Financial Modeling:

UNIT 1: Introduction to Financial modeling A financial model is designed to represent in mathematical terms the relationships among the variables of a financial problem so that it can be used to answer what if questions or make projections A financial model is a quantitative representation of a companys past, present, and future business operations. Types of financial models: Financial models are often developed over the course of months and years, and many financial analysts get caught up the grind of building, auditing and maintaining existing financial models on a daily basis, losing the big picture of understanding best practice modeling solutions used in business and economic decision analysis. It is therefore useful for a good financial analyst to take a step back, examine the broad categories of financial models that are commonly used, and determine the optimal approach for the financial and business modeling of different scenarios and situations. Let us first re-visit the basics, and look at how financial models can be related to its usage in modeling an economy, industry or company. Macroeconomic Financial Models The models are usually econometric analysis based, built by government departments, universities or economic consulting firms, and used to forecast the economy of a country. Macroeconomic models are used to analyze the like effect of government policy decisions on variables such as foreign exchange rates, interest rates, disposable income and the gross national product (GNP). Industry Financial Models Industry models are usually econometric based models of specific industries or economic sectors. Industry models are often similar to macroeconomic models, and typically used by industry associations or industry research analysts to forecast key performance indicators within the industry in question. Corporate Financial Models Corporate financial models are built to model the total operations of a company, and often perceived to be critical in the strategic planning of business operations in large corporations and startup companies alike. Almost all corporate financial models are built in Excel, although specialized financial modeling software are increasingly being used especially in large corporations to ensure standardization and accuracy of multiple financial models, or to comply with spreadsheet management requirements imposed by the Sarbanes Oxley financial reporting act.

Now that weve looked at the context of financial models from an economic and financial analysis perspective, let us now examine financial models specifically from a financial modeling build perspective. Deterministic Financial Models In a deterministic model, a financial analyst enters a set of input data into a spreadsheet, programs the spreadsheet to perform a series of mathematical calculations, and displays an output result. Most deterministic financial models are built by performing an analysis on historical data to derive the relationship between key forecast variables. In a corporate context, historical accounting relationships are often used to forecast key revenue and cost variables. Most deterministic models use one or two dimensional sensitivity analysis tables built into the model to analyze the question of risk and uncertainty in the models output results. Each sensitivity analysis table allows a financial analyst to perform a what if analysis on 1 or 2 variables at a time. The advantage of sensitivity tables are its simplicity and ease of integration into existing deterministic financial models that have already been built. Simulation Based Financial Models While a deterministic financial model is normally structured in such a way that a single point estimate is used for each input variable, simulation based financial models work by entering the likely distribution of key inputs defined by the mean, variance and type of distribution. Simulation models use these range of inputs to recalculate the defined mathematical equation in the financial model through a few hundred iterations, normally 500 or more. The results of the analysis will produce the likely distribution of the result, therefore providing an indication of the expected range of results instead of a single point estimate. Specialized Financial Models Specialized financial models are narrower in scope and essentially sophisticated calculators built to address a specific business problem or financial computation. Cost management models, marginal contribution analysis models and option pricing models are examples of specialized financial models. EIGHT STEPS TO SUCCESSFUL USE OF FINANCIAL MODELING: Financial modeling is therefore the foundation for determining feasibility, whether for a new project program, a joint venture or a new business. Eight key steps for success in using financial modeling to evaluate new initiatives. 1. INCLUDE THE RIGHT STAKEHOLDERS ON THE PLANNING TEAM 2. BUILD YOUR MODEL ONE LEVEL BEYOND WHAT IS EXPECTED 3. NAIL THE VOLUME 4. CLARIFY ALL ASSUMPTIONS WITH STAKEHOLDERS 5. DEMAND THAT THE FINANCIAL MODEL BE ROBUST

