RIFT VALLY UNIVERSITY

FINANCIAL MODELING
Chapter one:
Introduction to financial modeling and Evaluation

1.1.What is a financial model?

A model is any representation of an actual phenomenon such as an actual system or process. The
real world system is represented by the model in order to explain it, to predict it, and to control it.
Any model represents a compromise between reality and manageability. A given representation
of real world system can be a model if it fulfills the following requirements.
(1) It must be a “reasonable” representation of the real world system and in that sense it should
be realistic.
(2) On the other hand it must be “manageable” in that it yields certain insights or conclusions.
A good model is both realistic and manageable. A highly realistic but too complicated model is a
“bad” model in the sense it is not manageable. A model that is highly manageable but so
idealized that it is unrealistic not accounting for important components of the real world system,
is a “bad” model too. In general to find the proper balance between realism and manageability is
the essence of good Modeling. Thus a good model should, on the one hand, specify the
interrelationship among the parts of a system in a way that is sufficiently detailed and explicit
and, on the other hand, it should be sufficiently simplified and manageable to ensure that the
model can be readily analyzed and conclusions can be reached concerning the real world.
A model is a simplified representation of a real- world process. For instance, saying that the
quantity demanded of oranges depends on the price of oranges is a simplified representation
because there are a host of other variables that one can think of that determine the demand for
oranges. For instance, income of consumers, an increase in diet consciousness (“drinking coffee
cause’s cancer, so you better switch to orange juice,” etc.), an increase or decrease in the price of
applies and so on. However, there is no end to this stream of other variables. In a remote sense
even the price of gasoline can affect the demand for oranges.
Many scientists have argued in favor of simplicity because simple models are easier to
understand, communicate and test empirically with data. This is the position of Karl popper and
Milton friedman. The choices of a simple model to explain complex real world phenomena leads
to two criticisms:
1. The model is oversimplified.
2. The assumptions are unrealistic.
For instance, in our example of the demand for oranges, to say that it depends on only of oranges
is an oversimplification and also an unrealistic assumption.
1. The model is oversimplified.
To the criticism of oversimplification, one can argue that it is better to start with a simplified
model and progressively construct more complicated models. This is the idea expressed by
Koopmans. On the other hand, there are some who argue in favor of starting with a very general

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 model and simplifying it progressively based on the data available. The famous statistician
L.J.(Jimmy) Savage used to say that “ a model should be as big as an elephant.” What ever the
relative merits of this alternative approach area, we will start with simple models and
progressively build more complicated models
2. The assumptions are unrealistic.
The other criticism we have mentioned is that of “Unrealistic assumptions.” To this criticism
friedman argued that the assumptions of a theory are never descriptively realistic. He says:
“The relevant question to ask about the assumptions” of a theory is not whether they are
descriptively “realistic” for they never are, but whether they are sufficiently good
approximations for the purpose at hand. And this question can be answered by only seeing
whether the theory works, which means whether it yields sufficiently accurate predictions.”
Returning to our example of demand for oranges, to say that it depends only on the price of
oranges is a descriptively unrealistic assumption. However, the inclusion of other variables, such
as income and price of apples in the model, does not render the model more descriptively
realistic. Even this model can be considered to be based on unrealistic assumptions because it
leaves out many other variables (like health consciousness, etc.). But the issue is which model is
more useful for predicting the demand for oranges. This issue can be decided only from the data
we have and the data we can get.

A financial model is simply a tool that’s built in spreadsheet software such as MS Excel to
forecast a business’ financial performance into the future. The forecast is typically based on the
company’s historical performance, assumptions about the future, and requires preparing an
financial performance, financial position, cash flow statement, and supporting schedules (known
as a 3 statement model). From there, more advanced types of models can be built such as
discounted cash flow analysis (DCF model), leveraged-buyout (LBO), mergers and acquisitions
(M&A), and sensitivity analysis.

1.2. Overview of excel functions for modeling

Today well over 400 functions are available in Excel, and Microsoft keeps adding more with
each new version of the software. Many of these functions aren't relevant for use in finance, and
most Excel users only use a very small percentage of the available functions. If you're using
Excel for the purpose of financial modeling, you need a firm grasp on the most commonly used
functions, at the very least.
Although there are many, many more that you'll find useful when building models, here's a list of
the most basic functions that you can't be without.

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 Function What It Does
SUM Adds up, or sums together, a range of cells.
MIN Calculates the minimum value of a range of cells.
MAX Calculates the maximum value of a range of cells.
AVERAGE Calculates the average value of a range of cells.
ROUND Rounds a single number to the nearest specified value, usually to a whole
number.
ROUNDUP Rounds up a single number to the nearest specified value, usually to a whole
number.
ROUNDDOWN Rounds down a single number to the nearest specified value, usually to a
whole number.
IF Returns a specified value only if a single condition has been met.
IFS Returns a specified value if complex conditions have been met.
COUNTIF Counts the number of values in a range that meet a certain single criterion.
COUNTIFS Counts the number of values in a range that meet multiple criteria.
SUMIF Sums the values in a range that meet a certain single criterion.
SUMIFS Sums the values in a range that meet multiple criteria.
VLOOKUP Looks up a range and returns the first corresponding value in a vertical table
that matches exactly the specified input.
HLOOKUP Looks up a range and returns the first corresponding value in
a horizontal table that matches exactly the specified input. An error is
returned if it cannot find the exact match.
INDEX Works like the coordinates of a map and returns a single value based on the
column and row numbers you input into the function fields.
MATCH Returns the position of a value in a column or a row. Modelers often combine
MATCH with the INDEX function to create a lookup function, which is far
more robust and flexible and uses less memory than the VLOOKUP or
HLOOKUP.
PMT Calculates the total annual payment of a loan.
IPMT Calculates the interest component of a loan.
PPMT Calculates the principal component of a loan.
NPV Returns the net present value of an investment based on a discount rate and a
series of future payments (negative value) and income (positive value)
XNPV Returns the net present value for a schedule of cash flows.
IRR Returns the internal rate of return for a series of cash flows

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 XIRR Returns the internal rate of return for a schedule of cash flows
1.3. Basic Financial Calculations using excel
 Net present value (NPV)
 Internal rate of return (IRR)
 Payment schedules and loan tables
 Future value
 Pension and accumulation problems
 Continuously compounded interest
 Time-dated cash flows (Excel functions XNPV and XIRR)
Almost all financial problems are centered on finding the value today of a series of cash receipts
over time. The cash receipts (or cash flows, as we will call them) may be certain or uncertain.
CFt
The present value of a cash flow CF tanticipated to be received at time t is PV =  . The
(1  r ) t
numerator of this expression is usually understood to be the expected time t cash flow, and the
discount rate r in the denominator is adjusted for the riskiness of this expected cash flow—the
higher the risk, the higher the discount rate. The basic concept in present value calculations is the
concept of opportunity cost.
Opportunity cost is the return which would be required of an investment to make it a viable
alternative to other, similar investments. In the financial literature there are many synonyms for
opportunity cost, among them: discount rate cost of capital, and interest rate. When applied to
risky cash flows, we will sometimes call the opportunity cost the risk-adjusted discount rate
(RADR) or the weighted average cost of capital (WACC). It goes without saying that this
discount rate should be risk-adjusted, and much of the standard finance literature discusses how
to do this. As illustrated below, when we calculate the net present value, we use the investment’s
opportunity cost as a discount rate. When we calculate the internal rate of return, we compare the
calculated return to the investment’s opportunity cost to judge its value.
1.4. Present Value and Net Present Value
Both of these concepts are related to the value today of a set of future anticipated cash flows. As
an example, suppose we are valuing an investment which promises $100 per year at the end of
this and the next 4 years. We suppose that these cash flows are risk free: There is no doubt that
this series of 5 payments of $100 each will actually be paid. If a bank pays an annual interest rate

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 of 10% on a 5-year deposit, then this 10% is the investment ’ s opportunity cost, the alternative
benchmark return to which we want to compare the investment. We can calculate the value of
the investment by discounting its cash flows using this opportunity cost as a discount rate:

A B C D
1 COMPUTING THE PRESENT VALUE
2 Discount rate 10%
3
Present
4 Year Cash flow value
5 1 100 90.9091 =B5/(1+$B$2)^A5
6 2 100 82.6446 =B6/(1+$B$2)^A6
7 3 100 75.1315 =B7/(1+$B$2)^A7
8 4 100 68.3013 =B8/(1+$B$2)^A8
9 5 100 62.0921 =B9/(1+$B$2)^A9
10
11 Net present value
12 Summing cells C5:C9 379.08 =SUM(C5:C9)
13 Using Excel's NPV function 379.08 =NPV(B2,B5:B9)
14 Using Excel's PV function 379.08 =PV(B2,5,-100)

