview
>> Analyse the selection process
>> Interpret the concept of selecting a firm

12.1 INTRODUCTION

S
In the previous chapter, you studied the variance-covariance matrix. Quick Revision
A square matrix called a variance-covariance matrix holds the vari-
ances and covariances related to various variables. The variances of
IM
the variables are contained in the matrix’s diagonal elements, while
the covariances of every conceivable pair of variables are contained in
the off-diagonal members.

The creation and upkeep of suitable workforce sources is recruitment.

It entails building a pool of readily accessible human resources that
the organisation may use to draw from when it needs more workers.
M

Recruitment is the process of luring candidates to open positions in

an organisation who possess particular qualifications, aptitudes and
personality traits.

Denerley and Plumblay (1969) assert that recruiting involves both

enlisting the necessary quantity of individuals and assessing their
N

calibre. In addition to addressing immediate demands, it also has an

impact on how a firm will develop in the future. The requirement for
recruiting may result from:
i. Openings caused by promotions, transfers, terminations,
retirement, permanent disabilities or death;
ii. Openings caused by business expansion, diversification, growth
and other factors.

People chosen for the organisation based on criteria other than merit
would not fit in well and cause several issues for both the company NOTE
and the other employees. The process begins with recruitment and Recruiting is the stage of the
moves through selection and placement before coming to an end. employee life cycle in which
Manpower planning is the initial stage in the procurement function, prospective candidates are
sourced, interviewed and
and recruitment comes after that. The organisation can recruit the assessed in order to identify the
individuals it needs in the numbers and demographics it needs. Find- best fit for a job opening.
ing possible candidates for current or future organisational openings
entails recruiting.

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396 FINANCIAL MODELLING

“Recruitment is a procedure to uncover the sources of personnel to sat-

NOTE isfy the requirements of the staffing schedule and to utilise efficacious
The recruitment process means for attracting that workforce in enough numbers to permit suc-
involves finding the candidate cessful selection of an efficient working force,” note Yoder and others.
with the best skills, experience
and personality to fit the job.
As a result, the goal of recruiting is to identify sources of labour that
can fulfil the needs and criteria of a given position.

In this chapter, you will study recruiting and interviewing, financial

institutions and investment banks, the process of interviewing, selec-
tion, etc., in detail.

12.2 RECRUITING AND INTERVIEWING

Although people management has been practised for about 70 years,
its significance has just lately undergone a significant shift. There

S
are now several levels of bureaucracy due to the complexity and size
expansion of the majority of organisations. All businesses and organ-
isations are aware of the rising cost of labour. A strategic human
IM
resources management concept has recently been created by schol-
ars. This viewpoint essentially adopts a wider and more comprehen-
sive perspective of the people’s function. It looks to connect the peo-
ple function to an organisation’s long-term goals and asks how it may
make those goals and strategies easier to achieve. Organisations are
rethinking old beliefs about career planning to provide workers with
more alternative career choices and also take into account their life-
style demands while moving them from one station to another due to
M

increased concern with careers and life fulfilment. This tendency is

fairly prevalent in the hotel sector.

The most valuable resource in every organisation is its human capi-

tal. The quality of the employees of an organisation determines much
N

of its success or failure. Organisations cannot advance and thrive

without the positive and innovative contributions of individuals. An
organisation has to hire people with the relevant knowledge, training
and experience to accomplish its objectives. They must accomplish
this while keeping in mind both the organisation’s current and future
needs. Employment and selection are not the same as recruitment.
Before choosing qualified applicants for employment, management
must first identify where the needed human resources will be acces-
sible and how to attract them to the organisation. Once the required
quantity and kind of human resources are known.

Interviewing is the most common resource or instrument utilised in

social casework; hence interviewing skills are the fundamental abilities
on which the success of all other process elements depends. The idea
and nature of interviews and the most common instrument employed
in social casework should already be familiar to you. Additionally, you
have acknowledged that communication is a key component of the
interviewing process. In other words, you should be able to under-
stand the “what,” “why,” “when” and “where” of a social casework

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 Recruiting, Interviewing and Selection  397

interview. You must now become familiar with the social casework
interview’s “how.” Although aspiring professionals might be able to Know More
understand the notion of an interview, doing so in practical and real- As interviewing is the most
world settings can be quite challenging. They experience uneasiness used resource or tool of social
case work, interviewing skills
and a lack of confidence before beginning or continuing an interview.
are the central skills on which
They could also struggle to maintain the momentum. They are inter- all the components of the social
ested in learning “how to start an interview, what questions to ask or case work process depend.
not ask and how to deal with emotionally sensitive situations.” They
do accept that assisting individuals in need while also doing it effec-
tively is a key component of social casework, a basic way of the social
work profession.

SELF ASSESSMENT QUESTIONS

S
1. The most valuable resource in every organisation is its:
a. Human capital
b. Human resource management
IM
c. Strategic management
d. None of these

ACTIVITY

Find some key terms for recruiting with the help of the Internet.
M

FINANCIAL INSTITUTIONS AND

12.3
INVESTMENT BANKS
N

In the financial institutions, financial activities are a crucial compo-

nent of any economy, and consumers and businesses rely on financial NOTE
institutions for transactions and investments. As a result, financial A corporation that deals
institutions provide services to the majority of people. The govern- with financial and monetary
ment considers the supervision and regulation of banks and other activities such deposits, loans,
financial institutions important due to their crucial role in the econ- investments, and currency
exchange is known as a
omy. Financial institution failures have led to panic in the past. financial institution (FI).
Regular bank accounts are insured in the United States by the Federal
Deposit Insurance Corporation (FDIC) to reassure people and com-
panies about the security of their money with financial institutions.
The strength of a country’s financial sector is essential to its overall
economic stability. A bank run is a simple outcome of losing trust in a
financial organisation.

Financial institutions are crucial because they offer a market for

money and assets, enabling effective capital allocation to the most
beneficial uses. As an illustration, a bank accepts client deposits and
loans the money to borrowers. Without the bank acting as a middle-
man, it would be difficult for one person to discover a suitable bor-

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398 FINANCIAL MODELLING

rower or understand how to manage the loan. As a result, the deposi-

Know More tor can obtain interest through the bank. Investment banks similarly
The major categories of locate investors to whom they advertise a company’s shares or bonds.
financial institutions are central
banks, retail and commercial In the investment banks, careers in investment banking are partic-
banks, internet banks, credit ularly appealing to both new college graduates and seasoned finan-
unions, savings and loan
cial professionals due to the high salary and fantastic benefits offered.
associations, investment banks
and companies, brokerage Unsurprisingly, one of the most competitive employment markets is
firms, insurance companies and investment banking.
mortgage companies.
The following traits are sought by investment banks in job applicants:
‰‰ Intellectual abilities: Despite being a strange interview ques-
tion, “How many jellybeans can fit in the Empire State building?”
might reveal something about the candidate’s mentality. With this

S
unexpected question, the interviewer is attempting to gauge the
candidate’s level of intelligence. There’s a rationale behind that.
Consider yourself an investment banker who meets a business
magnate. The businessman begins to consider the possibility of
IM
selling tractors in India, a nation he is unfamiliar with. A skilled
investment banker should be ready to appraise the market, the
industry and the company concept fast. They should start by
making an informed prediction about the prospective market for
tractors in India and estimating the number of farmers there and
the size of the country’s farmland.
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Investment banking is a field where new business possibilities,

deals, products and ideas are constantly emerging. Candidates
should be skilled at spotting and investigating them which requires
a quick mind.
‰‰ Analytical skills: Investment bankers frequently have to provide
N

extremely demanding customers with extensive analysis of com-

pany endeavours and investment plans. To articulate business
strategies and risk-return tradeoffs and to back them up with facts
and numbers when questioned, analytical skills are needed in
addition to strong numerical and quantitative skills.
‰‰ Skills in communication: Persuading and convincing others are
the main job requirements in investment banking. It needs excel-
lent presentation and communication abilities to sell a concept.
These include creating effective papers, presentations and spread-
sheets.
‰‰ Management and leadership abilities: Candidates are evaluated
based on their long-term potential. Investment bankers frequently
begin as junior analysts. They initially receive full ownership of
a business opportunity, which is followed by the assignment of a
whole area or business sector. Later on, they can advance to vice
president-level positions and upwards, managing company divi-
sions.

