PROJECT REPORT SUBMITTED TOWARDS THE

PARTIAL FULFILLMENT OF
The Bachelor of Commerce with Honors

PROJECT REPORT
ON

FINANCIAL MODELLING
BATCH: 2017-2020

SUBMITTED BY: PROJECT GUIDE:

RISHABH SHARMA MS. DIVYA GUPTA
Enrollment No. : - 43820688817 (Assistant Professor)

TRINITY INSTITUTE OF PROFESSIONAL STUDIES

Affiliated To Guru Gobind Singh Indraprastha University, New Delhi

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 CERTIFICATE

This is to certify that the project work “Financial Modeling” made by RISHABH SHARMA,
B.COM(H), 4th semester, Enrollment no: 43820688817 is an authentic work carried out by
him/her under guidance and supervision of Ms. Divya Gupta.
The project report submitted has been found satisfactory for the partial fulfillment of the
degree of Bachelor of Commerce (Honors).

Project Supervisor

Ms. Divya Gupta

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 DECLARATION

I hereby declare that the following documented project report on “Financial Modeling” is an
original and authentic work done by me for the partial fulfillment of Bachelor of Business
Administration degree program.
I hereby declare that all the Endeavour put in the fulfillment of the task and genuine and original
to the best of my knowledge & I have not submitted it earlier elsewhere.

Signature:
RISHABH SHARMA
B.COM (H), SECTION-A, 1st SHIFT
43820688817

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 ACKNOWLEDGEMENT

It is in particular that I am acknowledging my sincere feeling towards my mentors who

graciously gave me their time and expertise.

They have provided me with the valuable guidance sustained and friendly approach it would
have been difficult to achieve the results in such a short span of time without their help.

I deem it my duty to record my gratitude towards my internal project supervisor Ms. Divya
Gupta who devoted her precious time to interact, guide and gave me the right approach to
accomplish the task and also helped me to enhance my knowledge and understanding of the
project.

Signature:
RISHABH SHARMA
B.COM (H), SECTION-A, 1st SHIFT
43820688817

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 CONTENTS

Teachers
Particulars Page No.
SR.NO Signature

1) Basic Excel In brief 8-16

2) Problem solver tool 17-19

3) What if analysis 20-29

4) Pivot Table & pivot chart 30-30

5) Basic formulas 31-48

Financial modelling basic concept
6) introduction 50-52

Types of financial models

7) 53-55
Steps of creating a financial model
9) 55-57
Advance excel function
10) 57-57
Building template
11) 57-58

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 Forecasting of financial statement
12) 59-61

Cash flow statement

13) 62

Various approaches to valuation

14) 64-66

Financial ratio & company analysis

15) 67-77

Sensitivity analysis
16) 78-80

Probabilistic analysis
17) 81-84

Market based method

18) 85-88

19) Time value of money

90-91

20) Capital budgeting model

91-94

21) Cost of capital calculation

94-98

22) Forecasting method

99-102

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UNIT-I

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1.1 INTRODUCTION TO EXCEL

MICROSOFT EXCEL 
Microsoft Excel is a software program produced by Microsoft that allows users to organize,
format and calculate data with formulas using a spreadsheet system.

ROW
A row is the range of cells that go across (horizontal)
the spreadsheet/worksheet.Rows are identified by numbers e.g. row 1, row 5.
Examples of use. A row might contain the headings of a table e.g. product ID,
product name, price, number sold.

COLOUMN
A column is a vertical series of cells in a chart, table, or spreadsheet. Below is an
example of a MicrosoftExcel spreadsheet with column headers (columnletter) A,
B, C, D, E, F, G, and H. As you can see in the image, the last column H is the
highlighted column in red and the selected cell D8 is in the D column.

CELL
A cell is the intersection between a row and a columnon a spreadsheet that starts
with cell A1. ... Each cell in a spreadsheet can contain any value that can be called
using a relative cell reference or called upon using a formula

ACTIVE CELL
Alternatively referred to as a cell pointer, current cell, orselected cell, an active
cell is a rectangular box, highlighting the cell in a spreadsheet. An active cellhelps
identify what cell is being worked with and where data will be entered

INSERT A CELL

Select one or more cells. Right-click and select Insert.

From the Insert box, select a row, column or cell to insert.

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 1.1.1Cut, Copy and Paste

Cut, Copy, and Paste are useful operations in Excel XP. You can quickly copy and/or cut
information in cells and paste them into other cells. These operations save you from having to
type and retype the same information.

The Cut, Copy, and Paste buttons are located on the Standard toolbar.

1.1.2 DELETING CELLS, ROWS, OR COLUMNS

Deleting cells gets rid of the whole kit and caboodle — cell structure along with all its contents
and formatting. When you delete a cell (or an entire row or column), Excel has to shuffle the
position of entries in the surrounding cells to plug up any gaps caused by the deletion.

To delete the actual cell selection rather than just clear the cell contents, follow these steps:

1. Select the cells, rows, or columns you want to delete.

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2. Click the drop-down button attached to the Delete button in the Cells group of the Home tab.
3. Click Delete Cells on the drop-down menu.

The Delete dialog box opens, showing these options for filling in the gaps:

o Shift Cells Left moves entries from neighbouring columns on the right to the left to fill
in gaps created when you delete the cell selection. This is the default option.

o Shift Cells Up moves entries up from neighbouring rows below.

o Entire Row removes all the rows in the current cell selection.

o Entire Column deletes all the columns in the current cell selection.

1.1.2 Resize

Double click on the border, and all of the rows or columns will automatically adjust to fit the
data. To adjust an entire worksheet with both rows and columns, type Control A to select the
entire worksheet. Then, double click with a double arrow on any column or row border.

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1.1.3 Add / hide / unhide comment

First I should say that the ways of inserting text and picture notes are different. So let's begin
with the easiest of two and add a text comment to a cell.
1. Select the cell that you want to comment on.

2. Go to the REVIEW tab and click on the New Comment icon in the Comments section.

Note. To perform this task you can also use the Shift + F2 keyboard shortcut or right-click
on the cell and choose the Insert Comment option from the menu list.

By default, every new comment is labelled with the Microsoft Office user name, but this
may not be you. In this case you can delete the default name from the comment box and
enter your own one. You can replace it with any other text as well.

Note. If you want your name to always appear in all your comments, follow the link to one
of our previous blog posts and find out how to change the default author name in Excel.

3. Enter your remarks in the comment box.

4. Click on any other cell in the worksheet.

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 The text will go, but the little red indicator will remain in the upper-right corner of the cell. It
shows that the cell contains the comment. Just hover the pointer over the cell to read the
note

1.1.4. WRAP TEXT

Wrap Text is a feature that wraps the text within a cell.
Q. Use the Wrap Text function

In a worksheet, select the cells that you want to format.

2. On the Home tab, in the Alignment group, click Wrap Text. Data in the cell wraps to fit the
column width, so if you change the column width, data wrapping adjusts automatically
Example: We used the ‘Wrap Text’ function to wrap the text ‘Financial Modeling
Assignment’ in one cell

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1.1.5. FILTERING AND SORTING
Sorting is a common spreadsheet task that allows you to easily reorder your data. The most
common type of sorting is alphabetical ordering, which you can do in ascending or descending
order
Q. Use the sorting and filtering functions on the given data

Let us take the above example for Sorting

1. Select a cell in the column you want to sort (a column with numbers).
2. Click the Sort & Filter command in the Editing group on the Home tab.
3. Select From Smallest to Largest. Now the information is organized from the smallest to
largest amount

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Filtering data in a spreadsheet means to set conditions so that only certain data is displayed. It
is done to make it easier to focus on specific information in a large database or table of data.

1.1.6 MERGER AND CENTER

Merging cells is often used when a title is to be centered over a particular section of a
spreadsheet. When a group of cells is merged, only the text in the upper-leftmost box is
preserved
Q. Use the Merger and Center functions

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On the Home tab, in the Alignment group, click Merge and Center. The cells will be merged
in a row or column, and the cell contents will be centered in the merged cell. To merge cells
without centering, click the arrow next to Merge and Center, and then click Merge Across or
Merge Cells.

In the Example above we will merge E3 and F3 and the word ‘March’ will be placed in the
center as shown below
1. Select E3 and F3 cells.
2. Choose the ‘Merge and Center’ function.
3. E3 and F3 merge into a single cell with the word ‘March’ being placed in the center.
4. To unmerge the merged cell, select the merged cell and choose the ‘unmerge cells’ option.

1.1.7 CONDITIONAL FORMATTING

Conditional Formatting (CF) is a tool that allows you to apply formats to a cell or range of
cells, and have that formatting change depending on the value of the cell or the value of a
formula.
1. Select the cells which you want to format and choose the ‘Conditional Formatting’.
2. Select the following:-
Q. Use Conditional Formatting
A. Greater than (Example 70) B. Data Bars

C. Icon Sets D. Color Scales

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Macros

A macro is simply a series of instructions. After you’ve created a macro, Excel will execute
those instructions, step-by-step, on any data that you give it.

For example, we could have a macro that tells Excel to take a number, add two, multiply by
five, and return the modulus.

Now, whenever we tell Excel to run that macro, we don’t have to manually do each step; Excel
will do them all.

To start automating your Excel actions with macros, you’ll need to “record” a macro.

