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 Video Lectures on Financial Modelling
 Financial Modelling

Chapter 1: Introduction to Financial Modelling and Valuation

 Introduction to Financial Modelling

 A model is a numerical or mathematical representation of a real-life

situation.
 A financial model is one which relates to business and finance contexts.
 The typical objectives of financial modelling include
 to support decisions relating to business plans and forecasts,
 to the design, evaluation and selection of projects,
 to resource allocation and portfolio optimisation,
 to value corporations, assets, contracts and financial instruments, and
 to support financing decisions
 Financial Modelling: A Definition

 In fact, there is no generally accepted (standardised) definition of

financial modelling.
 A suitable definition should mention processes, variables, and
quantitative relations, hence the following definition
 Financial modelling is a theoretical construction of a project,
process, or transaction in a spreadsheet that deals with the
identification of key drivers and variables and a set of logical and
quantitative relationships between them.
 Financial Modelling: A Definition

 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, & supporting schedules
 THE STAGES OF MODELLING
 Specification: This involves describing the real-life situation, either qualitatively
or as a set of equations.
 Implementation: This is the process to translate the specification into
numerical values, by conducting calculations based on assumed input values
(Excel & VBA)
 Decision support: A model should appropriately support the decision.
 Where Are Financial Models Used?
 Financial models are used in the finance departments of most organizations, but particularly are
employed in these areas
 Investment banking: Risk modelling, option pricing models, and various quantitative models
 Insurance: Insolvency models, actuarial models, risk models (Monte Carlo Simulations)
 Retail banking: Funding models (models that can assess client viability by using a number of metrics),
credit models
 Corporate finance: Capital budgeting models, cost of capital, financial statement analysis, governance
models (SOX compliance testing)
 Governments and institutions: Econometric analysis-based models (used to forecast the socio economy
in a country or region), macroeconomic models (used to analyse the like effect of government policy
decisions on variables such as foreign exchange rates, interest rates, disposable income, and the gross
national product)
 Outsourcing and BPO (Business Process Outsourcing): Cost modelling, price and margin models, bid
models
 Types of financial models
 There are differing types of financial models, depending on their
objectives and goals, such as the following:
 Transactions: Used in acquisitions, divestments
 Investments: Used in capital projects such as procuring new equipment
and property development.
 Corporate finance: Used to assist in deciding the best capital/corporate
structure of a company
 Project financing: Used by banks to show if borrowers will be able to meet
repayments and stay within the covenants set by the bank
 Joint venture: Used to calculate returns to various parties at various exit
times
 What is a financial model used for?
 The output of a financial model is used for decision making and performing
financial analysis, whether inside or outside of the company. Inside a company,
executives will use financial models to make decisions about:
 Raising capital (debt and/or equity)
 Making acquisitions (businesses and/or assets)
 Growing the business(opening new stores, entering new markets, etc.)
 Selling or divesting assets and business units
 Budgeting and forecasting (planning for the years ahead)
 Capital allocation (priority of which projects to invest in)
 Valuing a business
 Financial statement analysis/ratio analysis
 Management accounting
 KINDS OF FINANCIAL MODEL:
 Discounted Cash Flow (DCF) Model:
 Among different types of financial model, DCF Model is the most important. It is based
upon the theory that the value of a business is the sum of its expected future free cash
flows, discounted at an appropriate rate.
 Comparative Company Analysis Model:
 Also referred to as the “Comparable” or “Comps”, it is the one of the major company
valuation analyses that is used in the investment banking industry. In this method we
undertake a peer group analysis under which we compare the financial metrics of a
company against similar firms in industry
 Sum-Of-The-Parts Model:
 It is also referred to as the break-up analysis. This modelling involves valuation of a
company by determining the value of its divisions if they were broken down and spun off or
they were acquired by another company
 TYPES OF FINANCIAL MODEL
 Leveraged Buy Out (LBO) Model:
 It involves acquiring another company using a significant amount of borrowed funds to meet
the acquisition cost. This kind of model is being used majorly in leveraged finance at bulge-
bracket investment banks and sponsors like the Private Equity firms who want to acquire
companies with an objective of selling them in the future at a profit
 Merger & Acquisition (M&A) Model:
 Merger & Acquisitions type of financial Model includes the accretion and dilution analysis. The entire
objective of merger modelling is to show clients the impact of an acquisition to the acquirer’s EPS and
how the new EPS compares with the status quo.
 In simple words we could say that in the scenario of the new EPS being higher, the transaction will be
called “accretive” while the opposite would be called “dilutive.”
 Benefits of Using Models
 Providing Numerical Information
 A model calculates the possible values of variables that are considered important in the context of the
decision at hand. Of course, this information is often of paramount importance, especially when committing
resources, budgeting and so on.
 Capturing Influencing Factors and Relationships
 The process of building a model should force a consideration of which factors influence the situation, including which
are most important
 Generating Insight and Forming Hypotheses
 The modelling process should highlight areas where one’s knowledge is incomplete, what further actions could be
taken to improve this, as well as what data is needed.
 Improving Working Processes, Enhanced Communications and Precise Data Requirements
 CHALLENGES IN USING MODELS
1. The Nature of Model Error
 Specification error. This is the difference between the behaviour of the real-world situation and that
captured within the specification or intentions of the model (sometimes this individual part is referred to as
“model risk” or “model error”).
 Implementation error. This is the difference between the specified model (as conceived or intended)
and the model as implemented.
 Decision error. This is the idea that a decision that is made based on the results of a model could be
inappropriate. It captures the (lack of) effectiveness of the decision-making process, including a lack of
understanding of a model and its limitations
2. Inherent Ambiguity and Circularity of Reasoning
3. Inconsistent Scope or Alignment of Decision and Model
4. The Presence on Biases, Imperfect Testing, False Positives and Negatives
5. Lack of Data or Insufficient Understanding of a Situation
 Future Value
 Amount/ Future Value /Maturity Value of a Single Sum (Lump Sum)
FV= PV (1+i) n
 Future Value of an Ordinary Annuity (FVOD)