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Candidates must assume responsibility, form teams, ask for help

from various corporate departments and develop relationships NOTE
with vendors and partners even in entry-level positions. The ability An investment bank is a financial
to manage and lead is a need for the position of an investment services company that acts as
banker. an intermediary in large and
complex financial transactions.
‰‰ Entrepreneurial skills: Deals involving mergers and acquisitions,
corporate restructuring strategies, initial public offerings and the
financing of new businesses all include investment banking to
some extent.
The position calls on the capacity to spot business prospects in
novel and unique areas. It could entail providing funds for a group
of entrepreneurs to start a company from scratch or identifying
expansion opportunities in an already-existing company.

S
‰‰ Networking skills: Investment bankers need to be able to estab-
lish relationships with individuals from many different businesses
and cultural backgrounds. Candidates must be able to manage
unusual situations and sustain positive client connections.
IM
SELF ASSESSMENT QUESTIONS

2. Which of the following are a crucial component of any economy,

and consumers and businesses rely on financial institutions
for transactions and investment?
a. Financial institutions
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b. Financial activities
c. Investment banks
d. None of these
N

3. Which of the following provides services to the majority of

people?
a. Financial activities
b. Investment banks
c. Financial institutions
d. All of these

ACTIVITY

Find some advantages of financial institutions.

12.4 PROCESS OF INTERVIEWING

You have learned about interviewing and many sorts of interviews in
the sections above. This section will concentrate on the interviewing

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400 FINANCIAL MODELLING

process, which includes creating a plan of action to handle any unfore-

seen circumstances, training interviewers or field staff, scheduling an
interview, choosing a data recording system, conducting a pilot inter-
view, making adjustments for the final interview, conducting interview
sessions and finally performing data analysis.

The process of interviewing are discussed below:

‰‰ Plan: At this stage, the researcher determines the interviewer’s
training, the amount of time allotted for the interview and the
interview location. It also considers the cost element, travel time
and waiting time. When there are more interviewers, field per-
sonnel are needed. For the enormous number of respondents, one
primary interviewer and one research assistant are insufficient.
To successfully handle the interview session, field employees, enu-

S
merators or research assistants must get training. The questions
and guidelines for the interview will become clear to the inter-
viewer during this procedure.
IM
‰‰ Preparation of interview schedule: An interview schedule is a
collection of written questions that are arranged in some order or
sequence. During the interview, the interviewer records the can-
didates’ responses on the printed schedule. A timetable for inter-
views is created in advance. Anyone taking on this assignment—
whether they are the researcher, the interviewer or merely the
enumerator—needs hands-on instruction to conduct the interview
M

successfully. We must take into account the interviewer’s predilec-

tion for interpreting responses, though. The researcher is aware
of the respondent’s identity thanks to the interview schedule. This
approach does not have a low response rate issue. However, only
the information provided by the respondent that has shown to be
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extremely accurate is recorded there. Personal contact with the

responder can be made through an interview schedule. Even in
situations when the target audience is uneducated, this approach
may be effective. This approach also has significant shortcom-
ings. When the target population is dispersed geographically, the
approach cannot be used since the interviewer may be prejudiced
and the inquiry would be hampered.
‰‰ Pilot test of the schedule: Pre-testing the interview questions is
advised before the actual interview process begins. It is important
to choose a sample of interviews for the pilot research. The appro-
priate study should not include this group. The interviewer should
ask the chosen responders for any observations or ideas on how to
make the interview process better. The researcher should adjust
it by the results of the pilot study group. To receive appropriate
replies from the respondents, this approach is crucial.
‰‰ Conducting the interview: Interviewing is an art, as we are all
aware. However, it is the most challenging assignment for research-

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ers. The researcher or interviewer must juggle many responsibili-

ties at once. For instance, he or she asks the respondent questions,
carefully considers the responses, provides clarification, occasion-
ally explanations and instructions to allay the respondents’ fears
and records the responses. It is crucial to see how an interviewer
conducts themselves during the interview. His manually or using
any available technological equipment (i.e., tape recorder). The
interviewer is also paying attention to the session’s schedule of
questions and other details. This requires talent and to do such a
task, the interviewer needs to have training. As demonstrated by
experience, this ability may be developed through time or her good
looks, charming demeanour, actions, language use and domain
understanding can significantly impact the outcomes. The way we
communicate might also be influenced by our body language. It

S
could make the person feel more at ease or comfortable.
The interviewer should not keep the respondent waiting. He or
she should arrive on time and act appropriately. Before beginning
Know More
the real interview, he or she should clarify the purpose of the
IM The interview process typically
study and the significance of the respondent’s participation in the includes the following steps:
research. The interviewer should speak less and listen more. He writing a job description,
or she needs to be capable of listening. The interview’s primary posting a job, scheduling
goal is to make it easier for participants to react. Therefore, the interviews, conducting
interviewer must ask the relevant questions to elicit responses preliminary interviews,
conducting in-person
from the respondent and then accurately record those responses. interviews, following up with
candidates and making a hire.
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12.4.1 GENERAL INTERVIEWING OVERVIEW

An employer and you converse during the interview to share informa-

tion. Your goal is to receive a job offer, while the employer’s goal is to
learn the following:
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‰‰ What you have to offer (your skills, abilities, basic knowledge).

‰‰ Who you are (your personality, character and interests).
‰‰ Why you should be hired (you have what they are seeking).

The interviewer will try to determine whether you will be an asset to

the organisation. Your objective is to sell yourself as the finest candi-
date for the job while also learning more about the company and the
role to see whether it aligns with your professional objectives. Thus,
unlike how it is frequently viewed, the interview is a two-way conver-
sation rather than an interrogation.

The interview is a crucial stage in getting a job and frequently relies on

your ability to sell yourself. Do not let a lack of planning and practice
cause you to lose out on a fantastic opportunity for which you are eligi-
ble. You must be prepared to talk about your professional aspirations
and experience. To get the data you need to make an informed conclu-
sion, you need also to come up with some smart questions of your own.

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The key to a good interview is preparation, which also increases your

self-confidence in your interviewing abilities.

12.4.2 QUALITATIVE/FIT QUESTIONS

Researchers that use qualitative methods aim to comprehend phe-

nomena that statistics alone cannot fully capture. Qualitative research,
although frequently referred to be a soft scientific technique, aids in a
complex understanding of people.

The best interview candidates should be devoted to comprehending

NOTE relevant power dynamics before approaching places of interest while
The interview process is a multi- speaking with qualitative researchers. Candidates without empathy
stage process for hiring new
employees. or reflexivity should be avoided.

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The following are the researcher qualitative interview questions:
1. How would you select appropriate projects?
You can select relevant projects by demonstrating an
IM
understanding of one’s interests, social requirements and
knowledge gaps.
2. What distinguishes participants from collaborators in the most
important ways?
Collaborators join in to assist participants.
3. What would you do if a subject showed signs of reluctance to
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participate in your study?

Examines the ability to protect participants’ volition.
4. How would you respond to those who question the value of
qualitative research?
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Demonstrates self-assurance in these endeavours and the

capacity to have civil debates regarding research.
5. When would you discuss your findings with the participants?
Evaluates how well participants’ feedback has been respected
throughout the project.

12.4.3 TECHNICAL QUESTIONS

Candidates are evaluated through technical interviews for careers in

IT, engineering and science. They contain inquiries that are pertinent
to the position for which you have applied, enabling the employer to
determine if you possess the necessary qualifications. They frequently
consist of logical exams, number reasoning issues or brain teaser chal-
lenges.

Although it is crucial, interviewers are also concerned about how

applicants tackle challenges, organise their mental processes and
exhibit interpersonal skills like communication.

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Depending on the job, an employer will have certain technological

requirements. When considering potential interview questions, the Know More
job specification is a fantastic place to start because it provides a clear Behavioral questions allow you
idea of the skill set, they are looking for. to find the best fit for each role,
and help you hire employees
Naturally, the employer will evaluate your technical skills and indus- who can drive innovation,
productivity, customer
try knowledge to make sure you can perform the job, but they will also
satisfaction and profits.
consider how you arrived at your answers (your methodology).

Additionally, they will be evaluating your presentation skills and your

ability to relate the technical issue to a practical professional scenario.

