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Finance Modeling Guide

The document outlines the importance and applications of financial modeling in corporate finance, investments, and derivatives, highlighting its utility for various financial professionals. It details the financial modeling process, which includes problem conception, model construction, flexibility testing, and output summarization, along with five essential rules for effective spreadsheet design. Additionally, it discusses the use of Excel functions relevant to financial modeling, including financial, mathematical, conditional, text, and statistical functions.

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chanaka ashan
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5 views34 pages

Finance Modeling Guide

The document outlines the importance and applications of financial modeling in corporate finance, investments, and derivatives, highlighting its utility for various financial professionals. It details the financial modeling process, which includes problem conception, model construction, flexibility testing, and output summarization, along with five essential rules for effective spreadsheet design. Additionally, it discusses the use of Excel functions relevant to financial modeling, including financial, mathematical, conditional, text, and statistical functions.

Uploaded by

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

AND

FORCASTING

Prof Y.K.Weerakoon
Financial Modeling is useful for many
purposes
• Corporate: valuation, forecasting,
strategic planning, EVA measurement,
cash management, budgeting, ...
• Investments: securities analysis,
portfolio construction, analysis of risk-
return tradeoff, risk management, ...
• Derivatives: asset pricing, portfolio
insurance, Value at Risk analysis, ...
Who needs Financial Modeling

• Financial Controllers
• Managers
• Owners
• Financial analysts
• Present and potential investors
Uses of Financial Modeling
• Allows accurate decision making
• Less time consuming
• Easy to use
• Consistency in decision making
Financial Modeling Process
• Problem Conception
• Model Construction
• Flexibility Testing
• Output Summary
1.Problem Conception
“Understanding the purpose for a
model”
A spreadsheet is developed in order
to aid in the solution of a specific
problem.
Problem Conception Involves,
• Constructing a proper theoretical foundation
• Identifying, evaluating and documenting
assumptions
• Identifying input and output variables
Ex. What information must the user provide?
What results should the model produce?
Are there interim calculations?
2.Model Construction
It is the construction of a
spreadsheet.
It includes,
• Layout
• Prototyping
• Reporting
• Formatting
Layout
• Documentation area
a) Description of the problem
b) Solution
c) Instructions for using the model
• Input area
• Interim calculations
• Output area
Prototyping

Unique initial equations that tie the


inputs, interim and output areas
together
Verifying initial equation is crucial in
spreadsheet construction.
Reporting
• Display of pertinent results. A good
model displays in an easily
understood manner what the inputs
were, what interim values were
formed, and what results were
generated.
Formatting

• Include assigning the proper numeric


format, highlighting important results
and delineating separate spreadsheet
areas.
3.Flexibility Testing
• Does the model quickly adapt when
variables or assumptions change?
• Does the input area account for all the
necessary model inputs?
• Can a change in a prototype equation be
efficiently copied throughout the relevant
range?
• Can expansion or modification of the
input area be accomplished quickly?
• Does the model accurately account for all
facts of the problem?
• Is the model consistent throughout?
Output Summary
• After all the work of understanding
the problem, laying out a logical
model and generating a solution, this
solution must be presented in a well
written, competent fashion.
5 rules for financial modeling
• These rules will help you build better
spreadsheets
• Readibility, Logic, Simplicity—this is what
you should strive for
Rule 1: Try to put important variables
in one place
A B C D E F G H I
1 SAVING FOR COLLEGE
2 Interest rate 8% Critical parameters (sometimes called "value
3 Annual deposit 12,000.00 drivers") are in the upper left-hand corner. The
4 Annual cost of college 35,000 actual of saving for a college education is
5 discussed in Chapter 2.
In bank on birthday, Deposit or End of year
End of year
Birthday before withdrawal at before
with interest
deposit/withdrawal beginning of year interest
6
7 10 0.00 12,000.00 12,000.00 12,960.00
8 11 12,960.00 12,000.00 24,960.00 26,956.80
9 12 26,956.80 12,000.00 38,956.80 42,073.34
10 13 42,073.34 12,000.00 54,073.34 58,399.21
11 14 58,399.21 12,000.00 70,399.21 76,031.15
12 15 76,031.15 12,000.00 88,031.15 95,073.64
13 16 95,073.64 12,000.00 107,073.64 115,639.53
14 17 115,639.53 12,000.00 127,639.53 137,850.69
15 18 137,850.69 -35,000.00 102,850.69 111,078.75
16 19 111,078.75 -35,000.00 76,078.75 82,165.05
17 20 82,165.05 -35,000.00 47,165.05 50,938.25
18 21 50,938.25 -35,000.00 15,938.25
19
20 NPV of all payments 6,835.64 <-- =C7+NPV(B2,C8:C18)
Rule 2: Don’t hard-wire numbers
• Use formulas instead of numbers
Rule 3: Avoid using blank
columns to accommodate cell
“spillovers”
Rule 4: Make your Excel default one
sheet

Office Button 
Excel Options
Rule 5: Turn off the “auto jump-down”
feature
• Excel default: when you hit Enter, the
cursor jumps down one cell
• In finance, we need to carefully look at
what we’ve entered into the cell …
• So turn this off (next slide)
Using EXCEL

In Financial Modeling
Excel Functions
• Financial Functions
• Math Functions
• Conditional Functions
• Text Functions
• Statistical Functions
Financial Functions
• NPV
Ex. The discount rate is 10%, cash flows are -
100,35,33,34,25,and 16 from year 0 to year 5. Calculate
NPV.
• IRR
Ex.i. Calculate IRR for above.
ii. See work sheet
• FV
i. Calculate FV of 5 annual deposits of Rs.1000 at
5%.Whan deposited beginning of the year, at the end of
the year.
• PV
i. Payment of 100 for 10 periods at 10%. Calculate PV if cash flow
occur at end of period and at beginning of period.
• PMT
i . Loan of Rs.1000 to be paid over 10 years at an interest rate of
8%. Calculate annual payment if happens end of period and
beginning of period.
• Rate
i. Initial payment Rs.600,number of periods 10,annual payment
100 calculate the rate if payment is made end of period and
beginning of period. Rate Vs. IRR
• NPER
i. You borrow Rs.1000 from a bank, it charges 10% interest. You
intend to pay Rs.250 per year. How long is to repay the loan.
Math Functions
• Exp
• Continuous compounding
FV= PVert
In Excel FV = PV *Exp(r*t)

PV=FV/ert
In Excel PV= FV*Exp(-r*t)
• LN
Discrete return =P1/P0-1

Continuous compounding
P0exp(r )= P1 exp (r) =P1/P0
The function that solves this equation is the natural
logarithm ln,
r=ln(P1/P0)
• When t = 1

P0exp(rt )= P1 exp (rt) =P1/P0

r= 1/t ln(P1/P0)
• Round, RoundDown, RoundUp, Trunc
• Sqrt
• Sum
• SumIf
• Sumproduct
Conditional Functions
• If
• VLookup
• Hlookup
Text Functions
• Text
• Left, Right, Mid,Len
Statistical Functions
• Average
• Covar
• Correl
• Frequency
• Intercept
• Median,Large and Rank
• Count, CountIf, CountA

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