Future Value of an Annuity Due (FVAD)

 Present Value
 The formula to compute the present value of a single sum is as shown below;
PV= FV/ (1+i) n or Fv [1+i] -n
 Present Value of Ordinary Annuity

 Present Value of an Annuity Due (PVAD)

 SINKING FUND
 A sinking fund is a fund into which equal periodic payments are made in order to accumulate
a definite amount of money up on a specific date. Sinking funds are generally established in
order to satisfy some financial obligations or to reach some financial goal.
 The formula for determining R (periodic Payment)
 How much will have to be deposited in a fund at the end of each year at 8%
compounded annually, to pay off a debt of Br. 50, 000 in five years?
 The Net Present Value (NPV) Method
• The net present value (NPV) method is an investment project proposals
evaluating and ranking method using the net present value, which is the
difference between the present values of future cash inflows and the present
value of cash outflows, discounted at the given cost of capital, or opportunity
cost of capital.
• In order to use this method properly, the following procedures are followed.
– Find the present value of each cash flow, including both inflows and out flows using the
cost of capital of the project for discounting.
– Sum the discounted cash inflows and the discounted cash outflows separately.
– Obtain the difference between the sum of the cash inflows and the sum of the cash flows.
– If all the cash outflows for the project occur at time zero, i.e. at the beginning of year 1,
the present value of the cash our flows is the same as to the net investment amount.
 The Net Present Value (NPV) Method

The sum of the present value of all expected cash flows, where the
discount rate is the cost of capital

n
CFt
NPV   1  k 
t 1
t
 CF0 .Cost often is CF0
and is negative.

Accept projects if NPV > 0 and If NPV < Zero, Reject

 The Net Present Value (NPV) Method
• To illustrate the NPV method, consider the following mutually exclusive
project alternatives, together with their cash flows.
Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

A (80,000) 20,000 25,000 25,000 30,000 20,000

B (100,000) 25,000 20,000 30,000 35,000 40,000

The required rate of return on both projects is 12 percent. Then, evaluate these
projects using the net present value method. The evaluation of these two projects
requires the computation of the net preset values for both projects
 The Net Present Value (NPV) Method
• The net present value (NPV) for project A is
Year Cash flows Discount Factor (12%) Present Values
1 20,000 0.893 17,860
2 25,000 0.797 19,925
3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) 6,005 Birr
 The Net Present Value (NPV) Method
• The net present value (NPV) for project B is
Year Cash flows Discount Factor (12%) Present Values
1 25,000 0.893 22,325
2 20,000 0.797 15,940
3 30,000 0.712 21,360
4 35,000 0.636 22,260
5 40,000 0.567 22,680
Present values of cash inflows (sum) 104,565
Present values of cash outflows 100,000
Net Present Value (NPV) 4,565 Birr
 The Net Present Value (NPV) Method
• Since the two projects are mutually exclusive, the one with the higher
NPV has to be accepted.
• Thus, project A is selected as its NPV is higher than that of project B.
• Had the two project been independent of one another, both of them would
be accepted because both projects have positive net present values
(NPVs)
Internal Rate of Return (IRR)
• A project’s IRR is the discount rate that forces the PV of the inflows to
equal the initial cost (or to equal the PVs of all the costs if costs are
incurred over several years).
• This is equivalent to forcing the NPV to equal zero. The IRR is an
estimate of the project’s rate of return, and it is comparable to the YTM
on a bond.
• To calculate the IRR, we begin with for the NPV, replace r in the
denominator with the term “IRR,” and set the NPV equal to zero. This
transforms NPV Equation to the one used to find the IRR. The rate that
forces NPV to equal zero is the IRR.
Internal Rate of Return (IRR)

If the IRR criterion is used to rank projects, then the decision rules are as
follows.
 Independent projects: If IRR exceeds the project’s WACC, then the project
should be accepted. If IRR is less than the project’s WACC, reject it.
 Mutually exclusive projects. Accept the mutually exclusive project with
the highest IRR, provided that the project’s IRR is greater than its WACC.
Reject any project whose best IRR does not exceed the firm’s WACC
International Valuation Standards Council

Overview
The IVSC – Objectives
• Develop high quality international standards and support their adoption
and use;
• Facilitate collaboration and cooperation among its member bodies;
• Collaborate and cooperate with other international organisations;
• Serve as the international voice for the valuation profession.
 The IVSC – Structure
Board of Trustees:
Strategy, Governance
and
Fund-raising

Standards Board: Professional Board:

Standards and Technical Development and Promotion
Guidance of the Valuation Profession
 International Valuation Standards (IVS)
• Serve as the key guide for valuation professionals globally to underpin consistency,
transparency and confidence in valuations.
• The IVS are comprised of five ‘General Standards’ and eight ‘Asset-specific
Standards’.
• The General Standards set requirements for the conduct of all valuation assignments,
including establishing the terms of a valuation engagement, bases of value, valuation
approaches and methods, and reporting.
• The Asset Standards include requirements related to specific types of asset valuation,
including background information on the characteristics of each asset type that
influence value, and additional asset-specific requirements regarding common
valuation approaches and methods used.
 IVS Framework
General Standards Asset-specific Standards
1) IVS 101 Scope of Work 1. IVS 200 Businesses and Business Interests
2) IVS 102 Investigations and Compliance 2. IVS 210 Intangible Assets
3. IVS 220 Non-Financial Instruments
3) IVS 103 Reporting
4. IVS 230 Inventory
4) IVS 104 Bases of Value 5. IVS 300 Plant and Equipment
5) IVS 105 Valuation Approaches and 6. IVS 400 Real Property Interests
Methods 7. IVS 410 Development Property
8. IVS 500 Financial Instruments
Multumesc!