12.4.4 POST INTERVIEW

The responses to these queries might provide you with information

S
about their hiring procedure as well as how quickly they need to fill
the position. And perhaps how keenly they are interested in recruiting
you. Employers ought to disclose this information to you without ask-
ing for it, but many fail to do so.
IM
The following are the procedure of hiring the employees:
1. Learn how the employer’s hiring and job interview process
works: Ask hiring related questions ideally during the job
interview if the company does not provide this information.
You need to know so that you may be ready for whatever comes
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next in this employer’s procedure, whether it be an email, phone

call, further interview (or two), trip to their facility, tests, a list of
your references to call or something else. Therefore, before you
leave their location or hang up the phone, ask them:
 Your Question: What are the phases in the interview process,
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exactly?
Ask this question to as many people as you can.
The next step could involve interviewing additional applicants,
conducting a second interview with you, checking your references
and having you take a test (or several tests) or it could involve
waiting for them to meet and decide what to do after they have
discussed the next steps. This depends on where you are in their
typical hiring chronology.
Although every organisation is unique, most follow a process—
whether formally or informally—when hiring new employees.
You must be familiar with the process—or at the very least,
know what the next step is— to properly navigate through it and
comprehend how it functions.
It is quite likely that the individuals you speak with will not think
to inform you of what happens next. They will presume that
you already know (or will learn), or they will not recognise the
significance of the knowledge to you.

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2. Find out when they intend to get in touch with you again to
discuss the next stages or their timetable: Repeat this query to
every individual or group you converse with.
When you learn what the next step is, ask them the following
question, assuming that they will encourage you to move on in
their recruiting process:
 Your Question: When can I anticipate hearing about this po-
sition from someone?
You could hear from them today (unlikely, but possible), to-
morrow, at the end of the week, next week, next month, after
the holidays, etc., depending on where you are in their re-
cruiting process. You will have a basic notion of everyone’s
schedule even if they do not all agree on the timing.

S
Because the procedure does not always (or often) proceed
as anticipated, especially in huge organisations, expect this
response to be incorrect. Ask them anyhow since it will give you
IM an indication of how long the recruiting process is likely to take
and will set the stage for the next inquiries.
3. Choose your official point of contact: Ask this query after each
NOTE job interview stage (phone screen, in-person round one, in-
The interview process is an person round two, etc.):
important phase in recruitment.
It helps an employer understand  Your Question: Whom should I continue to communicate
with?
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whether a candidate is ideal

for a job and aids the candidate
in determining whether the job The “point person” will often be one individual. And with that
suits them or not. individual, you typically maintain contact during the proce-
dure. Get the person’s business card by asking.
The recruiting manager or an HR manager could be added later
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on in the process. Your inside contact, who ideally recommended

you for the position (the greatest way to be recruited!), maybe
your finest informal source of information.
4. How can I get in touch with your contact the quickest?
This information is crucial:
 Your Question: How can I get in touch with [you, this person,
or their work title]?
I’m hoping they’ll say something along the lines of “Call me
at ###-###-####.” An email address is less helpful. It is
helpful to have both so you can follow up if you do not hear
back from your email.
If you have the person’s business card, take it out and mark the
card with a circle next to the preferred means of contact or write
a comment on the back.
5. Discover when you may anticipate receiving a response from
them: This is a significant query. If they miss their deadline, as

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they typically do, the response gives you the go-ahead to get in
touch with them.
Usually, when you respond, they give you both information and
consent to communicate further.
 Your Question: What would be a good day to follow up?
If they give you a date, extend your back-in-touch deadline by
one or two days. Don’t call Tuesday morning if they indicated
they will contact you next Tuesday. Call early on Thursday.

Accept their response if they state you don’t need to get in touch with
them since they will be in touch right away (in this discussion). Then,
take into account including a date in your interview thank you for an
email (as in this model email) when you will follow up, making sure

S
the date is a day or two following their response to question number
one (above).

One of the biggest errors job searchers make is aggressively and fre-
IM
quently following up. Aggressive follow-up might be taken as a sign
that the person is someone who would be challenging to deal with or
manage.

The anticipated time frame for replying is frequently inaccurate and

typically excessively optimistic. They promise to respond to you by
Friday, but by the Wednesday following the deadline, they still have
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not. You can contact them (politely, of course) to find out what’s going
on if they have missed their deadline by several weeks or working
days.

12.4.5 FOLLOWING UP
N

Sending a follow-up email after an interview is appropriate. Here is

how to send an email to follow up after an interview. The following are
the follow-up after a job interview:
1. Use the recipient’s first name alone.
2. Convey your appreciation for their time and work.
3. State your interest in the position and firm once again.
4. Mention your interview date, your job title and any pertinent
information.
5. Directly inquire as to the state and the following actions.
6. Provide further details (if needed).
7. Conclude the email by expressing gratitude and thanks.
8. Check your email for errors (or have someone else do it).
9. Remain upbeat (especially in your tone).

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Every company and the employer are unique. The recruiter and you
may communicate during the interview process. Alternatively, you
might speak with the recruiting manager directly.

Regardless, it’s crucial to decide who you want to get in touch with
personally. Ensure that you have accurately spelt their name. Then,
say thank you and appreciate it. Although the recruiting process may
appear straightforward, it is not. A candidate may need to pass through
several approval processes and hoops, depending on the business.

It is time to restate your interest after thanking the person for their
time. Mention the position and the employer, along with your excite-
ment for the chance. Make sure to include the date of the interview
and the precise position title. If a recruiter is responding to your mes-
sage, they probably have several vacant positions and prospects on

S
their plate.

Finally, be direct. Inquire about the status of the job for which you have
been interviewed. Ask about the subsequent stages. At this point, you
IM
could also provide other details like references. Finally, add one more
expression of thanks to the end of your email.

But wait a moment before sending. Have you had this edited for mis-
takes? Have you used spellcheck or another grammar checker on the
email? What is the gist of your voice? Are you still having a good atti-
tude? Or what changes can you make if you sound frustrated?
M

WAYS TO FOLLOW UP AFTER A JOB INTERVIEW

There are specifics to post-interview follow-up. Every organisation

has a unique approach to the interview process. So, you could encoun-
ter many situations when you look for a job.
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THE INITIAL THANK YOU INTERVIEW

Sending a thank-you email within 24 to 48 hours of seeing the inter-

viewer is often a good idea.

Each organisation is unique. Some businesses might do just one inter-

view. Others, like BetterUp, could do many rounds of interviews.

Regardless, you ought to send a thank-you note after every meeting

with a new interviewer. Say Maria recently spoke with a recruiter on
the phone about a marketing position. The next step would be for her
to meet the team because she is interested in the position.

She discovered during the phone interview that her skills exactly fit
the position. She also gained additional knowledge about the corpo-
rate culture and career prospects. After her phone interview, Maria
chooses to write a thank you follow-up email since she is anxious to
learn what comes next.

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YOU’RE WAITING TO HEAR IF YOU’VE MADE IT TO THE NEXT

ROUND

This response most likely will not suit your tastes. However, you need
to be patient as you wait to find out if you have advanced to the next
round of interviews. It may be irritating in this situation.

But it will take time if there are several contenders in the running.

Consider your personal experience first. There may have been tele-
phonic interviews or emails regarding recruitment. Recall how many NOTE
individuals you may have already spoken to during interviews. An interview process is
a multistep practice that
Now increase it by the number of candidates for the position. Addi- companies use to screen
tionally, double it on the recruiter’s end by any available positions candidates from a larger
pool. It allows managers and
they might be hiring for.

S
company stakeholders to gauge
if candidates are a good fit for
Say David has just finished his first interview with the hiring manager their company.
and the recruiter. He was first informed by the recruiter that there
would be three rounds of interviews. With the VP of the team comes
IM
the third and final round. David just finished his interview with the
recruiting manager two days ago.

After the interview, he already wrote a thank-you message, so he

chooses to be patient while waiting to hear about the next round. He
speaks with his coach, who advises him to hold off on following up for
at least a week.
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It’s OK to send a follow-up message if you have not heard back from
them after 7–10 days. You may even request feedback from the inter-
view. But make an effort to be patient.
N

YOU’RE WAITING FOR THE FINAL DECISION AFTER A JOB

INTERVIEW

Theoretically, it should not take long for businesses to decide on this.

If you have gone through all the interview stages, you are aware that
they like you. They are intrigued, but they have probably only selected
a small number of final applicants.

With the final round of applicants, the schedule will probably be the
deciding factor. Let us imagine that the final round has been reached
by three contestants, including you. You may be the first applicant to
have successfully passed the last round of interviews. Behind you, two
additional applicants could be conducting interviews.

It should not take long for the business to choose after all of the can-
didates have finished the last round of interviews. It is OK to inquire
about the number of candidates participating in the last round of
interviews from the recruiter. You can get a better idea of the time-
frame by doing that.