6. MAKE SURE THE MODEL IS TRUSTWORTHY 7. ADDRESS UNCERTAINTY BY MODELING DIFFERENT SCENARIOS 8. DO WHAT IT TAKES TO MAKE SURE YOUR BOARD WILL HAVE CONFIDENCE IN YOUR RESULTS 1. INCLUDE THE RIGHT STAKEHOLDERS ON THE PLANNING TEAM Involving the right people from the beginning is critical. It allows everyone to work out agreement on the scope of the analysis, the constraints and the parts of the model that can be based on simple assumptions rather than in-depth analysis. Having the right team working together can uncover unexpected information that is critical to all further analysis of a venture. The team should include clinical, financial and operational stakeholders; the participation of relevant physicians is essential. 2. BUILD YOUR MODEL ONE LEVEL BEYOND WHAT IS EXPECTED Its one thing to do a quick and dirty analysis to give yourself a general sense of how a venture might go. Its quite another to let the results of that analysis go beyond your office door. Figures on a spreadsheet always seem to carry a certain weight and validity, no matter how simplistic the model. Before you know it, everyone has forgotten that the figures were preliminary, and you have to start justifying any changes as the analysis gets more rigorous. To avoid this, design the model one or two levels up from what you think you need at the moment. Fight the pressure for a quick answer; the figures will hold up better, youll be more comfortable and so will your stakeholders 3. NAIL THE VOLUME Volume projections are at the heart of most financial models. The key to developing solid projections is triangulation. Use multiple approaches to projection that provide checks on each other. Consider historical volumes where relevant (both yours and the markets). Check that your volume results in an achievable market share. Use the best available utilization benchmarks and population data. For new technology, look at research articles about the technologys uses, and relate that to incidence or prevalence. Once you are informed, talk with the clinicians. Watch out for hockey stick projectionswhere a handle of slow growth suddenly turns up dramatically (and usually, unrealistically). 4. CLARIFY ALL ASSUMPTIONS WITH STAKEHOLDERS Make sure that everyone on your team, and eventually, everyone involved in the initiative, buys off on all significant assumptions. Lay out the figures and talk through them, covering variables including:

Volume and growth curve Payment rate Payer mix Facility size Cost per square foot Staffing levels Hours of operation

5. DEMAND THAT THE FINANCIAL MODEL BE ROBUST As planning moves forward and thinking changes, financial models need to change to reflect that. The core model must be clean, organized and well-documented, so that when the inevitable refinements and patches are made, sometimes months later, you can still see how the model is working and spot any anomalies. 6. MAKE SURE THE MODEL IS TRUSTWORTHY Check the model for reasonableness and accuracy before relying on the figures it produces. You want to be sure there are no errors in logic. If you take the volume to zero and you still have variable costs, something is wrong. If you change the volume growth rate, the model should show a proportional increase in gross revenue. Fixed costs should never vary. Have someone outside the model-building process review the model for accuracy. It is no reflection on the model-builder if fresh eyes spot a problemin fact, its all but inevitable. 7. ADDRESS UNCERTAINTY BY MODELING DIFFERENT SCENARIOS When you have a robust model that you trust, and youre comfortable with your base case, you are ready to look at how market uncertainties might influence your bottom line. Make sure the model can answer what if? questions such as:

What if the physicians only move half the volume you are projecting? What if Medicare cuts rates? What if competitors open a similar program six months after you launch? The model will be more sensitive to variation in some factors than others. Once you know where the model is most sensitive, you can consider how you might control uncertainty or how you would respond to certain scenarios. 8. DO WHAT IT TAKES TO MAKE SURE YOUR BOARD WILL HAVE CONFIDENCE IN YOUR RESULTS To make sure your board is comfortable with and confident in your results, do some extra homework. Present a baseline scenario and show them a worst case scenario as well. Review results with a test audience before taking your presentation to the board. Anticipate board members questions, and answer them before the meeting.

