Chapter 1 Financial Modeling

CHAPTER ONE

Introduction to financial modeling and Evaluation

1.1. What is a financial model?

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
income statement, balance sheet, 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.

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

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 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
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)

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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.

The present value of a cash flow CF t anticipated to be received at time t is PV = CFt

. 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
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:

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 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 ―𝖠‖ to represent the power and the use of both the relative and absolute
references; for example: =B5/(1+$B$2)𝖠A5 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 NPV function
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

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

5
 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
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% the NPV in cell B12 is zero:

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 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:

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 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
=-B3
Division of cash =$B$10*B15
flow between investment income and return of
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 zero, indicating that all the principal
24

25has 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.

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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, Earned during yearaccount, end year
Year
beginning of
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
9 5 1,464.10 146.41 1,610.51
10 6 1,610.51 161.05 1,771.56
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  1, 000* 1  10%10  2, 593.74