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Assume Arianna has finished the three interviews for the post of a
software engineer. She breezed through the first and second rounds
with ease. However, setting up the third round with the team’s director
required more time. Before her third and final interview, she enquired
as to the number of applicants. Arianna discovered that there was only
room for one contestant.

Her last interview, which was also a working interview, was just a day
ago. Arianna chooses to wait it out in the hopes of receiving a response
soon. Unsurprisingly, Arianna gets a call from the recruiter on day
four with a job offer.

Send a follow-up email if you have not heard anything after 7 to 10

days. After the interviews are over, perhaps you will hear relatively

S
quickly; that is always a positive indication! Keep your head up if you
have not received anything back from your follow-up email yet. There
are several options available. You will discover the best person to
assist you in realising your greatest potential.
IM
12.4.6 SELECTING A FIRM

You want to work for a company that offers a positive work atmo-
sphere, partners who are available to answer any concerns you have,
mentors throughout the company, an increased salary to help pay off
that hefty school loan and the opportunity to advance reasonably rap-
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idly.

Keep in mind that the field you have selected has expectations that,
when you sit and think about them, could appear intimidating. A sig-
nificant element is often a rise in total remuneration. The long-term
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potential, however, is more important than the initial starting remu-

neration. If you get the invitation, you should at the very least under-
stand the lockstep associate ranges and, more importantly, the part-
nership chances.

BALANCING WORK AND LIFE IS ALWAYS CHALLENGING

Regardless of the business, you select. It appears that the moment

you decide to establish a family is also the time when business in
the legal profession is briskest. You have made a challenging career
choice. Years, when you establish and raise a family, are directly and
significantly at odds with years when you learn your trade, hone your
speciality, get acceptance, get promoted and forge relationships with
clients. What you can do is talk about the decisions you will make with
your life partner to handle the process as efficiently as possible. U.S.
News & World Report also offered some advice on how to deal with
workplace stress.

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DO NOT ASSUME THAT SIZE ALWAYS MATTERS

Do not expect that working for a smaller legal firm entails a few hours
and workplace kumbaya. Many lawyers who transition from large firms
to smaller ones are horrified to discover that the hours and demands
remain the same. They are further troubled to discover that what they
mistakenly believed to be a millennial workplace with group hugs and
unlimited kombucha on tap is a place where the need to produce is of
utmost importance. To that purpose, in-house positions can demand
longer hours and lower pay than those at legal firms. This knowledge
is not easily accessible through online sources or self-praise. A skilled
recruiter will be aware of the variations in expectations between dis-
tinct career paths.

CHOOSE A FIRM BASED ON THE PEOPLE

S
Choose a company depending on the staff. Although the structural
elements are useful, it is ultimately up to the decision makers to deter-
mine where you belong inside the system. When you are asked to join
IM
the partnership, it does not matter if a company has $4 million in PPP.
If you are a person who stands out and is appropriately acknowledged,
you could be better suited to work for a company with considerably
lower metrics.

There is simply no way to adequately describe the advantages and

drawbacks of parenting for those of you who are not parents but antic-
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ipate becoming one in the future. You will never have a career more
gratifying or hard than this one. It is intriguing, unexpected, time-con-
suming, taxing and stressful. And that’s only in the initial days follow-
ing the hospital discharge of a child. Leaving aside the times of amaze-
ment and awe, it is also demanding and challenging. Your eyelids may
hurt on some days. There are certain evenings when it is impossible to
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distinguish between the pressures of a job and motherhood. You will

go through restless nights and difficult days.

What then is the lesson of the tale? There is no such thing as a flawless
firm, and anyone who claims there probably just wants to sell you a
bridge and is not trustworthy. The better choices are more in line with
your professional objectives, nevertheless. To discuss your unique
goals and how to develop a custom strategy that meets your needs, get
in touch with one of our knowledgeable recruiters right now.

12.4.7 SELECTING A GROUP

Group interviews are widespread in many professions and save time

for hiring managers. They can be set up in several ways. One appli-
cant may be interviewed by a group of interviewers, or a single inter-
viewer may speak with numerous candidates at once.

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Learn more about the many types of group interviews that occur, the
questions to anticipate and how to succeed in an interview.

TYPES OF GROUP INTERVIEWS

There are two types of group interviews, i.e., Panel Interviews and
Group Interviews.
‰‰ Panel Interview: Depending on which of the two types of group
interviews you attend, your experience will change. Both can be
difficult for applicants.
In one kind of group interview, an applicant is met and interviewed
by several interviewers (also known as a “group” or “panel”). A
representative from human resources, the manager and sometimes

S
staff members from the division where you would work if recruited
are frequently on the panel.
‰‰ Group Interview: In a different variation, one interviewer con-
IM ducts simultaneous interviews with many candidates (typically
the hiring manager). In such a case, you and the other applicants
would go through a group interview process. A group interview
may occasionally use both methods. A panel of interviewers may
ask you a series of questions with several other applicants.

SELF ASSESSMENT QUESTIONS

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4. The researcher determines the interviewer’s training, the

amount of time allotted for the interview and the interview
location. Which of the following option is correct regarding
the above statement?
N

a. Preparation of interview schedule

b. Plan
c. Pilot test of the schedule
d. Conducting the interview
5. Pre-testing the interview questions is advised before the
actual interview process begins.
Which of the following option is correct regarding the above
statement?
a. Pilot test of the schedule
b. Conducting the interview
c. Both a and b
d. None of these

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 Recruiting, Interviewing and Selection  411

ACTIVITY

Write some more questions asked in an interview.

12.5 INVESTMENT BANKING

Investment banking is a branch of banking that coordinates massive,
intricate financial transactions like mergers or the underwriting of
Initial Public Offerings (IPOs). In addition to underwriting the issuing
of new securities for a corporation, municipality or other entity, these
banks may raise money for businesses in several other ways. They
might oversee an organisation’s Initial Public Offering (IPO). They will
offer guidance on reorganisations, mergers and acquisitions. Invest-
ment bankers are professionals who are acutely aware of the state of

S
the market for investments. They assist their clients in navigating the
difficult high finance industry.

Investment banks deal with the selling of securities, mergers and

IM
acquisitions, reorganisations and broker transactions for both insti-
tutions and individual investors. They also underwrite new debt and
equity securities for all kinds of firms. Investment banks advise issu-
ers on the offering and placement of stock as well.

The largest include Goldman Sachs, Morgan Stanley, JPMorgan

Chase, Bank of America Merrill Lynch and Deutsche Bank. Numer- NOTE
M

ous significant investment banking systems are subsidiaries or affili- Investment banking is a type of
ates of bigger financial organisations. banking that organises large,
complex financial transactions
Investment banks often support significant, complex financial trans- such as mergers or Initial Public
actions. If the investment banker’s client is considering an acquisi- Offer (IPO) underwriting.
tion, merger or sale, they could offer guidance on how much a firm
N

is worth and the best way to organise a deal. In addition to these ser-
vices, investment banks may also issue securities to raise funds for
their clientele and prepare the paperwork required by the Securities
and Exchange Commission (SEC) for a firm to go public.

Businesses and institutions turn to investment banks for advice on

how to best plan their development because, in theory, investment
bankers are experts who have their finger on the pulse of the current
investing climate. Investment bankers can tailor their recommenda-
tions to the current state of economic affairs.

SELF ASSESSMENT QUESTIONS

6. Which of the following is a branch of banking that coordinates

massive, intricate financial transactions like mergers or the
underwriting of Initial Public Offerings (IPOs)?
a. Investment banking b. Financial institutions
c. Financial activities d. All of these

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412 FINANCIAL MODELLING

ACTIVITY

Find some features of investment banking.

12.6 SELECTION
The two phases of personnel practices and processes, recruitment and
NOTE selection, work in tandem. Any effort required to generate enough
Investment banking is a special applications for a given post so that there is a chance for meaning-
segment of banking operation ful selection constitutes recruiting. Three typical sources are used to
that helps individuals or fill positions: job postings, employment exchanges or private employ-
organisations raise capital and ment agencies and current workers. Additionally, deputations, casual
provide financial consultancy
services to them. They act as
applications, unions and educational institutions are also used. The

S
intermediaries between security process then moves on to assess each candidate’s background and
issuers and investors and help credentials to make a decision. As has been stated many, selection
new firms to go public. fundamentally involves choosing the employees who are most suited
to the organisation’s needs.
IM
Because the selection of unskilled or semi-skilled personnel for cer-
tain professions does not provide many difficulties, a complex selec-
tion process is not necessary. However, a complex selection process
has been recognised to be necessary for supervisory, higher-level and
specialised employment, notably in public undertakings, private firms
and industries and it is now being implemented. Depending on the
context and requirements of the organisation, as well as the level at
M

which the selection is made, different organisations have different

selection techniques and procedures.

In most cases, the selection process will start with a screening inter-
NOTE view and end with the choice to hire. Seven phases typically make
N

A systematic and accurate up the selection process: an initial screening interview, filling out an
occupational information is
necessary before the employees application, employment tests, a complete interview, a background
can be recruited, selected or check, a physical exam and a final hiring decision. Each of these
placed on the job. phases is a decision point that must receive approval for the process
to move forward. Every stage of the hiring process aims to deepen
the organisation’s understanding of the candidate’s background, skills
and motivation and it does so by supplying more data on which deci-
sion-makers may base their forecasts and make their ultimate pick.

Utilising application blanks with pre-structured and pre-determined

questions is a crucial selection approach. Name, residence, age, mar-
ital status, number of dependents, education level, work history and
references are the primary pieces of information sought on applica-
tion blanks. The other fields on the application forms differ greatly
between organisations and jobs.

These application blanks serve the twin purposes of introducing the

applicant and assisting the interviewer by posing questions and spark-
ing conversation.

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 Recruiting, Interviewing and Selection  413

Application blanks are used for the following things:

1. They provide the candidate with their official first introduction
to the business. Know More
2. They produce data in consistent forms, making it simple to cross- After a complete job analysis,
compare candidates. the planning of a recruitment
programme can be done.
3. The information so produced might be used as the starting point
for an interview discourse.
4. Information provided in the application’s blank can be utilised
for personnel analysis and research.

The majority of application blanks appear to include personal infor-

mation, marital information, physical information, educational infor-
mation, employment information, extracurricular information and

S
references, although the information requested may vary depending
on the level of the position and the organisation. There are two types
of formal application blanks:
1. Preliminary application blanks, which merely ask about an
IM
applicant’s personal and educational background and work
experience, assist the employer in determining if a candidate
qualifies for the first round of hiring. These are used to narrow
down the pool of candidates for further consideration.
2. Applicants who have been selected for further consideration after
a preliminary screening are asked for highly specific information
M

in the thorough application forms. Creating a thorough profile

of the applicant and identifying topics that need to be further
investigated in the interview to determine the applicant’s fit for
the position are the goals of this application blank.
N

12.6.1 HOW TO HIRE FINANCIAL ADVISORS

As managing personal finances and retirement planning become more

crucial for people and families, the demand for financial planning ser-
vices keeps rising. Both financial job forums and sites for general job
postings may be used to find top financial advisers.

A step-by-step manual for locating the best financial experts for your
company. consists of a thorough recruiting procedure that will assist
you in finding and hiring the top financial advisers quickly.

The following are the step-by-step procedure to hire financial advi-

sors:
‰‰ Write the perfect financial advisor job description: Attracting
the best ones to your company is no easy task in a financial advi-
sor’s market where the number of vacancies far exceeds the num-
ber of financial advisors. The job description you advertise needs

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414 FINANCIAL MODELLING

to achieve a number of goals in order to position your business as

a top place for financial advisors.
These include:
 Providing a rewarding pay structure that combines a base sal-
ary and commission.
 Flexibility with regard to the necessary experience. Place a fo-
cus on a recruiting strategy that gives potential and mentoring
more weight than professional experience.
 Presenting your position in the market to candidates. Finan-
cial advisors may join you if you hold a dominant position in a
particular niche.
 Highlighting the marketing strategy you use, which financial

S
advisors can use to increase leads and sales.
 Promoting your group. Your position will be strengthened by
having a diversified team that includes in-house attorneys, in-
IM surance experts, and any other beneficial resource your finan-
cial adviser can access.
 Examining the prospect of providing stock ownership. The pos-
sibility of increased control within a company and increased
long-term financial benefit may influence elite, seasoned finan-
cial counsellors. You should only make this offer to exceptional
prospects.
M

 Assuring elder financial advisers that, should they want to re-

tire with the firm, their customers would be looked after. This
is a lovely, thoughtful addition.
A thorough process that demands effort on the part of the can-
N

didate is found to be the best predictor of success. The hiring

process for a financial advisor can take between three and six
months.
‰‰ Appeal to millennials: In the next 10 years, 35% of financial advis-
ers are expected to retire. The next generation of financial advis-
ers will be heavily dominated by millennials, suggesting a minor
shift in how financial institutions acquire new employees.
Use the following hiring principles to appeal to millennial financial
advisors:
 Keep your technology up to date to guarantee that your finan-
cial advisors are using the best resources available. Offering
millennials the newest tools to work with will help you get the
most out of them because they will view fintech as being cen-
tral to their professional lives.
 Provide ongoing training after their first year of strong mento-
ring. To exchange knowledge and fresh ideas, pair up younger
and more experienced advisors.

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 Recruiting, Interviewing and Selection  415

 Appeal to their ambition by highlighting opportunities for pro-

fessional advancement. Over time, give them more freedom
and authority. The length of time a new financial advisor re-
mains with your company may depend on the possibility of fu-
ture job advancement.
 Increase the flexibility of their work schedules and foster a
more social workplace.
 Be socially conscious and explicit about your company’s cul-
ture and values.
 When you first join the company, don’t put too much empha-
sis on short-term objectives like acquiring new customers and
assets.

S
‰‰ Use a financial advisor job description template to make it eas-
ier: Much of the boilerplate information you’ll need, like responsi-
bilities and qualifications, will be provided by a financial advisor
job description template, making your task a little bit easier.
IM
‰‰ Post your job: The following are the steps for posting your job:
 Post your job to general sites, such as Indeed: Start by adver-
tising your position on cost-free, popular websites like Indeed.
These are excellent starting points since they are both free and
get a lot of traffic.
 Make sure your job ad is recognised by Google: You should
M

also check to see whether Google for Jobs has indexed your
website, since this will assist your job ad appear in Google’s
search results. By having it correctly structured on your web-
site or by employing a service (like Betterteam) that automati-
cally generates a properly prepared jobs page for you, you may
N

have it picked up by Google.

 Target dedicated job boards for financial advisors: The next
thing you should do is focus on financial advisor-specific job
boards. By doing this, you will limit your search to applicants
who browse niche job boards. To post job openings and hire a
financial advisor, use a job board for financial professionals.
 Partner with colleges to hire finance students: Establishing
partnerships with prestigious business schools and colleges is
your best option if you’re considering hiring new talent straight
out of college:
99 Begin by concentrating on business schools in your state or
the whole country.
99 Speak with the campus career services office at each insti-
tution to discuss developing collaboration.
99 Enquire about attending campus job fairs, and think about
supporting events and fairs.

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416 FINANCIAL MODELLING

99 Establish close ties with top business schools by supporting

student organisations like fraternities and clubs focused on
finance and investing.
99 Discuss the process of setting up a financial advisory in-
ternship with their school with the campus career service
office.
99 Make strong connections with the academic staff and pro-
fessors who teach finance. They are your best resource for
spotting students with potential.
 Develop an internship program: The best way to select the
top students to mentor and train as potential financial advisors
for your company is through internships:

S
99 Include an internship in the degree curriculum for finan-
cial students.
99 Comply with your state’s legal internship obligations, such
IM as paying the minimum salary and providing workers’ com-
pensation. States have different laws.
99 Find out if your internship qualifies for college credit by
speaking with your partner college. This will encourage
students even more to look for internships.
99 Announce your internship at job fairs on campus.
M

99 Conduct interviews with candidates, and then choose the

best ones.
99 Treat their internship the same way you would any other
N

job. Assign resources to them, give them a thorough on

boarding, and create a sense of care for them.
99 Make sure the internship is organised appropriately and
promote its educational advantages. Give tasks and daily
obligations, as well as explicit learning objectives and goals.
These might include doing investment research, revising
financial projections, going through client notes, and more.
99 Decide on a period of time equal to a semester. Internships
throughout the summer are another option.
99 Promote your interns as spokespersons who highlight the
advantages of an internship in financial advice with you.
99 Request recommendations from other deserving college
students from your interns.
99 If their internship is a success, give your interns the option
of full employment.