Recording a macro is how you tell Excel which steps to take when you run the macro.

And while you can code a macro using Visual Basic for Applications (VBA), Excel also lets
you record a macro by using standard commands.

Let’s take a look at a basic example. In our spreadsheet, we have a list of names and a
corresponding list of their sales for the month:

We’ll record a macro that sorts the sales from highest to lowest, copies the information of the
most successful salesperson, and changes the formatting to make that information stand out.

Before we get started, we’ll need to make sure that the Developer tab is visible.

Head to File > Options, and select Customize Ribbon in the sidebar. Then, in Main Tabs,
make sure that Developer is checked:

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Click OK, and open up that tab in the main window. You’ll see a button labeled Record
Macro.

To start recording a macro, just click that button.

You’ll be asked to name your macro (we’ve named ours “HighSales”), and enter a shortcut key
if you choose.

Keep in mind that there are already a lot of Ctrl-based shortcuts, so try not to overwrite any of
those that you use regularly.

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You can also choose to save the macro in one of three places: the current workbook, a new
workbook, or your personal macro workbooks.

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1.2 Problem solver

Excel Solver is an optimization tool that can be used to determine how the desired outcome
can be achieved by changing the assumptions in a model. It is a type of what-if analysis and is
particularly useful when trying to determine the “best” outcome, given a set of more than two
assumptions. Learn with video instruction in CFI’s Advanced Excel Course.

How to Use Excel Solver – Example

The best example of how to use Excel solver is by graphing a situation where there is a non-
linear relationship between, for example, the number of salespeople in a company and
the profit that they generate. There is a diminishing return on salespeople, so we want to figure
out what the optimal number of people to hire is. Put another way, we want to figure out how
many salespeople we should hire to get the maximum amount of profit.

Step 1: Ensure the Solver Add-In is Installed

The first step is to make sure you have Solver installed in your Excel file. To do this, go to File
-> Options -> Add-Ins -> Manage Excel Add-Ins. When the dialogue box appears, make sure
the box is ticked, as shown below.

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Step 2: Build a Model

Here, we’ve created an example where there is a non-linear relationship between the number
of salespeople in a company and their profit. This is because as more salespeople are added,
the less effective they become. Image a very niche market that only has a certain number of
customers.

As you add more salespeople initially, you generate a lot more revenue, but at some point
additional sales people run out of new people to prospect and they become dead weight for the
company. The point of this model is to show an example that can’t easily be calculated
using Goal Seek or some other solution.

Learn with video instruction in CFI’s Advanced Excel Course.

Step 3: Use the Ribbon to Launch Excel Solver

The Excel Solver function is located on the Data Ribbon and the keyboard shortcut on
Windows is Alt, A, Y21. Once the dialog box appears you will notice several options you can
work with.

1. Set the “Objective” cell. In our case, this is Profit.

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 2. Set it “To” something (Max, Min, or a specific value). In our case, we want the Max
Profit.
3. Select the Cell(s) you want to change in order to find the solution. In our case, we want
to select the number of salespeople cell.
4. Add constraints. If you want to set a constraint (e.g., a cell must be > or < some number),
you can add this in. In our case, there are no constraints.
5. Click “Solve.”
6. Decide if you want to keep the solution in the cells or restore the original values.

Graph Solution
In this example, we’ve also shown how you could use a graph to get the solution, and this really
helps illustrate the relationship between the number of salespeople and the profit of the
business. Using both Excel Solver and the graph together really instills confidence in our
analysis.

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1.3 What if Analysis

What-if-analysis in Excel is a tool in Excel that helps you run reverse calculations, sensitivity
analysis and scenarios comparison.

Decision making is a crucial part of any business or job role. When you can take decisions,
which are informed based on data, the outcome of the business or project or task is always
more in control.

Thus, What if Excel is used by almost every data analyst and especially middle to higher
management professionals, to make better, faster and more accurate decisions based on data.

3 parts of what-if-analysis in Excel

 Goal Seek – Reverse calculations

 Data Table – Sensitivity analysis
 Scenario Manager – Comparison of scenarios

Goal Seek in What if analysis

Let’s consider a simple dataset, where the invoice amount is Rs. 10,000, on which there is 9%
CGST and 9% SGST, which thus amounts to a total of Rs. 11,800.

The customer asks you for a discount of Rs. 800 and thus the final amount should be Rs. 11,000.

Now, the equation in simple terms is, X + 18% = 11000, where X is the invoice amount, 18%
is the total GST.

To find out, how much + 18% = 11000, we will use Goal Seek in What if analysis.

 Place your cursor on the ‘Total’ cell

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 Under the ‘Data’ tab, click on ‘What-If-Analysis’, then on ‘Goal Seek’

 In ‘Set Cell’, B4 will automatically be selected as you had kept your cursor on it.
 In ‘To value’, enter the desired value, 11000 in this case.
 In ‘By changing cell’, choose the value that needs to be changed, invoice amount in this
case. Thus cell B1 is selected.
 Press Ok

Excel will reverse calculate and immediately give you the value Rs. 9,322, which + 18% equals
exactly to Rs. 11,000

This was a very simple example of using Goal Seek in what-if analysis. You can use Goal Seek
even for more complex models, let’s take an example of a Car loan model.

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The ‘EMI’ calculated Rs. 19,786 is the outgoing amount per month. The value is negative as
money is going out of your pocket.

But, you have a budget of only Rs. 17,000 per month. So, how much can you afford as ‘Price
of Car’?

Put the Goal Seek values as above and you will know the Price of Car that you can afford.

This was calculations at multiple levels that Goal Seek in What-if analysis did, as it had to
consider Available funds, ROI, Number of payments to reverse calculate and give you the
answer.

That’s how powerful it is.

Data Table in What-If analysis

Data Table is used for Sensitivity analysis. What this means is basically, either 1 or 2 of the
inputs in your model are changing, you want to know output based on each change.

Let’s take the same Car loan example as earlier.

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Now, after applying the Goal Seek, you know you can afford to buy a car worth Rs. 7,15,526
instead of Rs. 8,00,000.

1- input Data Table

Then you go to the Car showrooms and research on more cars available. You find out 5 cars
that you like, you want to know what would be the EMI amount for each of the car?

Car 1 – Rs. 5,54,000

Car 2 – Rs. 5,96,000

Car 3 – Rs. 6,24,000

Car 4 – Rs. 7,36,000

Car 5 – Rs. 7,94,000

Use what if analysis data table to find this.

Since only 1 input is changing, that is, Price of Car, we will use 1-input data table.

Make this structure in your Excel sheet next to your model.

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In D3, you can write anything you want, doesn’t matter.

Next to that, in E4, put =B9. Basically, you are pointing to the formula that is used to calculate
the EMI. Thus, here you have informed Excel that you want to calculate the resulting EMI for
each value, using the formula in B9.

Now select this structure you have created and go to ‘Data table’ under what-if analysis in Data
tab.

Since our options of Prices of Cars are put vertically in a column, we will use Column input
cell. Select cell B1 to inform Excel that the 5 values are Price of Car values.

Press OK

Excel has calculated for you, the EMI for each change in Price of Car.

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2- input Data Table

Similarly, you can have 2 inputs varying and still get the respective outputs.

So now you think about what if I change the duration of the loan, and compare for all these 5
cars?

Go to Data Table and select Row input cell as ‘No. of payments in months’ and Column input
cell as ‘Price of car’

You will get the EMI amount for each combination in no time, without much effort or any
complicated formulas.

Scenario Manager in what if analysis

Let’s say you are working in a Car Showroom in the Sales department. You have been given
the task to plan the sales for the next quarter. You must build multiple scenarios and prepare a
comparison of all the scenarios.

You make a model as below and then want to create multiple scenarios based on number of
cars that you will be able to sell for each of the cars.

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Under What-if analysis, go to scenario manager.

Click on ‘Add’

Let’s start building our 1st scenario

 Scenario Name – Best Case

 Changing Cells – select cells C2:C6 as these are the No. of cars that you will be able to
sell, basically the variable cells
 Press OK
 Enter values for each Car

I have entered values as above, you can enter whatever you like.

Similarly add 1 more Scenario and name it as ‘Worst Case’. The changing cells will ofcourse
remain the same.

I have put in the below values for Worst case.

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You can create many more scenarios like this.

Compare the scenarios

Now that your scenarios are created, let’s compare them.

In the Scenario Manager window, click on Summary.

You will now be asked for ‘Result cells’. Choose the Total Sales Value, cell D8, as that’s what
you want to compare. If you want to compare more outputs, you can choose multiple cells here
too.

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A new Sheet will be created automatically on pressing OK which will give you a comparison
of the Current values in your Sheet + the 2 scenarios you created.

Thus, in best case, the Total Sales is over Rs. 6 CR. Worst Case is 3.77 CR.

Now you can take your business decisions based on this output.

Goal Seek
What if you want to know how many books you need to sell for the highest price, to obtain a
total profit of exactly $4700? You can use Excel's Goal Seek feature to find the answer.
1. On the Data tab, in the Forecast group, click What-If Analysis.

2. Click Goal Seek.

The Goal Seek dialog box appears.

3. Select cell D10.

4. Click in the 'To value' box and type 4700.

5. Click in the 'By changing cell' box and select cell C4.

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6. Click OK.