STEPS IN CREATING A MODEL: Step 1: Define and Structure the Problem Step 2: Define the Input and Output Variables of the Model Step 3: Decide Who Will Use the Model and How Often Step 4: Understand the Financial and Mathematical Aspects of the Model Step 5: Design the Model Step 6: Create the Spreadsheets or Write the VBA Codes Step 7: Test the Model Step 8: Protect the Model Step 9: Document the Model Step 10: Update the Model as Necessary

Step 1: Define and Structure the Problem Start by discussing and defining why the model is needed and what decisions, if any, will be made based on its outputthat is, what questions the model is supposed to answer. As we discussed, all models have to capture the relationships among their variables, and discovering and quantifying these can take a lot of time. Step 2: Define the Input and Output Variables of the Model Make a list of all the inputs the model will need and decide who will provide them or where they will come from Make a list of the tabular, graphical, and other outputs the model needs to create. If you plan ahead and lay out your spreadsheets with the outputs in mind, you will save yourself a lot of time later on. Step 3: Decide Who Will Use the Model and How Often Own use Others use Used only once Used frequently

Step 4: Understand the Financial and Mathematical Aspects of the Model Calculations Necessary formulas or instructions Excel or VBA skills You are sure that you know how to solve the problem Step 5: Design the Model Sketch the steps that Excel or VBA will have to follow to solve the problem. The other aspect of design is planning how the model will be laid out in Excel or VBA. Entire model in one spreadsheet (or VBA module) or split it into several spreadsheets (or VBA modules or procedures)? Step 6: Create the Spreadsheets or Write the VBA Codes Excel VBA Step 7: Test the Model

Find the problems (bugs) and fix them. There is no standard approach to testing and debugging a model The better you understand a problem and a model, the easier it will be to debug it Checking a models output against hand-calculated answers is a common and effective approach to debugging. Step 8: Protect the Model

Protecting it against accidental or unauthorized changes Excel provides several flexible tools that you can use to hide and protect parts or your entire model. Step 9: Document the Model Documenting a model means putting in writing, diagrams, flowcharts, and so on, Step 10: Update the Model as Necessary Update programme Update presentation

The Purpose of Financial Model: Financial model serve five most important purposes: 1. 2. 3. 4. 5. To demonstrate the size of the market opportunity To explain the business model To show the path to profitability To quantify the investment requirement To facilitate valuation of the business To demonstrate the size of the market opportunity: A market opportunity product or a service, based on either one technology or several, fulfills the need(s) of a (preferably increasing)market better than the competition and better than substitution-technologies within the given environmental frame (e.g. society, politics, legislation, etc.). To explain the business model: A business model describes the rationale of how an organization creates, delivers, and captures value.(economic, social, cultural, or other forms of value). The process of business model construction is part of business strategy In theory and practice, the term business model is used for a broad range of informal and formal descriptions to represent core aspects of a business, including purpose, target customers, offerings, strategies, infrastructure, organizational structures, trading practices, and operational processes and policies. The literature has provided very diverse interpretations and definitions of a business model. A systematic review and analysis of manager responses to a survey defines business models as the design of organizational structures to enact a commercial opportunity. Further extensions to this design logic emphasize the use of narrative or coherence in business model descriptions as mechanisms by which entrepreneurs create extraordinarily successful growth firms. To show the path to profitability: Path to profitability (sometimes abbreviated as P2P, which also stands for peer-to-peer ) is a term that refers to a business plan that is designed to take an enterprise from startup to turning a profit. In Internet business, the prevalent emphasis on profitability, especially in the ebusiness world, is in contrast to the attitude prevalent in recent years, when dotcom ventures were often encouraged to open for business, "burn" enough venture capital to dominate a particular business niche, and worry about profits later. Industry and stock market analysts suggest that the popularity of this term indicates a return to traditional business practices and a new, more mature stage in the evolution of the Internet

To quantify the investment requirement: There is a strong consensus that reform of the financial regulatory system must include significant increases in the capital requirements for banks. All else equal, this should make the banks safer by providing a greater cushion to survive the mistakes and accidents from which they inevitably suffer. Higher capital requirements should also discourage transactions of lower economic value by creating a higher hurdle rate, since the extra units of capital need to be paid for by additional expected return. Some of the regrettable transactions that seemed attractive during the bubble might not have been undertaken at a higher hurdle rate. To facilitate valuation of the business Business valuation is a process and a set of procedures used to estimate the economic value of an owners interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.