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 Recruiting, Interviewing and Selection  417

‰‰ Screen your prospective financial advisors: The following are the

steps for screening your prospective financial advisors:
 Administer tests: The most reliable approach to evaluate a
candidate’s aptitude for problem-solving and salesmanship—
two traits that are often seen as indications of effective finan-
cial advisors—is via a test.
The critical thinking, problem-solving, and attention to detail
of a financial adviser are assessed with a Criteria Cognitive Ap-
titude Test (CCAT).
A Sales Achievement Predictor (Sales AP) test evaluates a can-
didate’s competitiveness, initiative when making cold calls, and
sales closing skills. Financial advisors must act as salespeople
in order to convince customers to use their services. This exam

S
is a useful indicator of a candidate’s aptitude for working with
clients.
For financial advisors, these tests have been shown to be bet-
ter success predictors than interviews and years of experience;
IM
however, your best option is to use them in addition to your
interview process.
 Send screening questions via email: A fair screening process
that is rigorous but not overly demanding on the candidate is
required when hiring a financial advisor. Start by sending a
brief email that includes a few fundamental inquiries, like:
M

99 Approximately how long have you been a financial advisor?

99 Do you currently hold a Series 7 and Series 63 Securities

Registration from FINRA?
99 How many customers did you have at your previous posi-
N

tion?
This is a useful tactic for eliminating unqualified candidates.
You might want to try assigning someone to make brief phone
calls to your applicants to ask these questions if you’re con-
cerned that they won’t respond to an email.
 Conduct background checks: After you’ve selected a smaller
group of candidates, you must run background checks to con-
firm information such as their employment history, application
information, criminal record, and more. Check out our guide to
the top services for new hire background checks.
‰‰ Conduct interviews: The following are the steps for conducting
the interviews:
 Conduct phone interviews: Everyone engaged needs a lot of
time for in-person interviews. Short phone interviews may be
scheduled, and you can find out right away which applicants
need more of your time.

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418 FINANCIAL MODELLING

Check the candidates’ responses to the screening questions to

determine whether they are consistent, see if their expecta-
tions for pay and benefits align with yours, and learn why they
left their prior employer.
The following are the example questions:
99 Why did you decide to work in financial consulting?
99 Why did you quit your prior position as a financial advisor?

99 What benefits and pay are you anticipating?

99 At what point could you begin?
99 What made you interested in this job?
Use this procedure as a chance to spot warning signs. The ap-

S
plicant won’t be a suitable match if they left their former posi-
tion due to problems that you are aware would exist in the po-
sition you are offering, such as a lack of a higher compensation
or lack of access to superior marketing tools.
IM
If a prospect meets your criteria at this stage, be sure to go
through the job’s highlights with them and ask if they have any
more questions. Keep pitching the position since they could be
considering alternative offers.
Investigating a candidate’s motivations for wanting to become
a financial adviser might be helpful. A strong motivation for
M

becoming a financial adviser is often having first-hand experi-

ence with the effects of poor personal finance. This experience
is also a sign of a candidate’s commitment to providing solid
financial advice.
Additionally, it lessens the possibility that they may get disin-
N

terested in their work and leave early. Perhaps they saw their
parents making poor financial choices when they were young,
imbuing them with a feeling of obligation that goes beyond the
requirements of their position. These are often indicators of
strong applicants.
 Conduct in-person interviews: A face-to-face interview will
give you insight into how you’d work with them, their client-fac-
ing and communication skills, and how they’ll fit in with the
rest of your staff. At this point, you should have the majority of
the information you need to determine whether a candidate is
the right fit for your company.
The following are the example questions:
99 A customer wishes to begin a retirement fund. What advice
would you give them?
99 How would you explain complicated financial terms to a
client who had no prior experience with the industry?

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 Recruiting, Interviewing and Selection  419

99 What arguments would you use to convince a client who

was hesitant to begin an investment portfolio?
99 A customer wishes to establish his children’s college fund.
What advice would you give him?
More importantly, it’s an opportunity to keep pitching them
on the job. Introduce them to co-workers, show them around,
go over their justifications for accepting the position, and re-
iterate the advantages you have to offer. For helpful interview
questions, take a look at our list of financial advisor interview
questions.
Your questions should evaluate their approach to closing busi-
ness, ascertain how they behave under duress, and give them a
chance to show off their familiarity with financial markets and

S
products.
‰‰ Hire a new financial advisor: The following are the steps for hir-
ing a new financial advisor:
 Make
IM
an offer: You’ve discovered how to find a financial advi-
sor who fits your company, so you’ll want to extend an offer to
them as soon as possible to get them off the market before an-
other company does. The best way to handle this is frequently
to start with a casual phone call and then follow up with a letter
or email outlining the position, its compensation, and its ben-
efits.
M

 On-board your new financial advisor: The employment pro-

cess’s crucial last stage, on boarding, should not be skipped. A
thorough and well-organised on boarding procedure can help
you make a strong first impression and get your new recruit up
and running quickly.
N

SELF ASSESSMENT QUESTIONS

7. The process then moves on to assess each candidate’s

background and credentials to make a decision. Which of the
following option is correct regarding the above statement?
a. Recruitment
b. Selection
c. Both a and b
d. None of these

ACTIVITY

Discuss the process of selection in an interview.

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420 FINANCIAL MODELLING

S 12.7 SUMMARY
‰‰ The creation and upkeep of suitable workforce sources is recruit-
ment. It entails building a pool of readily accessible human
resources that the organisation may use to draw from when it
needs more workers.
‰‰ Recruitment is the process of luring candidates to open positions
in an organisation who possess particular qualifications, aptitudes
and personality traits.
‰‰ People chosen for the organisation based on criteria other than
merit would not fit in well and cause several issues for both the
company and the other employees.
‰‰ The process begins with recruitment and moves through selec-

S
tion and placement before coming to an end. Manpower planning
is the initial stage in the procurement function, and recruitment
comes after that.
IM
‰‰ The organisation can recruit the individuals it needs in the num-
bers and demographics it needs. Finding possible candidates for
current or future organisational openings entails recruiting.
‰‰ Although people management has been practised for about 70
years, its significance has just lately undergone a significant shift.
There are now several levels of bureaucracy due to the complexity
and size expansion of the majority of organisations.
M

‰‰ Financial activities are a crucial component of any economy, and

consumers and businesses rely on financial institutions for trans-
actions and investments.
‰‰ The interview is a crucial stage in getting a job and frequently
N

relies on your ability to sell yourself. Do not let a lack of planning

and practice cause you to lose out on a fantastic opportunity for
which you are eligible.
‰‰ Researchers that use qualitative methods aim to comprehend
phenomena that statistics alone cannot fully capture. Qualitative
research, although frequently referred to be a soft scientific tech-
nique, aids in a complex understanding of people.
‰‰ Every company and employer are unique. The recruiter and you
may communicate during the interview process. Alternatively, you
might speak with the recruiting manager directly.
‰‰ Group interviews are widespread in many professions and save
time for hiring managers. They can be set up in several ways. One
applicant may be interviewed by a group of interviewers, or a sin-
gle interviewer may speak with numerous candidates at once.
‰‰ The two phases of personnel practices and processes, recruitment
and selection, work in tandem. Any effort required to generate

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 Recruiting, Interviewing and Selection  421

enough applications for a given post so that there is a chance for

meaningful selection constitutes recruiting.