Result. You need to sell 90% of the books for the highest price to obtain a total profit of exactly
$4700.

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1.4 PIVOT CHART AND PIVOT TABLE
A pivot table is a program tool that allows you to reorganize and summarize selected columns
and rows of data in a spreadsheet or database table to obtain a desired report. A pivot chart is
the visual representation of a pivot table in Excel.
Q. Create a Pivot Table and Pivot Chart
A B C

10 30 40

20 50 10

80 10 70

1. Click a cell in the source data or table range.

2. Go to Insert > Tables > Recommended PivotTable.
3. Excel analyzes your data and presents you with several options
4. Select the PivotTable that looks best to you and press OK

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1.5 BASIC FORMULA SUM
Microsoft Excel defines SUM as a formula that “Adds all the numbers in a range of cells”.
This definition clearly points that Sum function has a job to add numbers and the
arguments can be supplied using combinations of both numbers and range of cells.

Formula

=SUM (number1, [number2], [number3]……)

The SUM function uses the following arguments:

1. Number1 (required argument) – It is the first item that we wish to sum.

2. Number2 (required argument) – It is the second item that we wish to sum.
3. Number3 (optional argument) – It is the third item that we wish to sum.

AVERAGE
he Microsoft Excel AVERAGE function returns theaverage (arithmetic mean) of the
numbers provided.

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Formula

=AVERAGE (number1, [number2], …)

The function uses the following arguments:

1. Number1 (required argument) – It is the first number or a cell reference or a range for
which we want the average.
2. Number2 (optional argument) – They are the additional numbers, cell references or a
range for which we want the average. A maximum of 255 numbers is allowed.

COUNT
Excel's Count() function is one of a group of countfunctions that totals the number of cells
in a selected range that contain a specific type of data. Each member of this group does a
slightly different job and the Count() function's job is to count only numbers.

Formula

=COUNT (value1, value2….)

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Where: Value1 (required argument) – The first item or cell reference or range for which we
wish to count numbers.

Value2… (Optional argument) – We can add up to 255 additional items, cell references, or
ranges within which we wish to count numbers.

Remember this function will count only numbers and ignore everything else.

COUNTA
The Microsoft Excel COUNTA function counts the number of cells that are not empty as well
as the number of value arguments provided. ... It can be used as a worksheet function (WS)
in Excel. As a worksheet function, the COUNTA function can be entered as part of a formula
in a cell of a worksheet.

Excel Count if Not Blank Formula

=COUNTA (value1, [value2] …)

The Excel count if not blank formula uses the following arguments:

1. Value1 (required argument) – It is the value at which we evaluate the function.

2. Value2 (optional argument) – Additional arguments that represent the values that we
wish to count.

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IF
Use the IF function, one of the logical functions, to return one value if a condition is true
and another value if it's false.

=IF(logical test, value_if_true, value_if_false)

The formula uses the following arguments:

1. Logical_test (required argument) – It is the condition to be tested and evaluated as

either TRUE or FALSE.
2. Value_if_true (optional argument) – It is the value that will be returned if the
logical_test evaluates to TRUE.
3. Value_if_false (optional argument) – It is the value that will be returned if the
logical_test evaluates to FALSE.

SUMIF:

The SUMIF function is categorized under Math and Trigonometry functions. It will sum up
cells that meet the given criteria. The criteria are based on dates, numbers, and text. It supports
logical operators such as (>, <, <>, =) and also wildcards (*?). This guide to the Sum If Excel
function will show you how to use it, step-by-step.

As a financial analyst, SUMIF is a frequently used function. Suppose we are given a table
listing the consignments of vegetables from different suppliers. The names of the vegetable,

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names of suppliers and quantity are in column A, column B, and column C, respectively. In
such scenario, we can use the SUMIF function to find out the sum of the amount related to a
particular vegetable from a specific supplier.

Formula

=SUMIF (range, criteria, [sum_range])

=SUMIF (range, criteria, [sum_range])

The formula uses the following arguments:

1. Range (required argument) – It is the range of cells that we want to apply the criteria
against.
2. Criteria (required argument) – It is the criteria which are used to determine which cells
need to be added.

When we provide the criteria argument, it can either be:

A numeric value (which may be an integer, decimal, date, time, or logical value) (e.g.
10, 01/01/2018, TRUE) or
 A text string (e.g. “Text”, “Thursday”) or
 An expression (e.g. “>12”, “<>0”).

3. Sum_range (optional argument) – It is an array of numeric values (or cells containing

numeric values) that are to be added together if the corresponding range entry satisfies
the supplied criteria. If the [sum_range] argument is omitted, the values from the range
argument are summed instead.

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VLOOKUP:

The VLOOKUP function in Excel is a tool for looking up a piece of information in a table or
data set and extracting some corresponding data/information. In simple terms, the VLOOKUP
function says the following to Excel: “Look for this piece of information (e.g., bananas), in this
data set (a table), and tell me some corresponding information about it (e.g., the price of
bananas)”.

VLOOKUP Formula

=VLOOKUP (lookup_value, table array, col_index_num, [range_lookup])

To translate this to simple English, the formula is saying, “Look for this piece of information,
in the following area, and give me some corresponding data from another column”.

The VLOOKUP function uses the following arguments:

1. Lookup_value (required argument) – Lookup_value specifies the value that we want to

look up for in the first column of a table.
2. Table array (required argument) – The table array is the data array that is to be searched.
The VLOOKUP function searches in the left-most column of this array.
3. Col_index_num (required argument) – This is an integer, specifying the column
number of the supplied table array that you want to return a value from.
4. Range_lookup (optional argument) – This defines what this function should return in
the event that it does not find an exact match to the lookup_value. The argument can be
set to TRUE or FALSE, which means:
o TRUE – Approximate match, that is, if an exact match is not found, use the
closest match below the lookup_value.
o FALSE – Exact match, that is, if an exact match not found, then it will return
an error.

VLOOKUP is used with the following steps:

1. Select the name that’s entered in cell C20.

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 2. Select the range of the entire table B14:D18.
3. Select the corresponding output from column “3.”
4. “False” requires an exact name match.

HLOOKUP:

HLOOKUP stands for Horizontal Lookup and can be used to retrieve information from a table
by searching a row for the matching data and outputting from the corresponding column. While
VLOOKUP searches for the value in a column, HLOOKUP searches for the value in a row.

Formula

=HLOOKUP (value to look up, table area, row number)

CONCATENATE
The Excel CONCATENATE functionconcatenates (joins) join up to 30 text items together
and returns the result as text. The CONCAT functionreplaces CONCATENATE in newer
versions ofExcel. Join text together. Text joined together.

37
Drop Down List:

An Excel drop down list is a data validation function that allows users to select an option from
a list of choices. It can be particularly useful in performing financial modeling and analysis by
incorporating scenarios and making a spreadsheet more dynamic.

How to Make an Excel Drop down List?

Below are step-by-step instructions on how to build a drop down list in Excel:

Step 1: Create a List of Options

Make a vertical list of options you want users to be able to choose from.

Step 2: Pick a Cell and Access Data Validation on the Ribbon

Pick a cell where you want the Excel drop down list to be located and use the ribbon to access
the Data Validation function, which is located on the Data ribbon.

Step 3: Select “List” and Link the Data

When the data validation dialogue box appears, you will need to select “List” where it asks you
what you want to “Allow” in the cell.

Once that is done, you can select the data you want to include as the options that will appear in
the list.

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39
FINANCIAL – ACCRINT
The Microsoft Excel accrint function returns the accrued interest for a security that pays interest
on a periodic basis. The accrint function is a built-in function in Excel that is categorized as
a FinancialFunction. It can be used as a worksheet function (WS) in Excel. As a worksheet
function, the ACCRINT function can be entered as part of a formula in a cell of a worksheet.

Syntax: =ACCRINT( issue date, first interest date, settlement date, rate, par, frequency, [basis],
[calculation method] )

Q. Accrued Interest on a security with an issue date of 01-Jan-2012, first interest

date of 01-April-2012 and a settlement date of 31-December-2013. The annual
coupon rate is 8%, the par value of security is $10,000 and payments are made
quarterly.

1. Select the ACCRINT Function from the Financial Formulas.

2. Fill in the above details as required

Accrued Interest is 160.22222

40
Accrintm
The Microsoft Excel accrintm function returns the accrued interest for a security that pays
interest at maturity. The accrintm function is a built-in function in Excel that is categorized as
a FinancialFunction. It can be used as a worksheet function (WS) in Excel. As a worksheet
function, the accrintm function can be entered as part of a formula in a cell of a worksheet.

Syntax : =ACCRINTM( issue date, maturity date, rate, par, [basis] )

Issue date : The date that the security was issued.

Maturity date :The maturity date of the security.

Rate : The annual coupon rate for the security.

Par : The par value of the security. If this parameter is omitted, the ACCRINTM function will
assume that the par is set to $1,000.

Basis : Optional. It is the type of day count to use when calculating interest for the security. If
this parameter is omitted, it assumes that the basis is set to 0. It can be any of the following
values.

41
 PV Function

The Excel PV function is a financial function that returns the present value of an investment.
You can use the PV function to get the value in today's dollars of a series of future payments,
assuming periodic, constant payments and a constant interest rate.

Purpose:

Get the present value of an investment

Syntax :

=PV (rate, nper, pmt, [fv], [type])

Arguments:

 rate - The interest rate per period.

 nper - The total number of payment periods.
 pmt - The payment made each period.
 fv - [optional] A cash balance you want to attain after the last payment is made. If omitted,
assumed to be zero.
 type - [optional] When payments are due. 0 = end of period, 1 = beginning of period. Default
is 0.

FV Function

The Excel FV function is a financial function that returns the future value of an investment.
You can use the FV function to get the future value of an investment assuming periodic,
constant payments with a constant interest rate.

Purpose:

Get the future value of an investment

Syntax :

42
 =FV (rate, nper, pmt, [pv], [type])

Arguments:

 rate - The interest rate per period.

 nper - The total number of payment periods.
 pmt - The payment made each period. Must be entered as a negative number.
 pv - [optional] The present value of future payments. If omitted, assumed to be zero. Must be
entered as a negative number.
 type - [optional] When payments are due. 0 = end of period, 1 = beginning of period.

RATE Function

The Excel RATE function is a financial function that returns the interest rate per period of an
annuity. You can use RATE to calculate the periodic interest rate, then multiply as required to
derive the annual interest rate. The RATE function calculates by iteration.

Purpose

Get the interest rate per period of an annuity

Syntax

=RATE (nper, pmt, pv, [fv], [type], [guess])

43
 Arguments

 nper - The total number of payment periods.

 pmt - The payment made each period.
 pv - The present value, or total value of all loan payments now.
 fv - [optional] The future value, or desired cash balance after last payment. Default is 0.
 type - [optional] When payments are due. 0 = end of period. 1 = beginning of period. Default
is 0.
 guess - [optional] Your guess on the rate. Default is 10%.

PMT Function

The Excel PMT function is a financial function that returns the periodic payment for a loan.
You can use the NPER function to figure out payments for a loan, given the loan amount,
number of periods, and interest rate.

Purpose

Get the periodic payment for a loan

Syntax

=PMT (rate, nper, pv, [fv], [type])

Arguments

 rate - The interest rate for the loan.

 nper - The total number of payments for the loan.
 pv - The present value, or total value of all loan payments now.

44
 fv - [optional] The future value, or a cash balance you want after the last payment is made.
Defaults to 0 (zero).
 type - [optional] When payments are due. 0 = end of period. 1 = beginning of period. Default
is 0.

NPER Function

The Excel NPER function is a financial function that returns the number of periods for loan or
investment. You can use the NPER function to get the number of payment periods for a loan,
given the amount, the interest rate, and periodic payment amount.

Purpose

Get number of periods for loan or investment

Syntax

=NPER (rate, pmt, pv, [fv], [type])

Arguments

 rate - The interest rate per period.

45
 pmt - The payment made each period.
 pv - The present value, or total value of all payments now.
 fv - [optional] The future value, or a cash balance you want after the last payment is made.
Defaults to 0.
 type - [optional] When payments are due. 0 = end of period. 1 = beginning of period. Default
is 0.

PPMT Function

The Microsoft Excel PPMT function returns the payment on the principal for a particular
payment based on an interest rate and a constant payment schedule.The PPMT function is a
built-in function in Excel that is categorized as a Financial Function. It can be used as a
worksheet function (WS) and a VBA function (VBA) in Excel. As a worksheet function, the
PPMT function can be entered as part of a formula in a cell of a worksheet. As a VBA function,
you can use this function in macro code that is entered through the Microsoft Visual Basic
Editor.

Syntax : =PPMT( interest_rate, period, number_payments, PV, [FV], [Type] )

Interest rate -The interest rate for the loan.

Arguments
Period- The period used to determine how much principal has been repaid. Period must be a
value between 1 and number payments.

Number payments -The number of payments for the loan.

PV -The present value or principal of the loan.

FV Optional. It is the future value or the loan amount outstanding after all payments have been
made. If this parameter is omitted, it assumes a FV value of 0.

Type Optional. It indicates when the payments are due. If the Type parameter is omitted, it
assumes a Type value of 0

46
IPMT
The Microsoft Excel IPMT function returns the interest payment for an investment based on
an interest rate and a constant payment schedule.

The IPMT function is a built-in function in Excel that is categorized as a Financial Function. It
can be used as a worksheet function (WS) and a VBA function (VBA) in Excel. As a worksheet
function, the IPMT function can be entered as part of a formula in a cell of a worksheet. As a
VBA function, you can use this function in macro code that is entered through the Microsoft
Visual Basic Editor.

Syntax

IPMT( interest_rate, period, number_payments, PV, [FV], [Type]

Arguments

Interest rate -The interest rate for the investment.

Period- The period to calculate the interest rate. It must be a value between 1 and number
payments.

Number payments -The number of payments for the annuity.

PV -The present value of the payments.

FV Optional- It is the future value that you'd like the investment to be after all payments have
been made. If this parameter is omitted, it will assume a FV of 0.

Type Optional.- It indicates when the payments are due. If the Type parameter is omitted, it
assumes a Type value of 0.

47
48
UNIT-II

49
 2.1Financial Modeling Basic Concepts

Meaning - Financial modeling is the task of building an abstract

representation (a model) of a real world financial situation. This is a
mathematical model designed to represent (a simplified version of) the
performance of a financial asset or portfolio of a business, project, or any other
investment.

Users - Financial models can be used by many different parties for many
different goals:-
Investment bankers use models for transactions involving capital structure or
ownership
Accountants and valuation advisors use financial models for valuation projections
Credit analysts use financial models to determine ability to repay debt, buy/sell
side research analysts use financial models to determine a buy or sell rating on a
particular security
Management uses financial models to determine internal budgets for various
reasons.

50
2.1.1 Benefits of Financial Modeling

Quick answers

Financial Modeling exercises help in providing instant answers to things that may take months
or even years to actually take place. This is good for businesses because they will know what
to expect when they make certain decisions. However, if a change is made in the financial
model, then automatically all the related values and formulae will also change.

Minimize risks

Financial models help projects and businesses to lower financial risks. This is because
business owners will know that if they do this, then this is what is likely to occur. With these
models, businesses can know the impact of marketing campaigns and the cost of entering a
new market, the effect of price changes on the business and much more

Monthly assessments

Financial models can help in providing monthly assessments of the actual performance of the
company versus what the budget or plan predicted it would. This is a crucial feedback,
especially for small business owners or start-ups that are not used to the

Planning or budget process. Advanced Financial Modeling helps business owners to make
adjustments that will ensure the business rakes in profits at the end of the day.

Shareable

Business models can easily be shared with other individuals who are situated in various
locations. This helps in enhancing input and analysis because you get feedback from different
people in your organizations. As a result, you will make the right decisions for your company.

51
Consistent results

Financial Modeling provides consistent results. The same inputs that businesses implement
will always produce similar results. For example, a decision to take up a loan by a business
will still increase capital for expanding the business, whether the business owner decides to
take the financing today or after 10 years. In addition, the risks involved in taking the loan will
still be the same.

Most business owners are not specialists of analyzing their business financials through
modeling. This is because some people do not like dealing with numbers. However, if you do
not enjoy this, then you should get assistance from financial modeling experts. Financial
models are a crucial asset for your company or business and having a skilled expert work for
you will make things easier for you. With the right professional, you will be able to scale your
business to greater heights.

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Sectors of Financial Modeling:-
Investment Banks
Credit Rating Agencies
Equity Research
Mutual Funds
Financial KPOs
Project Finance companies

2.2 Types of Financial Model

1. Three Statement Model

The 3 statement model is the most basic setup for financial modeling. As the name implies, in
this model the three statements (income statement, balance sheet, and cash flow) are all
dynamically linked with formulas. In Excel. The objective is to set it up so all the accounts
are connected, and a set of assumptions can drive changes in the entire model.

2. Discounted Cash Flow (DCF) Model

The DCF model builds on the 3 statement model to value a company based on the Net
Present Value (NPV) of the business’ future cash flow. The DCF model takes the cash flows
from the 3 statement model, makes some adjustments where necessary, and then uses the
XNPV function in Excel to discount them back to today at the company’s Weighted Average
Cost of Capital.

These types of financial models are used in equity research and other areas of the
capital markets.

3. Merger Model (M&A)

The M&A model is a more advanced model used to evaluate the pro forma accretion/dilution
of a merger or acquisition. It’s common to use a single tab model for each company, where
the consolidation where Company A + Company B = Merged Co. The level of complexity
can vary widely and is most commonly used in investment banking and/or corporate
development

4. Initial Public Offering (IPO) Model

53
Investment bankers and corporate development professionals will also build IPO models in
Excel to value their business in advance of going public. These models involve looking
at comparable company analysis in conjunction with an assumption about how much
investors would be willing to pay for the company in question. The valuation in an IPO
model includes “an IPO discount” to ensure the stock trades well in the secondary market.

5. Leveraged Buyout (LBO) Model

A leveraged buyout transaction typically requires modeling complicated debt schedules and is
an advanced form of financial modeling. An LBO is often one of the most detailed and
challenging of all types of financial models as they many layers of financing create circular
references and requires cash flow waterfalls. These types of models are not very common
outside of private equity or investment banking.

6. Sum of the Parts Model

This type of model is built by taking several DCF models and adding them together. Next,
any additional components of the business that might not be suitable for a DCF analysis
(i.e. marketable securities, which would be valued based on the market) are added to that
value of the business. So, for example, you would sum up (hence “Sum of the Parts”) the
value of business unit A, business unit B, and investments C, minus liabilities D to arrive at
the Net Asset Value for the company.

7. Consolidation Model
This type of model includes multiple business units added into one single model. Typically
each business unit is its own tab, with consolidation tab that simply sums up the
other business units. This is similar to a Sum of the Parts exercise where Division A and
Division B are added together and a new, consolidated worksheet is created. Check out CFI’s
free consolidation model template

8. Budget Model

This is used to model finance for professionals in financial planning & analysis (FP&A) to get
the budget together for the coming year(s). Budget models are typically designed to be based
on monthly or quarterly figures and focus heavily on the income statement.

9. Forecasting Model
This type is also used in financial planning and analysis (FP&A) to build a forecast that
compares to the budget model. Sometimes the budget and forecast models are one combined
workbook and sometimes they are totally separate.

10. Option Pricing Model

54
The two main types of models are binomial tree and Black-Sholes. These models are based
purely on mathematical models rather than subjective criteria and therefore are more or less a
straightforward calculator built into Excel.

2.3 Steps in Creating Financial Model

1. Gather Requirements
This is a very critical stage and the analyst should obtain the answers to following critical
questions before moving on to the actually developing the model.
a. What is the purpose of this financial model? – E.g. is it for credit rating assessment or for
project performance forecast OR acquisition of business etc.
b. Who is the target audience that would consume this model? E.g. Is it for the clients or the
regulatory bodies or for financial institutions etc.
c. What kind of decisions would be taken based on this model? E.g. go/ No-go decision for
projects OR deciding upon budget allocation OR setting targets etc.
d. How much time is available for developing the model? While at times, there are no
exigencies, in some cases time is an extremely important factor. Knowledge of this factor
would enable the analyst to decide upon the trade-off between accuracy and speed with which
the financial model is developed.

2. Apply the industry knowledge

Applying the knowledge of the industry and the business model is extremely important as it
will have a certain impact on the logic used for deriving various output numbers. For
instance, projecting the prices of a commodity (say potato) which is used as a raw material
for manufacturing the end product (say potato chips) by a company, would need a good
understanding of the demand-supply dynamics for that commodity and an in depth analysis
of the emerging trends and the underlying factors which can affect the demand and supply
and in turn the prices of that commodity.

55
3. Define the scope and execution plan
It’s important to work backwards from the final delivery deadline to ensure smooth
development process. Clarifications such as those listed below would be helpful in defining
the structure (architecture) of the financial model
a. How many different P&L statements would be a part of the model?
b. For how many years do we need to project the financial statements?
c. Should the statements be projected on a yearly basis or on a quarterly half yearly basis?

4. Develop the structure (architecture) of the model

Similar to any software, every financial model has three important elements:
a. Input
b. Processing/ Logic
c. Output
The structure of the model should be such that it clearly segregates the inputs, processing
(calculations) and the output. The financial model should also be broken down into various re-
usable logic modules which would save the developer from unnecessary re-work and save a lot
of time. However, one should be careful in re-using modules because in such cases, errors or
bugs also tend to percolate along with the logic.

5. Develop and Test the modules

The first element of any financial model should be the output template, typically with time
periods on the horizontal axis and various outputs as rows. This would make it easier for the
analyst to keep targeting the row elements and keep working on them till all of the row elements
are estimated by the financial model.
Defining the logic of deriving the outputs and the corresponding required inputs (assumptions)
should be the next step. There can be various iterations at this stage and gathering the suitable
inputs and development of appropriate logic for estimating the outputs may be a time taking
and complex activity. At this stage, it is critical that the analyst who is developing the model
stays focused and does not get carried away by the complexity and must not lose track of time
or the real purpose behind development of the model.
Testing is an extremely critical element of the financial model as even a small error can create
havoc in the final stages and may lead to incorrect output, which if gone un-noticed may lead
to incorrect decision making.

56
 6. Final Testing
After all the outputs have been estimated, the financial model should be stress tested with
variety of inputs, especially the boundary conditions where there are higher chances of errors
creeping in.
At this stage, the financial analyst must be completely well versed with the financial model and
be aware of how the model should behave in various scenarios. This would enable the analyst
to test out the model thoroughly.

7. Sensitivity Analysis
Sensitivity Analysis is widely used for understanding the key risks and dependence of key
output parameters on various input parameters or assumptions. E.g. Variation in Net Present
Value (NPV) of a project due to changes in raw material costs.
Conducting and presenting the sensitivity analysis on key output parameters is an essential step
towards completion of the financial model.

2.4 BUILDING A TEMPLATE

To use the same layout or data in a workbook, we can save it as a template so you can use
the template to create more workbooks instead of starting from scratch. One can make his
own templates to create a new workbook.

Save a workbook as a template

1. Saving a workbook to a template for the first time, start by setting the default personal
templates location:
a. Click File > Options.
b. Click Save, and then under Save workbooks, enter the path to the personal templates location
in the Default personal templates location box.
This path is typically: C:\Users\[UserName]\Documents\Custom Office Templates.

c. Click OK.

57
 Once this option is set, all custom templates you save to the My Templates folder automatically
appear under Personal on the New page (File > New).
2. Open the workbook you want to use as a template.
3. Click File > Export.
4. Under Export, click Change File Type.
5. In the Workbook File Types box, double-click Template.
6. In the File name box, type the name you want to use for the template.
7. Click Save, and then close the template.
Insert picture

58
2.5 FORECASTING AND FINANCIAL STATEMENTS:-

 Income Statement.
 Balance Sheet.
 Cash Flow Statement.

#The income statement:-

The income statement illustrates a company's profitability. All three statements are presented
from left to right, with at least 3 years of historical results present in order to provide historical
rations and growth rates from which forecasts are based. Inputting the historical income
statement data is the first step in building a 3-statement financial model. The process involves
either manual data entry from the 10K or press release, or the use of an Excel plug in such as
Fact set or Capital IQ to drop historical data directly into Excel.

Forecasting typically begins with a revenue forecast followed by the forecasting of various
expenses. The net result is a forecast of the company's income and earnings per share. The
income statement covers a specified period such as quarter or year.

59
60
#The balance sheet:-
Unlike the income statement, which shows operating results over a period of time (a year or a
quarter), the balance sheet is a snapshot of the company at the end of the reporting period. The
balance sheet shows the company’s resources (assets) and funding for those resources
(liabilities and shareholder’s equity). Inputting historical balance sheet data is similar to
inputting data in the income statement. The data is inputted either manually or through an Excel
plug in.

In large part, the balance sheet is driven by the operating assumptions we make on the income
statement. Revenues drive the operating assumptions in the income statement, and this
continues to hold true in the balance sheet: Revenue and operating forecasts
drive workingcapital items, capital expenditures and a variety of other items. Think of the
income statement as the horse and the balance sheet as the carriage. The income statement
assumptions are driving the balance sheet forecasts.

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2.6 Cash flow statement
The final core element of the 3-statement model is the cash flow statement. Unlike on the
income statement or the balance sheet, you aren't actually forecasting anything explicitly on
the cash flow statement and it isn’t necessary to input historical cash flow statement results
before forecasting. That’s because the cash flow statement is a pure reconciliation of the
year-over-year changes in the balance sheet.
Every individual line item on the cash flow statement should be referenced from elsewhere in
the model (it should not be hardcoded) as this is reconciliation. Constructing the cash flow
statement correctly is critical to getting the balance sheet to balance.

62
UNIT-III

63
 3.1 VARIOUS APPROACHES TO VALUATION

American Institute of Chartered Public Accountants (AICPA) prescribes three approaches to

valuation. These approaches are:
1) Income Based approach: This approach values the company based on the future income
that the company can generate. The common method used in the valuation is the discounted
cash flow method and capitalization method.
 Capitalization of benefits method: The valuation of the future cash flows of the
company requires the following adjustments.
 Normalization adjustments- any business operates in a normal condition, and
the activities take place in a normal course. There may be situations that arise,
where the company may function slightly exceptional, for example, there may
be on huge one-time sales order, which the company undertakes, and this may
not recur every year. These kinds of abnormal adjustments need to be made to
arrive at the normal profits of the company.
 Nonrecurring revenue and expense items- any expense and income should be
recurring. Onetime expenses will have only bearing in the cash flow of the
company. Hence, the revenue expenses that occur should be considered.
 Taxes-the relevant tax rate has to be considered and the tax amortization
benefit has to be considered for valuation of intangibles.
 Capital structure and financing costs-capital structure refers to the composition
of the shareholders funds and the external funds. This is relevant for arriving
at the cost of capital.
 Appropriate capital investments – these have to be considered, as they will
have an impact on the cash flow. Especially if the company is using debt to
finance its capital expenditure, the cash flow to the extent of debt does not get
affected.
 Non cash items – non cash items do not have any relevance in cash flow hence
needs to be removed.
 Qualitative judgments for risks used to compute discount and capitalization
rates- the usage of cost of capital and discounting rates is generally a very
subjective factor. The method chosen to arrive at the cost of capital and its

64
 relevance has to be best suited for valuation, else the valuation will not show
the current picture.
 Expected changes in future benefits (e.g. earnings or cash flows).

 Discounted future benefits method : In addition to the items in a above, the valuation
analyst should consider:
 Forecast/projection assumptions – forecast has to have assumptions, that the
valuer obtains from the management and the industry.
 Forecast/projected earnings or cash flows – these are based on the projection
assumptions.
 Terminal value – this is the future values of all the cash flows till perpetuity of
the company based on growing concern concept.

2) Asset based approach: This is also called as the cost approach. A frequently used method
under the approach is the adjusted net asset method. When using the adjusted net asset
method in valuing a business, business ownership interest, or security, the valuation analyst
should consider, as appropriate, the following information related to the premise of value:
 Identification of the assets and liabilities.
 Value of the assets and liabilities
 Liquidation costs.
When using methods under the cost approach to value intangible assets, the valuation analyst
should consider the type of cost to be used (reproduction cost or replacement cost), and where
applicable, the appropriate forms of depreciation and obsolescence and the remaining useful
life of the intangible asset.

3) Market based approach: Three frequently used valuation methods under the market
approach for valuing a business, business ownership interest, or security are:
 Guideline public company method – Under this method, the publicly traded
company’s data is used for comparison, and the multiple based approach is
considered.
 Guideline company transactions method: Under this method the published data is
taken, based on some recent transactions that have taken place. The onus reliability of
the published data is on the valuer.

65
  Guideline sales of interests in the subject entity, such as business ownership interests
or security.
Three frequently used market approach valuation methods for intangible assets are:
 Comparable uncontrolled transactions method
 Comparable profit margin method
 Relief from royalty method
For the methods involving guideline intangible assets, the valuation analyst should consider
the subject intangible asset’s remaining useful life relative to the remaining useful life of the
guideline intangible assets, if available.
In applying the above methods under market approach, methods to determine valuation
pricing multiples or metrics, the valuation analyst should consider:
 Qualitative and quantitative comparisons
 Arm’s-length transactions and prices
 The dates and, consequently, the relevance of the market data.
The valuation analyst should set forth in the report the rationale and support the valuation
methods used.

66
3.2 FINANCIAL RATIOS
A Financial ratio or Accounting ratio is a relative magnitude of two selected numerical values
taken from an enterprise’s financial statements. Often used in accounting, there are many
standard ratios used to try to evaluate the overall financial condition of a corporation or other
organization.

1) Liquidity Ratios
a) Current Ratio
b) Quick Ratio

2) Profitability Ratios
a) Profit margin analysis
b) Return On Assets
c) Return On Equity
d) Return On Capital Employed
e) Cash flow margin

3) Solvency Ratios
a) Capital gearing ratio
b) Debt-Equity Ratio
c) Capitalization Ratio
d) Interest Coverage Ratio
e) Cash Flow To Debt Ratio

4) Activity Ratios
a) Account receivable turnover ratio
b) Inventory turnover ratio
c) Fixed Assest ratio
d) Account payable turnover ratio

5) Shareholder’s ratio
a) Earning per share
b) Price – earning ratio
c) Dividend pay out ratio
d) Dividend yield ratio

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3.1.1 LIQUIDITY RATIOS

The greater the coverage of liquid assets to short-term liabilities the better as it is a clear
signal that a company can pay its debts that are coming due in the near future and still fund
its ongoing operations. On the other hand, a company with a low coverage rate should raise a
red flag for investors as it may be a sign that the company will have difficulty meeting
running its operations, as well as meeting its obligations.

a) Current Ratio

The current ratio is a popular financial ratio used to test a company's liquidity (also referred
to as its current or working capital position) by deriving the proportion of current assets
available to cover current liabilities. The concept behind this ratio is to ascertain whether a
company's short-term assets (cash, cash equivalents, marketable securities, receivables and
inventory) are readily available to pay off its short-term liabilities (notes payable, current
portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current
ratio, the better.

b) Acid – test ratio

It is also termed as quick ratio. It is determined dividing quick assests i.e, cash ,marketable
investments and sundry debtors, by current liabilities. This ratio is a bitterest of financial
strength than the current ratio as it gives no consideration to inventory which may be very
low moving.

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2) Profitability Ratios

This ratio tells the different measures of corporate profitability and financial performance.
These ratios, much like the operational performance ratios, give users a good understanding of
how well the company utilized its resources in generating profit and shareholder value.

(a) PROFIT MARGIN ANALYSIS

Different profit margins are used to measure a company’s profitability at various levels
, including gross margin, operating margin, net margin. The margins shrink as layers of
additional costs are taken into consideration, such as the cost of goods sold, operating
and non-operating expenses and taxes paid.

Gross profit margin measures how much a company can mark up sales above COGS.
Operating margin is the percentage of sales left after covering additional operating
expenses. Net profit margin concerns a company’s ability to generate earnings after
taxes.

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 (b) RETURN ON ASSETS
Profitability is assessed relative to costs and expenses, and it is analyzed in comparison
to assests to see how effective a company is in deploying assests to generate sales and
eventually profits. The term return in the ROA ratio customarily refers to net profits or
net income , the amount of earnings from sales after all costs, expenses, and taxes.

(c) RETURN ON EQUITY

ROE is a ratio that concerns a company’s equity holders the most since it measures their
ability to earn a return on their equity investments. ROE may increase dramatically without
any equity addition when it can simply benefit from a higher return helped by a larger asset
base. As a company increases its assest size and generates a better return with higher margins
, equity holders can retain much of the return growth when additional assests are the result of
debt use.

(D) RETURN ON CAPITAL EMPLOYED

Return on capital employed (ROCE) is a financial ratio that measures a company’s
profitability and the efficiency with which its capital is used. In other words, the ratio measures
how well a company is generating profits from its capital. The ROCE ratio is considered an
important profitability ratio and is used often by investors when screening for suitable
investment candidates.

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3.1.2.SOLVENCY RATIO
The solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt
obligations and is used often by prospective business lenders. The solvency ratio indicates
whether a company’s cash flow is sufficient to meet its short and long term liabilities. The
lower a company’s solvency ratio, the greater the probability that it will default on its debt
obligations.
FORMULA: - SOLVENCY TERM RATIO = NET AFTER TAX INCOME/
SHORT TERM LIABILITIES

(A) CAPITAL GEARING RATIO

Capital gearing ratio is a useful tool to analyze the capital structure of a company and is
computed by dividing the common stockholders equity by fixed interest or dividend bearing
funds.
A company is said to be low geared if the larger portion of the capital is composed of common
stockholders equity. On the other hand , the company is said to be highly geared if the larger
portion of the capital is composed of fixed interest/dividend bearing funds.
FORMULA:- Fixed income bearing securities/ equity share holder fund

(B) DEBT TO EQUITY RATIO The debt to equity ratio is calculated by dividing a
company’s total liabilities by its shareholders equity. These numbers are available on the
balance sheet of a company’s financial statements.
The information needed for the debt to equity ratio is on a company’s balance sheet. The
balance sheet requires total shareholder equity to equal assests minus liabilities, which is a
rearranged version of the balance sheet equation ( assests = liabilities + shareholder equity)

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(C) CAPITALIZATION RATIO
Capitalization ratio describes to investors the extent to which a company is using debt to fund
its business and expansion plans. Generally, debt is considered riskier than equity . Hence the
higher ratio, the riskier the company is . Companies with higher capitalization ratio run higher
risk of insolvency or bankrupty in case they are not able to repay the debt as per the
predetermined schedule. However, higher debt on the books could also be earnings accretive
if the business is growing in a profitable manner.

(D) INTEREST COVERAGE RATIO

The interest coverage ratio is a financial ratio that measures a company’s ability to make
interest payments on its debt in a timely manner. Unlike the debt service coverage ratio, this
liquidity ratio really has nothing to do with being able to make principle payments payments
on the debt itself. Instead, it calculates the firm’s ability to afford the interest on the debt.
The interest coverage ratio formula is calculated by dividing the EBIT , or earnings before
interest and taxes , by the interest expense.

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4) ACTIVITY RATIOS

(A) ACCOUNT RECEIVABLE TURNOVER RATIO

Accounts receivable turnover is an efficiency ratio or activity ratio that measures how many
times a business can turn its accounts receivable into cash during a period. In other words, the
accounts receivable turnover ratio measures how many times a business can collect its
average accounts receivable during the year.

This ratio shows how efficient a company is at collecting its credit sales from customers.
Some companies collect their receivables from customers in 90 days while other take up to 6
months to collect from customers.

Accounts receivable turnover is calculated by dividing net credit sales by the average
accounts receivable for that period.

(B) INVENTORY TURNOVER RATIO

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is
managed by comparing cost of goods sold with average inventory for a period. This measures
how many times average inventory is “turned” or sold during a period.

This ratio is important because total turnover depends on two main components of
performance. The first component is stock purchasing. If larger amounts of inventory are
purchased during the year, the company will have to sell greater amounts of inventory to
improve its turnover. If the company can’t sell these greater amounts of inventory, it will
incur storage costs and other holding costs.

The second component is sales. Sales have to match inventory purchases otherwise the
inventory will not turn effectively. That’s why the purchasing and sales departments must be
in tune with each other.

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(C) FIXED ASSEST RATIO
Definition: The fixed asset turnover ratio is an efficiency ratio that measures a companies
return on their investment in property, plant, and equipment by comparing net sales with
fixed assets. In other words, it calculates how efficiently a company is a producing sales with
its machines and equipment.