Flat Payment Schedules:

A payment structure in which the borrower is not required to repay any of the principal until the maturity date and he can able to pay in desired installments.

FLAT INTEREST PAYMENT SCHEDULE Loan principal 10000 Interest rate 7% 6 Loan term Annual payment $2,097.96

<-- Number of years over which loan is repaid

YEAR 1 2 3 4 5 6 7

PRINCIAPL AT THE BEGINNING OF THE YEAR 10,000.00 8,602.04 7,106.23 5,505.70 3,793.15 1,960.71 0.00

Payment at end of year 2097.96 2097.96 2097.96 2097.96 2097.96 2097.96

Interest 700 602.14 497.44 385.40 265.52 137.25

Return of Principal 1397.96 1495.82 1600.52 1712.56 1832.44 1960.71

Future value
Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is the present value multiplied by the accumulation function. The value does not include corrections for inflation or other factors that affect the true value of money in the future. This is used in time value of money calculations.

EXAMPLES:

Present value
Present value, also known as present discounted value, is a future amount of money that has been discounted to reflect its current value, as if it existed today. The present value is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time value of money. Returns the present value of an investment. The present value is the total amount that a series of future payments is worth now. For example, when you borrow money, the loan amount is the present value to the lender. Syntax PV (rate, nper, pmt, fv,type)

Rate is the interest rate per period.

Nper is the total number of payment periods in an annuity.

Pmt is the payment made each period and cannot change over the life of the annuity.

Fv is the future value, or a cash balance you want to attain after the last payment is made.

Example:

Net present value:

NPV can be described as the difference amount between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) is called the yield and is more widely used in bond trading.

Formula:

the time of the cash flow the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital the net cash flow i.e. cash inflow cash outflow, at time t . For educational purposes, is commonly placed to the left of the sum to emphasize its role as (minus) the investment.

If...

It means...

Then...

NPV the investment would the project may be accepted > 0 add value to the firm the investment would NPV subtract value from the project should be rejected <0 the firm We should be indifferent in the decision whether to accept the investment would or reject the project. This project adds no monetary value. NPV neither gain nor lose Decision should be based on other criteria, e.g., strategic =0 value for the firm positioning or other factors not explicitly included in the calculation.

Example:
Net Present value Cost of project Cost of capital 50,000 10%

Years Cash inflows 1 10,000 2 12,000 3 18,000 4 25,000 5 8,000 6 4,000

Present vlaue factors@10%

Present value cash inflows(cif*pvf)

0.909 9,090 0.826 9,912 0.751 13,518 0.683 17,075 0.621 4,968 0.564 2,256 Present value cash inflows 56,819

Net Present value= Present value cash inflowscost of project(cash outflows)

6,819

Using excel Net present value Years Cash inflows 1 10,000 2 12,000 3 18,000 4 25,000 5 8,000 6 4,000 Present value cash inflows 56,833 Net Present value=Present value cash inflows-cost of project(cash outflows) 6,833

Example 2: multiple projects cash flows

Project A Data 16% 40,000 13,000 13,000 13,000 13,000 13,000 Description Annual discount rate Initial cost of investment or cash outflow Return from first year Return from second year Return from third year Return from fourth year Return from fifth year

Cash inflow Net present value

42,566 2,566

Project B Data 16% 40,000 70,000 10,000

Description Annual discount rate Initial cost of investment or cash outflow Return from first year Return from second year

16,000 19,000 30,000

Return from third year Return from fourth year Return from fifth year

Cash inflow Net present value

102,804 62,804

Internal Rate of Return:

The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or the rate of return (ROR)

Decision criterion:
If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

Multiple Internal Rates of Return: Sometimes a series of cash flows has 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: