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Chapter 1 (F modeling)

The course covers fundamental concepts and techniques in corporate finance across four chapters, focusing on financial calculations, valuation methods, cost of capital, and pro forma modeling. Chapter 1 introduces financial modeling using Excel, emphasizing present value, net present value, internal rate of return, and loan payment calculations. The course aims to equip students with the skills to analyze and value corporate financial situations effectively.

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seid mohammed
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Download as PDF, TXT or read online on Scribd
5 views

Chapter 1 (F modeling)

The course covers fundamental concepts and techniques in corporate finance across four chapters, focusing on financial calculations, valuation methods, cost of capital, and pro forma modeling. Chapter 1 introduces financial modeling using Excel, emphasizing present value, net present value, internal rate of return, and loan payment calculations. The course aims to equip students with the skills to analyze and value corporate financial situations effectively.

Uploaded by

seid mohammed
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Course Syllable

The four chapters in this course cover basic problems and techniques in corporate finance. Chapter 1 is an
introduction to basic financial calculations using Excel. Almost all of the applications discussed center on variations of
the discounted cash flow method. Chapter 2 is a short overview of various valuation methods, specifically the two
primary valuation methods accounting approach and market approach as applied to corporations. The cost of capital,
discussed in Chapter 3, is the rate at which corporate cash flows are discounted to arrive at enterprise value.
Calculating this rate is not trivial and involves a combination of theoretical models and numerical computation, both
discussed in the chapter. Chapter 4 shows how to build a pro forma model of a firm and how to use this model for the
valuation. It emphasizes on deriving the free cash flows required for corporate valuation from the pro forma models of
the corporate income statement and balance sheets. Pro forma models are at the heart of many corporate finance
applications, including business plans, credit analyses, and merger and acquisition valuations.

Chapter One: Introduction to Financial Modeling and Valuation


Introduction
If you have had a good introductory course in finance, this course is likely to be at best a refresher. This chapter aims
to give you some/varies finance basics and their Excel implementation.

Definition of Financial Modeling


Financial modeling is a representation in numbers of a company's operations in the past, present, and the forecasted
future. Financial modeling refers to the creation of a mathematical representation or summary or model of the
financial and operational characteristics of a business. Applications involving financial modeling include business
valuation, management decision making, capital budgeting, financial statement analysis, and determining the firm’s
cost of capital. It is a task of building an abstract representation of real world financial situations.

In general, financial modeling is the application of spreadsheet software (best example of this is application of Excel)
to define simple arithmetic relationships among variables within the firm's income, balance sheet, and cash-flow
statements, and to define the interrelationships among the various financial statements. The primary objective in
applying financial modeling techniques is to create a computer-based model, which facilitates the acquirer's
understanding of the effect of changes in certain operating variables on the firm's overall performance and valuation.
“The models require a mixture of finance, accounting, and Excel.”

This chapter covers:


Present value (PV)
Net present value (NPV)
Internal rate of return (IRR)
Flat payment schedule (PMT)
Future value (FV)
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 numerator of this expression is
usually understood to be the expected time (n) cash flow (CF), 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).

Present Value and Net Present Value


Both concepts, present value and net present value, are related to the value today of a set of future anticipated
cash flows.

1. The Present Value, PV


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, used as a discount rate.

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The present value, 379.08, is the value today of the investment.

1.2. Present Value of an Annuity


An annuity is a security that pays a constant sum in each period in the future (a series of fixed periodic payments).
Annuities may have a finite or infinite series of payments. If the annuity is finite and the appropriate discount rate is
r, then the value today of the annuity is its present value:

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This formula can also be computed using Excel’s PV function and Excel’s NPV function in valuing a finite annuity. If
the annuity promises an infinite series of constant future payments, then this formula reduces to:

2. The Net Present Value, NPV


The net present value is the present value of future cash inflows from an asset (the cash flow at time beyond year
one) minus the cost of acquiring the asset (the cash flow at time zero, initial investment donated by CF 0). In many
cases CF0 represents the cost of the asset purchased and is therefore negative. Suppose, for example, that the series
of 5 cash flows of $100 is sold for $250. Then, as shown below, the NPV = 129.08. Denoting by r the discount rate
applicable to the investment, the NPV is calculated as follows:

The NPV represents the wealth increment of the purchaser of the cash flows. If you buy the series of five cash
flows of 100 for 250, then you have gained 129.08 in wealth today, which is a NPV.

3. Internal Rate of Return (IRR)


The internal rate of return (IRR) is defined as the compound rate of return paid by the investment, r that makes the
NPV equal to zero

4. Flat Payment Schedules (Loan Table)


Another common problem is to compute a “flat” payment for a loan. Loan tables can be calculated using the PMT
function. Assume that the firm pays off its debt in equal payments of interest and principal over five years. Hint: You
have to use the PMT function to find the annual payments; then set up a loan table (as in this Chapter) to split the
annual payments into an interest and repayment of principal. The PMT function calculates the payment necessary to
pay off a loan with equal annual payments of interest and principal over a fixed number of periods. Alternatively, you
can use the functions PPMT and IPMT.

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As we have seen below, a loan table shows the split of a loan’s flat payments (computed with PMT) between interest
and principal. In the loan table of the later subsection, we computed this split by first computing the flat payment
per period (column D), then taking the interest on the principal at the beginning of the period (column E) and finally
subtracting this interest from the period’s total payment (column F). IPMT (for annual payments of an interest) and
PPMT (for repayment of principal) perform this calculation without the necessity of relying on the total payment.

For example, you take a loan for $10,000 at an interest rate of 7 percent per year. The bank wants you to make a
series equal of payments that will pay off the loan and the interest over six years. We can use Excel’s PMT function
to determine how much each annual payment should be:
P(r)
PMT =
1 − (1 + r)−n

The zero in cell C15 indicates that the loan is fully repaid over its term of 6 years. You can easily confirm that the
present value of the payments over the 6 years is the initial principal of 10,000. Simply at the end of the 6 years
the repayment of principal is exactly equal to the principal outstanding at the beginning of the year (i.e., the loan
has been paid off). Thus, the answer of $2,097.96 is correct by creating a loan table.

5. Future Values and Applications


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 is shown in the following spreadsheet.

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.

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