The present value, 379.08, is the value today of the investment. In a competitive
market, the present value should correspond to the market price of the cash flows. The
spreadsheet illustrates three ways of obtaining this value:
 Summing the individual present values in cells C5:C9. To simplify the copying, note the use
of “∧” to represent the power and the use of both the relative and absolute references; for
example: =B5/(1+$B$2)∧A5 in cell C5.
 Using the Excel NPV function. As we show on the next page, Excel’s NPV function is
unfortunately misnamed—it actually computes the present value and not the net present
value.
 Using the Excel PV function. This function computes the present value of a series of constant
payments. PV(B2, 5,-100) is the present value of 5 payments of 100 each at the discount rate
in cell B2. The PV function returns a negative value for positive cash flows; to prevent this
unfortunate occurrence, we have made the cash flows negative.
The Difference between Excel’s PV and NPV Functions
The above spreadsheet may leave the misimpression that PV and NPV perform exactly the same
computation. But this is not true—whereas NPV can handle any series of cash flows, PV can
handle only constant cash flows:

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 A B C D
COMPUTING THE PRESENT VALUE
In this example the cash flows are not equal
Either discount each cash flow separately or use Excel's NPVfunction
1 Excel's PV doesn't work for this case
2 Discount rate 10%
3
Cash Present Present value
4 Year flow value of each cash flow
5 1 100 90.9091 =B5/(1+$B$2)^A5
6 2 200 165.2893 =B6/(1+$B$2)^A6
7 3 300 225.3944 =B7/(1+$B$2)^A7
8 4 400 273.2054 =B8/(1+$B$2)^A8
9 5 500 310.4607 =B9/(1+$B$2)^A9
10 Net present value
11 Summing cells C5:C9 1065.26 =SUM(C5:C9)
12 Using Excel's NPV function 1065.26 =NPV(B2,B5:B9)
1.5.The Internal Rate of Return (IRR) and Loan Tables
Internal rate of return
 It is that rate which present value of benefits equals the initial investment
 It is that discount rate at which NPV equals zero
 IRR represents Return on investment in terms of percentage.
 IRR is popular appraisal criterion for capital budgeting decision.
 It is a method of making project proposals using the rate of return on
investment.
 IRR is calculated through trial and error method
IRR = LRD + NPVL X R LRD :- Lowe rate of discount
PV NPVL :-Net present values at lower rate of discount
R:- The difference b/n rate of discounts
PV:- PV cash lower – PV cash flow higher

The internal rate of return (IRR) is defined as the compound rate of return r which makes the
NPV equal to zero:
N
CFt
CF0 +∑ t =0
t =1 ( 1 +r)

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 To illustrate, consider the example given in rows 2–10 below: A project costing 800 in year zero
returns a variable series of cash flows at the end of years 1–5. The IRR of the project (cell B10)
is 22.16%:
A B C
1 INTERNAL RATE OF RETURN
Cash
2 Year Flow
3 0 -800
4 1 200
5 2 250
6 3 300
7 4 350
8 5 400
9
10 Internal rate of return 22.16% =IRR(B3:B8)
Note that the Excel IRR function includes as arguments all of the cash flows of the investment,
including the first—in this case negative—cash flow of –800.
Determining the IRR by Trial and Error
There is no simple formula to compute the IRR. Excel’s IRR function uses trial and error, which
can be simulated by using trial and error in a spreadsheet as illustrated below:
A B C
1 INTERNAL RATE OF RETURN
2 Discount rate 12%
3
4 Year Cash flow
5 0 -800
6 1 200
7 2 250
8 3 300
9 4 350

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 10 5 400
11
12 Net present value (NPV) 240.81 =B5+NPV(B2,B6:B10)
By playing with the discount rate or by using Excel’s Goal Seek (found under Data|What-if
analysis, we can determine that at 22.16% theNPV in cell B12 is zero:
A B C
1 INTERNAL RATE OF RETURN
2 Discount rate 22.16%
3
4 Year Cash flow
5 0 -800
6 1 200
7 2 250
8 3 300
9 4 350
10 5 400
11
12 Net present value (NPV) 0.00 =B5+NPV(B2,B6:B10)
Loan Tables and the Internal Rate of Return
The IRR is the compound rate of return paid by the investment. To understand this fully, it helps
to make a loan table, which shows the division of the investment’s cash flows between
investment income and the return of the investment principal:

A B C D E F
INTERNAL RATE OF RETURN
2 Year Cash flow
3 0 -800
4 1 200
5 2 250
6 3 300
7 4 350
8 5 400
9
10 Internal rate of return 22.16% =IRR(B3:B8)
11
USING THE IRR IN A LOAN TABLE
Division of cash flow
between investment

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 income and return of
=-B3 =$B$10*B15
principal
13
Investment at
beginning of Cash flow Return of
14 Year Year at end of year Income principal
15 1 800.00 200.00 177.28 22.72 =C15-D15
16 2 777.28 250.00 172.25 77.75
17 3 699.53 300.00 155.02 144.98
18 4 554.55 350.00 122.89 227.11
19 5 327.44 400.00 72.56 327.44
20 6 0.00

21 =B15-E15
22 The remaining investment principal
23 in the year after the last cash flow is
24 zero, indicating that all the principal
25 has been repaid.

26

The loan table divides each of the cash flows of the asset into an income component and a
return-of-principal component. The income component at the end of each year is IRR times the
principal balance at the beginning of that year. Notice that the principal at the beginning of the
last year (327.44 in the example) exactly equals the return of principal at the end of that year.
Future Values and Applications
We start with a triviality. Suppose you deposit 1,000 in an account today, leaving it there for 10
years. Suppose the account draws annual interest of 10%. How much will you have at the end of
10 years? The answer, as shown in the following spreadsheet, is 2,593.74:

A B C D E
1 SIMPLE FUTURE VALUE
2 Interest 10%
3
Account
Interest Total in
balance,
Year Earned account,
beginning of
during year end year
4 year
5 1 1,000.00 100.00 1,100.00 =C5+B5
6 2 1,100.00 110.00 1,210.00 =C6+B6
7 3 1,210.00 121.00 1,331.00
8 4 1,331.00 133.10 1,464.10
=$B$2*B5
9 5 1,464.10 146.41 1,610.51
10 6 1,610.51 161.05 1,771.56

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 11 7 1,771.56 177.16 1,948.72
12 8 1,948.72 194.87 2,143.59
13 9 2,143.59 214.36 2,357.95
14 10 2,357.95 235.79 2,593.74
15 11 2,593.74 =D5
16
17 A simple way 2,593.74 =B5*(1+B2)^10

As cell C17 shows, you don’t need all these complicated calculations: The future value of 1,000
in 10 years at 10% per year is given by:
FV = 1000 *(1.1) 10 = 2, 593.74
1.6. Introduction to valuation and valuation Standards
Valuation of Financial Assets
Valuation concept is the process that links risk and return to determine the worth of an asset.
Bond Valuation
When a corporation or government wishes to borrow money from the public on a long term
basis, it usually does so by issuing or selling debt securities that is generally called bonds. A
bond is normally an interest only loan, meaning that the borrower will pay the interest every
period, but none of the principal will be repaid until the end of the loan.
Terminologies
Coupon: is the stated interest payments made on a bond
Face value: is the principal amount of a bond that is repaid at the end of the term. It is also
called par value.
Coupon rate: is the annual coupon divided by the face value of a bond.
Maturity: is specified date at which the principal amount of a bond is paid
Yield to Maturity
The yield to maturity is the periodic interest rate that equates the present value of the expected
future cash flows (both coupons and maturity value) to be received on the bond to the initial
investment in the bon, which is its current price.
Approximate yield(kd)= I + (Pn-Npd)
n .
Pn+Npd
2
where, kd= effective before tax cost of a new bond issue
I= annual interest payment in birr
Pn= par or principal repayment required in n periods
Npd= net proceeds from the sale of the bond
N= length of the holding period of the bond in years
The net proceeds (Npd) from the sale of each bond can be calculated as follows:
Npd= Pd-F, where Pd is the market price of the bond
F is flotation cost

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 Flotation costs are any costs associated with selling new securities such as sales commission paid
to those selling securities, cost of printing, advertising, and registration with government
agencies, under pricing or discount offered to induce investors to buy securities.
The relevant cost of debt is the after tax cost of new debt.

Kdt= kd(1-T), Where, Kdt is firms after tax cost of debt.

Kd is effective before tax cost of debt

Measuring Specific cost of capital

A company’s capital structure may include: debt. Preferred stock, common stock and retained
earnings. The costs of the capital vary from most expensive to least expensive in the following
order:
 New common stock
 Preferred stock
 Debt
Common stock is most expensive because it has high risk and seeks highest return. Moreover, it
is last in case of dividend and asset distribution at a time of liquidation. Preferred stock is low
risky because it has a preferential right in dividend and asset distribution at a time of liquidation.
Debt is the least expensive cost of capital because interest is tax deductible.
Common stock Valuation
A share of common stock is more difficult to value in practice than a bond for the following
reasons:
 The promised cash flow are not known in advance
 The life of the investment is essentially forever since common stock has no maturity.
 There is no way to easily observe the rate of return that the market requires.

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