The fixed asset turnover ratio formula is calculated by dividing net sales by the total property,
plant, and equipment net of accumulated depreciation.

(D) ACCOUNT PAYABLE TURNOVER RATIO

The accounts payable turnover ratio is a liquidity ratio that shows a company’s ability to pay
off its accounts payable by comparing net credit purchases to the average accounts payable
during a period. In other words, the accounts payable turnover ratio is how many times a
company can pay off its average accounts payable balance during the course of a year.This
ratio helps creditors analyze the liquidity of a company by gauging how easily a company can
pay off its current suppliers and vendors. Companies that can pay off supplies frequently
throughout the year indicate to creditor that they will be able to make regular interest and
principle payments as well.The accounts payable turnover formula is calculated by dividing
the total purchases by the average accounts payable for the year.

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RATIO ANALYSIS

CURRENT RATIO

QUICK RATIO

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DEBT TO EQUITY RATIO

TOTAL ASSESTS TO DEBT RATIO

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INVENTORY TURNOVER RATIO

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3.3 SENSITIVITY ANALYSIS

Sensitivity Analysis is a tool used in financial modeling to analyze how the different values
of a set of independent variables affect a specific dependent variable under certain specific
conditions. In general, Sensitivity Analysis is used in a wide range of fields, ranging from
biology and geography to economics and engineering.

It is especially useful in the study and analysis of a “Black Box Processes” where the output
is an opaque function of several inputs. An opaque function or process is one which for some
reason can’t be studied and analyzed. For example, climate models in geography are usually
very complex. As a result, the exact relationship between the inputs and outputs are not well
understood.

What-If analysis
A Financial Sensitivity Analysis, also known as a What-If analysis or a What-If simulation
exercise, is most commonly used by financial analysts to predict the outcome of a specific
action when performed under certain conditions.

Financial Sensitivity Analysis is done within defined boundaries that are determined by the
set of independent (input) variables.
For example, Sensitivity Analysis can be used to study the effect of a change in interest rates
on bond prices if the interest rates increased by 1%. The “What-If” question would be:
“What would happen to the price of a bond If interest rates went up by 1%?”. This question is
answered with sensitivity analysis.
The analysis is performed in Excel under the Data section of the ribbon and the “What-if
Analysis” button, which contains Goal Seek and Data Table.
Sensitivity analysis example
John is in charge of sales for HOLIDAY CO that sells Christmas decorations at a shopping
mall. John knows that the holiday season is approaching and that the mall will be crowded.
He wants to find out whether an increase in customer traffic at the mall will raise the total
sales revenue of HOLIDAY CO and if so, by how much.

The average price of a packet of Christmas decorations is $20 and during the previous year’s
holiday season, HOLIDAY CO sold 500 packs of Christmas decorations, resulting in total
sales worth $10,000.

After carrying out a Financial Sensitivity Analysis, John determines that a 10% increase in
customer traffic at the mall results in a 7% increase in the number of sales.

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Using this information, John can predict how much money company XYZ will generate if
customer traffic increases by 20%, 40%, or 100%. Based on John’s Financial Sensitivity
Analysis, these will result in an increase in revenue by 14%, 28%, and 70%, respectively.

Sensitivity analysis example table….

Advantages of Sensitivity Analysis

There are many important reasons to perform sensitivity analysis:

 Sensitivity Analysis adds credibility to any type of financial model by testing the model
across a wide set of possibilities.
 Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries
within which to test the sensitivity of the dependent variables to the independent
variables. For example, the model to study the effect of a 5-point change in interest
rates on bond prices would be different from the financial model that would be used to
study the effect of a 20-point change in interest rates on bond prices.
 Sensitivity analysis helps one make informed choices. Decision-makers use the model
to understand how responsive the output is to changes in certain variables. This
relationship can help an analyst in deriving tangible conclusions and be instrumental in
making optimal decisions.

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80
 3.4 PROBABILISTIC ANALYSIS

Probabilistic analysis is also known as Scenario analysis. Scenario analysis is a process of

examining and evaluating possible events that could take place in the future by considering
various feasible results or outcomes. In financial modeling, this process is typically used to
estimate changes in the value of a business or cash flow, especially when there are potentially
favorable and unfavorable events that could impact the company.

Most business managers also use scenario analysis during their decision-making
process to find out the best-case scenario as well as worst-case scenario while
anticipating profits or potential losses. Individuals can use this process when they
have a big investment coming up like purchasing a house or setting up a business.
This guide will help you understand why scenario analysis is important and how to
perform it yourself.

Generating cases to be used in Scenario Analysis?

When performing the analysis, managers and executives at a company will
generate different future states of the business, the industry, and the economy.
These future states will form discrete scenarios that include assumptions such as
product prices, customer metrics, operating costs, inflation, interest rates, and other
drivers so of the business.

Managers typically start with 3 basic scenarios:

 Base case scenario – this is the average scenario based on management

assumptions. An example – when calculating the net present value, the rates
most likely to be used are the discount rate, cash flow growth rate, or tax
rate.

 Worst case scenario – considers the most serious or severe outcome that
may happen in a given situation. An example – when calculating the net
present value, one would take the highest possible discount rate and subtract
the possible cash flow growth rate or the highest expected tax rate.

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  Best case scenario – this is the ideal projected scenario and is almost
always put into action by management to achieve their objectives. An
example – when calculating the net present value, use the least possible
discount rate, highest possible growth rate, or lowest possible tax rate.

Steps to performing Scenario Analysis in financial modelling

Building scenarios into a financial model is an important exercise to help cater for
uncertainty. Below is a screenshot of scenarios being built in CFI’s Sensitivity &
Scenario Modelling Course.

The steps to performing this analysis are:

1. List the assumptions you want to create scenarios for

2. Copy and paste the list of assumptions by the number of scenarios you wish
to have
3. Fill in all details of each scenario
4. Ensure the layout of all three scenarios is identical
5. Create a new section called “Live Scenario”
6. Use Excel’s CHOOSE function to switch between selected scenarios (of
the OFFSET function)
7. Link the “Live Scenario” numbers directly into the financial model

Benefits of Scenario analysis in Financial modelling

There are many reasons why managers and investors perform the analysis.
Predicting the future is an inherently risky business, so it’s prudent to explore as
many different cases of what could happen as is reasonably possible.

Key benefits include:

 Future planning – gives investors a peek into the expected returns and risks
involved when planning for future investments. The goal of any business
venture is to increase revenue over time, and it is best to use informed
calculations when deciding to include the investment in the portfolio.
 Proactive – Companies can avoid or decrease potential losses that result
from uncontrollable factors by being aggressively preventive during worst-
case scenarios by analyzing events and situations that may lead to

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 unfavourable outcomes. As the saying goes, it is better to be proactive than
reactive when a problem arises.
 Avoiding risk and failure – to avoid poor investment decisions, scenario
analysis allows businesses or investors to assess investment prospects. It
takes the best and worst probabilities into account so that investors can
make an informed decision.
 Projecting investment returns or losses – the analysis makes use of tools
to calculate the values or figures of potential gains or losses of an
investment. This gives concrete, measurable data that investors can base the
approaches they take for a better outcome.

Drawbacks of Scenario Analysis of Financial modelling

Scenario analysis tends to be a demanding and time-consuming process that

requires high-level skills and expertise. Due to the difficulty in forecasting
exactly what takes place in the future, the actual outcome may be fully
unexpected and not foreseen in the financial modelling.

 It may be very difficult to envision all possible scenarios and assign

probabilities to them. Investors must understand that there are risk factors
associated with the outcomes and they must consider certain risk tolerance
to be able to pursue a goal.

Best Case/ Worse Case

With risky assets, the actual cash flows can be very different from expectations. At
the minimum, we can estimate the cash flows if everything works to perfection – a
best case scenario – and if nothing does – a worst case scenario. In practice, there are
two ways in which this analysis can be structured. In the first, each input into asset
value is set to its best (or worst) possible outcome and the cash flows estimated with
those values. Thus, when valuing a firm, you may set the revenue growth rate and
operating margin at the highest possible level while setting the discount rate at its
lowest level, and compute the value as the best-case scenario. The problem with this
approach is that it may not be feasible; after all, to get the high revenue growth, the
firm may have to lower prices and accept lower margins. In the second, the best
possible scenario is defined in terms of what is feasible while allowing for the
relationship between the inputs. Thus, instead of assuming that revenue growth and
margins will both be maximized, we will choose that combination of growth and
margin that is feasible and yields the best outcome. While this approach is more
realistic, it does require more work to put into practice. How useful is a best
case/worse case analysis? There are two ways in which the results from this analysis
can be utilized by decision makers. First, the difference between the best-case and
worst-case value can be used as a measure of risk on an asset; the range in value
(scaled to size) should be higher for riskier investments. Second, firms that are
concerned about the potential spill over effects on their operations of an investment
going bad may be able to gauge the effects by looking at the worst case outcome.

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Thus, a firm that has significant debt obligations may use the worst-case outcome to
make a judgements to whether an investment has the potential to push them into
default. In general, though, best case/worse case analyses are not very informative.
After all, there should be no surprise in knowing that an asset will be worth a lot in
the best case and not very much in the worst case. Thus, an equity research analyst
who uses this approach to value a stock, priced at $ 50, may arrive at values of $ 80
for the best caseand $ 10 for the worst case; with a range that large, it will be difficult
to make a judgment on a whether the stock is a good investment or not at its current
price of $50.