KEY WORDS

‰‰ Communication: An act of giving and receiving information to

different people through various mediums
‰‰ Entrepreneurial: A person who launches their firm or is adept
at spotting new revenue streams
‰‰ Networking: Interaction with others for knowledge sharing
and forming social or professional connections
‰‰ Recruitment: The active search for discovery of and employ-
ment of applicants for a certain post or job

S
‰‰ Workforce: The individuals employed or available for labour,
whether in a nation or region, a specific business or sector
IM
12.8 MULTIPLE CHOICE QUESTIONS
MCQ
1. Which of the following is the most common resource or instrument
utilised in social casework?
a. Selection
b. Recruitment
M

c. Interviewing
d. Both a and b
2. A skilled investment banker should be ready to appraise the
market, the industry and the company concept fast. Which of the
N

following statement is correct regarding the above statement?

a. Analytical skills
b. Intellectual abilities
c. Skills in communication
d. Management and leadership abilities
3. Investment bankers frequently have to provide extremely
demanding customers with extensive analyses of company
endeavours and investment plans. Which of the following
statement is correct regarding the above statement?
a. Analytical skills
b. Entrepreneurial skills
c. Networking skills
d. None of these

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422 FINANCIAL MODELLING

4. Candidates must be able to manage unusual situations and

sustain positive client connections. Which of the following
statement is correct regarding the above statement?
a. Entrepreneurial skills
b. Management and leadership abilities
c. Skills in communication
d. Networking skills
5. The interviewer is also paying attention to the session’s schedule
of questions and other details. Which of the following option is
correct regarding the above statement?
a. Plan

S
b. Pilot test of the schedule
c. Preparation of interview schedule
IM d. Conducting the interview
6. An employer and you converse during the interview to share
information. Which of the following option is correct regarding
the above statement?
a. Qualitative/fit questions
b. Technical questions
M

c. General interviewing overview

d. None of these
7. Candidates are evaluated through technical interviews for
N

careers in IT, engineering and science. Which of the following

option is correct regarding the above statement?
a. After the interview
b. Technical questions
c. Both a and b
d. None of these
8. The majority of application blanks appear to include
a. Personal information
b. Physical information
c. Both a and b
d. None of these

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 Recruiting, Interviewing and Selection  423

9. Which of the following information is used for application

blanks?
a. They provide the candidate with their official first introduc-
tion to the business.
b. They produce data in consistent forms, making it simple to
cross-compare candidates.
c. The information so produced might be used as the starting
point for an interview discourse.
d. All of these
10. Information provided in the application’s blank can be utilised
for __________.

S
a. Provide the first introduction
b. Compare candidates
c. Interview discourse
IM
d. Personnel analysis

12.9 DESCRIPTIVE QUESTIONS

?
1. Describe the concept of recruiting and interviewing?
2. What do you mean by financial institutions?
M

3. Discuss the concept of selection.

HIGHER ORDER THINKING SKILLS

12.10
(HOTS) QUESTIONS
N

1. Which of the following is the recruitment’s goal?

a. Verify if the cost and benefit are equal.
b. Decrease the number of candidates who are overqualified or
underqualified for the position to help the selection process
succeed more often.
c. Assist the company in hiring a more ethnically diverse work-
force.
d. None of these
2. Which of these is the most significant outside influence
influencing hiring?
a. Sons of the soil
b. Labour market

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424 FINANCIAL MODELLING

c. Unemployment rate
d. Supply and demand
3. Which of the following acts addresses hiring and selecting
employees?
a. Child labour act
b. The apprentice’s act
c. Mines act
d. All of these

12.11 ANSWERS AND HINTS

S
ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

IM
Recruiting and Interviewing 1. a. Human capital

Financial Institutions and 2. b. Financial activities

Investment Banks

3. c. Financial institutions

Process of Interviewing 4. b. Plan

M

5. a. Pilot test of the schedule

Anything you ever wanted to 6. a. Investment banking

know about investment banking
N

Selection 7. b. Selection

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. c. Interviewing
2. b. Intellectual abilities
3. a. Analytical skills
4. d. Networking skills
5. d. Conducting the interview
6. c. General interviewing overview
7. b. Technical questions
8. c. Both a and b
9. d. All of these
10. d. Personnel analysis

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HINTS FOR DESCRIPTIVE QUESTIONS

1. Although people management has been practised for about 70
years, its significance has just lately undergone a significant
shift. There are now several levels of bureaucracy due to the
complexity and size expansion of the majority of organisations.
All businesses and organisations are aware of the rising cost
of labour. A strategic human resources management concept
has recently been created by scholars. Refer to Section 12.2
Recruiting and Interviewing
2. Financial activities are a crucial component of any economy,
and consumers and businesses rely on financial institutions for
transactions and investments. As a result, financial institutions
provide services to the majority of people. The government views

S
the supervision and regulation of banks and other financial
institutions as essential due to their crucial role in the economy.
Financial institution failures have, in the past, led to panic. Refer
to Section 12.3 Financial Institutions and Investment Banks
IM
3. The two phases of personnel practices and processes, recruitment
and selection, work in tandem. Any effort required to generate
enough applications for a given post so that there is a chance
for meaningful selection constitutes recruiting. Three typical
sources are used to fill positions: job postings, employment
exchanges or private employment agencies and current workers.
Refer to Section 12.6 Selection
M

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
N

1. b. Decrease the number of candidates who are overqualified

or underqualified for the position to help the selection pro-
cess succeed more often.
2. d. Supply and demand
3. d. All of these

SUGGESTED READINGS &

12.12
REFERENCES

SUGGESTED READINGS
‰‰ Benninga, S. and Mofkadi, T., 2022. Financial Modeling. Cam-
bridge: MIT Press.
‰‰ Häcker, J., Kleinknecht, M., Plötz, G., Prexl, S., Röck, B., Ernst, D.,
Bloss, M. and Dirnberger, M., n.d. Financial Modeling.
‰‰ Pfaff,
P., 1990. Financial modeling. Needham Heights, Mass.: Allyn
and Bacon.

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426 FINANCIAL MODELLING

E-REFERENCES
‰‰ Meirc Training & Consulting. 2022. Recruitment, Interviewing
and Selection - Meirc. [online] Available at: <https://www.meirc.
com/training-courses/human-resources-training/recruitment-in-
terviewing-selection> [Accessed 11 October 2022].
‰‰ UniversalClass.com. 2022. How to Recruit, Interview and Select
the Right Employees for Your Company. [online] Available at:
<https://www.universalclass.com/articles/business/how-to-re-
cruit-interview-and-select-employees.htm> [Accessed 11 October
2022].
‰‰ SHRM. 2022. Recruitment and Selection Process. [online] Avail-
able at: <https://www.shrm.org/resourcesandtools/tools-and-sam-
ples/policies/pages/cms_000582.aspx> [Accessed 11 October 2022].

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 CASE STUDIES
10 TO 12

CONTENTS

Case Study 10 Financial Modelling OOVA

Case Study 11 Burke Marketing Services, Inc.
Case Study 12 Which is More Important – Recruiting or Retaining?

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428 FINANCIAL MODELLING

CASE STUDY 10

FINANCIAL MODELLING OOVA

Problem: Financial estimates based on research and presented in

Case Objective a form that investors can comprehend are necessary for a founder
This case study highlights the seeking to raise a seed round.
financial estimates.
The CEO and co-founder of OOVA, Amy Divaraniya, saw a mar-
ket need for a reproductive diagnosis kit that brought a clinic’s
precision into your house. But while she was attempting to com-
plete her seed round by pitching investors, she discovered that
the financial predictions required a second set of eyes. When dis-
cussing financial estimates, Divaraniya said, “I thought they were
poor. They lacked data to support them. Additionally, it was pre-
sented in a way that I could comprehend, but VCs were not used

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to seeing it.

Divaraniya had excellent connections with other start-ups, but

she was unable to get a quality template. The one thing no one
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wants to discuss is that. Even if she did, Divaraniya believed she
lacked the knowledge necessary to base her judgement on facts
and reasonable assumptions. “What might I expect in terms of
legal fee growth? Taxes? How does a CAC for a business like ours
typically look? What makes us different?

Solution: A financial model that is very flexible and logical, with

all of its assumptions supported by research.
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HOW DIVARANIYA FOUND THE RIGHT CONSULTANT

Divaraniya saw that Toptal also provided financial advice while

working with a Toptal developer in 2018. She came to the conclu-
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sion that it was time to act, so she started interviewing potential

candidates.

During the interview, Divaraniya picked Jeffrey Fidelman from

a list of two consultants with relevant backgrounds that the Top-
tal matching team had chosen. “With Jeffrey, he recognised my
needs. Have you given these ideas any thought? He would in-
quire. Someone had previously questioned me about everything
he stated, but I hadn’t given it any thought.

He really grasped my needs rather than my requests.

QUICK KICK OFF PROCESS

Fidelman integrated himself into the process right away. “He sup-
plied an example of a financial estimate over the weekend after
the interview, which took place around the end of the week. With-
in a few hours over the weekend, he answered to every message.
Next a launch call on Monday, they spoke at least twice a week

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 Case study 10: Financial Modelling OOVA 429

CASE STUDY 10

over the following several weeks. Divaraniya had a functioning

model in around two weeks.

UNDERSTANDING THE BIGGER PICTURE, NOT JUST THE

“ASK”

The initiative may have stopped there, but Fidelman’s further

inquiries revealed more gaps that Divaraniya wished to remedy
with her funding. Divaraniya also came to the realisation that her
model needed flexibility so she could examine the effects of varied
tactics (e.g., various distribution models). Divaraniya spent more
time working with Fidelman than she anticipated since she first
assumed she just needed a simple financial model. In the end, she
had six reports totaling around 25 pages each that supported each

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assumption in addition to a highly flexible financial model.

A FLEXIBLE FINANCIAL MODEL

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Both Fidelman and Divaraniya were still figuring out the ideal
sales channel strategy for OOVA at the time Fidelman was de-
veloping the financing model. We continued to work on product
development at the same time. The sales strategy keeps evolving.
Do we need to charge affiliate fees? One-time costs Jeffrey was
quite adaptable. With the model he developed, we could still make
it work regardless of what I selected. When Divaraniya settled on
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a model, Fidelman created an assumptions tab with all the sales

techniques she was contemplating so she could just put them in.

MARKET RESEARCH TO CREATE FACT-BASED FINANCIAL

MODEL INPUTS
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The quality of your model depends on its inputs. Fidelman sought

to produce a model that was as accurate to the business as fea-
sible. The topline numbers required considerable investigation;
however the expenditure side was rather simple. Fidelman used
his network to get answers to inquiries like: What is the typical
markup? What is the US fertility market size? “Yes, it’s consumer
items as well as health technologies. So a lot of my study included
things like heart rate monitoring, baby monitors and birth con-
trol, said Fidelman.

Fidelman conducted research on OOVA’s distinctive market posi-

tion. “Yes, it is tech-enabled. However, as they are still ovulation
sticks, you’ll probably need to replace them. Where can I get this
OTC? Would it fall under the heading of “Personal Care/Family
Planning”? Will the pharmacy’s front desk have it? We had to give
the people we wanted to sit with some serious thought.

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430 FINANCIAL MODELLING

CASE STUDY 10

RESULTS

OOVA was able to close its seed round with the help of a flexible
finance strategy built on extensive market research.

Divaraniya was able to complete her seed funding round with the
use of a flexible financial model and market analysis. “Discussions
with investors were a lot simpler. I felt like I could firmly stand on
my own two feet while fundraising.

QUESTIONS

1. Discuss the market need for a reproductive diagnosis kit.

(Hint: The CEO and co-founder of OOVA, Amy Divara-

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niya, saw a market need for a reproductive diagnosis kit
that brought a clinic’s precision into your house)
2. Discuss the quick kick off process in this case study.
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(Hint: Fidelman integrated himself into the process right
away. “He supplied an example of a financial estimate
over the weekend after the interview)
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 Case study 11: Burke Marketing Services, Inc. 431

CASE STUDY 11

BURKE MARKETING SERVICES, INC.

Burke is a full-service marketing research and decision support

firm that was founded in 1931. Burke uses cutting-edge research Case Objective
execution, innovative analytical approaches and cutting-edge This case study demonstrates
technology to give decision support solutions to businesses in all how Burke’s experimental
major industries. Burke provides a comprehensive range of re- design and subsequent
search services. analysis of variance aided
in making a product design
Burke Marketing Services, Inc. is one of the industry’s most sea- recommendation.
soned market research businesses. Every day, Burke writes more
proposals for more projects than any other market research firm
around the globe. Burke has a comprehensive range of research
capabilities, backed by cutting-edge technology and can answer

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practically any marketing query.

Burke was hired by a company to analyse possibly new versions

of a children’s dry cereal in one research. The cereal producer is
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referred to as the Anon Company to maintain anonymity. The fol-
lowing were the four important characteristics that Anon’s prod-
uct creators believed would improve the cereal’s taste:
1. Wheat-to-corn ratio in cereal flakes
2. Sweetener type (sugar, honey or artificial)
3. The presence or absence of fruit-flavoured flavour particles
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4. Cooking time (short or lengthy)

Burke devised an experiment to see how these four elements af-

fected cereal flavour. One test cereal, for example, was created
with a specific wheat-to-corn ratio, sugar as the sweetener, fla-
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vour bits and a short cooking time; another test cereal was made
with a different wheat-to-corn ratio but the other three elements
remained the same and so on. The cereals were then tasted by
groups of children, who gave their opinions on how they tasted.
Burke employs taste tests to gather statistical data on what people
desire from a product. The statistical method utilised to analyse
the data from the tests was an analysis of variance. The investiga-
tion revealed the following:

Flake composition and sweetener type had a significant impact

on taste evaluation. The flavour pieces detracted from the cere-
al’s taste. The taste was unaffected by the cooking duration. This
knowledge aided Anon in determining the parameters that would
result in the best-tasting cereal. Burke’s experimental design and
subsequent analysis of variance were useful in coming up with a
product design recommendation
Source: https://nscpolteksby.ac.id/ebook/files/Ebook/Accounting/Statistics%20for%20
Business%20and%20Economics%20(2011)/14.%20Chapter%2013%20%20Experimen-
tal%20Design%20and%20Analysis%20of%20Variance.pdf

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432 FINANCIAL MODELLING

CASE STUDY 11

QUESTIONS

1. Discuss the found year of Burke Marketing Services, Inc.

(Hint: Burke is a full-service marketing research and
decision support firm that was founded in 1931)
2. Describe the business of Burke Marketing Services, Inc.
in this case study.
(Hint: Burke Marketing Services, Inc. is one of the indus-
try’s most seasoned market research businesses. Every
day, Burke writes more proposals for more projects than
any other market research firm around the globe)

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 Case study 12: Which is More Important – Recruiting or Retaining? 433

CASE STUDY 12

WHICH IS MORE IMPORTANT – RECRUITING OR

RETAINING?

An innovative and well-known company in the electronics sec-

tor is Uptron Electronics Limited. It lured workers by providing Case Objective
high salaries, benefits and other incentives from internationally This case study highlights
renowned institutions and enterprises. An electronics Engineer the comparison between
vacancy has recently been advertised. There were around 150 recruiting and retaining.
applicants for the position. The 130 applicants who participated
in exams and interviews were narrowed down to Mr. Sashidhar,
an electronics engineering graduate from the Indian Institute of
Technology with five years of work experience in a medium-sized
electronics company. At his request, the interview panel suggest-
ed that his compensation be increased by 5,000 over his current

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income. Mr. Sashidhar was overjoyed to have done this and re-
ceived congratulations and good luck wishes from many people,
including his former company, for his outstanding interview per-
formance.
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Mr. Sashidhar enthusiastically joined Uptron Electronics Ltd. on
January 21, 2002. Additionally, he thought working for this organ-
isation in the early stages of his career was respectable. He also
thought his job was pretty pleasant and difficult. Both his super-
visors and his subordinates, in his opinion, were kind and helpful.
However, this climate was short-lived. After serving for a year, he
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gradually learned about a variety of unfavourable tales about the

business, the management, the relationships between superiors
and subordinates and the rate of employee turnover, particularly
at higher levels. However, he decided to remain because of the
promises he made to the management during the interview. By
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performing diligently, firmly committing to his commitment and

devoting himself, he hoped to win the management’s favour and
alter its attitude. The management believed Mr. Sashidhar had
made a commitment to the firm and had settled down when he
began to maximise his efforts.

After a while, Mr. Sashidhar began to feel disrespected by his su-

periors. He had too many different duties to do. It limited his abil-
ity to make decisions and carry them through. He was mistreated
in front of his subordinates on several occasions. His co-workers
began entrusting Mr. Sashidhar with their duties as well. As a re-
sult, his social, professional and familial lives were out of balance.
He appeared to be pleased and at peace, though. The manage-
ment team believed that Mr. Sashidhar could handle a lot more
organisational responsibility.

The General Manager was therefore taken aback when he dis-

covered Mr. Shashidhar’s resignation letter and a check for one

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434 FINANCIAL MODELLING

CASE STUDY 12

month’s salary one lovely morning on January 18, 2004, in his of-
fice. Mr. Sashidhar was not persuaded to rescind his resignation
by the general manager. On January 25, 2004, the General Man-
ager terminated his employment. The General Manager initially
intended to form a committee to investigate the situation right
away, but shelved the proposal.

QUESTIONS

1. Discuss the interview panel suggested about the compen-

sation in this case study.
(Hint: The interview panel suggested that his compensa-
tion be increased by 5,000 over his current income)

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2. Discuss the joining date of Mr. Sashidhar.
(Hint: Mr. Sashidhar enthusiastically joined Uptron Elec-
tronics Ltd. on January 21, 2002)
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