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3.5 VALUATION MULTIPLES
Valuation multiples are financial measurement tools that evaluate one financial
metric as a ratio of another, in order to make different companies more
comparable. Multiples are the proportion of one financial metric (i.e. Share Price)
to another financial metric (i.e. Earnings per Share). It is an easy way to compute
a company’s value and compare it with other businesses. Let’s examine the
various types of multiples used in business valuation.

Advantages and disadvantages of valuation multiples

Using multiples in valuation analysis helps make sound judgments for analysts
and companies. This is especially true when multiples are used appropriately
because they provide valuable information about a company’s financial status.
Furthermore, multiples are relevant because they revolve around key statistics
related to investment decisions. Finally, the simplicity of multiples makes them
easy to use for most analysts.

However, this simplicity can also be considered a disadvantage because of the

fact that it simplifies complex information into just a single value. This
simplification can lead to misinterpretation and makes it challenging to break
down the effects of various factors.

Next, multiples represent a single instance of a company’s status rather than a

period of time. As such, they do not easily show how a company grows or
progresses. Additionally, multiples reflect short-term data instead of long-term
ones. Thus, the resulting values may only be applicable on the short-term and not
in the longer future.

1) Equity multiples

Investment decisions make use of equity multiples especially when an investor

aspires for minority positions in companies. The list below shows some common
equity multiples used in valuation analyses.

 P/E Ratio – the most commonly used equity multiple; needed data is easily
accessible; computed as the proportion of Share Price to Earnings Per
Share (EPS)

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  Price/Book Ratio – useful if assets primarily drive earnings; computed as
the proportion of Share Price to Book Value Per Share
 Dividend Yield – used for comparisons between cash returns and
investment types; computed as the proportion of Dividend Per Share to
Share Price
 Price/Sales – used for firms that make losses; used for quick estimates;
computed as the proportion of Share Price to Sales (Revenue) Per Share

However, a financial analyst must take into account that companies have varying
levels of debt that ultimately influence equity multiples.

2) Enterprise Value (EV) multiples

When decisions are about mergers and acquisitions, enterprise value multiples
are the appropriate multiples to use. The list below shows some common
enterprise value multiples used in valuation analyses.

 EV/Revenue – slightly affected by differences in accounting; computed as

the proportion of Enterprise Value to Sales or Revenue.

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  EV/EBITDA – EBITDA can be used as a substitute of free cash flows;
most used enterprise value multiple; computed as the proportion of
Enterprise Value to Enterprise value / Earnings before Interest, Tax,
Depreciation & Amortization

 EV/Invested Capital – used for capital-intensive industries; computed as

the proportion of Enterprise Value to Invested Capital

What Is Enterprise Value-to-Sales – EV/Sales?

Enterprise value-to-sales (EV/sales) is a valuation measure that compares
the enterprise value (EV) of a company to its annual sales. EV-to-sales gives
investors a quantifiable metric of how much it costs to purchase the company's
sales.

The Formula for Enterprise Value-to-Sales – EV/Sales Is

Enterprise Value-To-Sales Formula. How to Calculate Enterprise Value-to-Sales
– EV/Sales
Enterprise value-to-sales is calculated by:

1. Adding total debt to a company’s market cap

2. Subtracting out cash and cash equivalents
3. And then dividing the result by the company’s annual sales

A slightly more complicated version of enterprise value with a few more variables
is sometimes used. The more complex formula for EV is:

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  EV = market capitalization + debt + preferred shares + minority interest -
cash and cash equivalents

Enterprise value-to-sales is an expansion of the price-to-sales (P/S) valuation,

which uses market capitalization instead of enterprise value. It is perceived to be
more accurate than P/S, in part, because the market capitalization alone does not
take a company's debt into account when valuing the company.

Generally, a lower EV/sales multiple means that a company is believed to be more

attractive or undervalued. The EV/sales measure can be negative when the cash
in the company is greater than the market capitalization and debt structure,
signaling that the company can essentially be bought with its own cash.

The EV-to-sales measure can be slightly deceptive. A high EV-to-sales can be a

sign that investors believe the future sales will greatly increase. A lower EV-to-
sales can signal that the future sales prospects are not very attractive. Compare
the EV-to-sales to that of other companies in the industry, and look deeper into
the company you are analyzing. EV-to-sales values are usually between 1 and 3.

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UNIT-IV

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4.1 Time Value Money

The time value of money (TVM) is the concept that money available at the present time is
worth more than the identical sum in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also sometimes referred to as present discounted
value.

Breaking Down Time Value of Money - TVM

The time value of money draws from the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money's potential to grow
in value over a given period of time. For example, money deposited into a savings
account earns a certain interest rate and is therefore said to be compounding in value.

Further illustrating the rational investor's preference; assume you have the option to choose
between receiving $10,000 now versus $10,000 in two years. It's reasonable to assume most
people would choose the first option. Despite the equal value at time of disbursement, receiving
the $10,000 today has more value and utility to the beneficiary than receiving it in the future
due to the opportunity costs associated with the wait. Such opportunity costs could include the
potential gain on interest were that money received today and held in a savings account for two
years.

Basic Time Value of Money Formula

Depending on the exact situation in question, the TVM formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has additional
or less factors. But in general, the most fundamental TVM formula takes into account the
following variables:

 FV = Future value of money

 PV = Present value of money
 i = interest rate
 n = number of compounding periods per year
 t = number of years

Based on these variables, the formula for TVM is:

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FV = PV x [1 + (i / n)] (n x t)

Time Value of Money Example

Assume a sum of $10,000 is invested for one year at 10% interest. The future value of that
money is:

FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000

4.2 CAPITAL BUDGETING MODEL

Capital budgeting, or investment appraisal, is the planning process used to determine whether
an organization's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth the funding of cash
through the firm's capitalization structure (debt, equity or retained earnings). It is the process
of allocating resources for major capital, or investment, expenditures. One of the primary
goals of capital budgeting investments is to increase the value of the firm to the shareholders.

Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.

 Net present value

Capital budgeting projects are classified as either Independent Projects or Mutually Exclusive
Projects. An Independent Project is a project whose cash flows are not affected by the
accept/reject decision for other projects. Thus, all Independent Projects which meet the
Capital Budgeting criterion should be accepted.

Mutually exclusive projects are a set of projects from which at most one will be accepted. For
example, a set of projects which are to accomplish the same task. Thus, when choosing
between "mutually exclusive projects", more than one project may satisfy the capital
budgeting criterion. However, only one, i.e., the best, project can be accepted.

Of these three, only the net present value and internal rate of return decision rules consider all
of the project's cash flows and the time value of money. As we shall see, only the net present
value decision rule will always lead to the correct decision when choosing among mutually
exclusive projects. This is because the net present value and internal rate of return decision
rules differ with respect to their reinvestment rate assumptions. The net present value
decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's
cost of capital, whereas the internal rate of return decision rule implicitly assumes that the
cash flows can be reinvested at the project's IRR. Since each project is likely to have a
different IRR, the assumption underlying the net present value decision rule is more
reasonable.

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Example : Business makes an investment of $10,000; and will receive an annual income of
$3,000, $4,200, and w$6,800 in the three years that follow; an annual discount rate of 10%.
Calculate NPV .

NPV is 1188.44

 Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value
(NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually
exclusive) projects in an unconstrained environment, in the usual cases where a negative cash
flow occurs at the start of the project, followed by all positive cash flows. In most realistic
cases, all independent projects that have an IRR higher than the hurdle rate should be
accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project
with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The
IRR exists and is unique if one or more years of net investment (negative cash flow) are
followed by years of net revenues. But if the signs of the cash flows change more than once,
there may be several IRRs. The IRR equation generally cannot be solved analytically but
only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the
actual annual profitability of an investment. However, this is not the case because
intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the
actual rate of return is almost certainly going to be lower. Accordingly, a measure called
Modified Internal Rate of Return (MIRR) is often used.

Example : Business makes an investment of $10,000; and will receive an annual income of
$3,000, $4,200, and w$6,800 in the three years that follow; an annual discount rate of 10%.
Reinvestment rate is 7%. Calculate IRR and MIRR.

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IRR is 16%

4.3 MIRR
The Excel MIRR function is a financial function that returns the modified internal rate of
return (MIRR) for a series of cash flows, taking into account both discount rate and
reinvestment rate for future cash flows.

MIRR is 14%

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4.4 NEED FOR CAPITAL BUDGETING

1. As large sum of money is involved which influences the profitability of the firm, making
capital budgeting an important task.

2. Long term investment once made cannot be reversed without significance loss of invested
capital. The investment becomes sunk, and mistakes, rather than being readily rectified, must
often be borne until the firm can be withdrawn through depreciation charges or liquidation. It
influences the whole conduct of the business for the years to come.

3. Investment decision are the base on which the profit will be earned and probably measured
through the return on the capital. A proper mix of capital investment is quite important to
ensure adequate rate of return on investment, calling for the need of capital budgeting.

4. The implication of long term investment decisions are more extensive than those of short
run decisions because of time factor involved, capital budgeting decisions are subject to the
higher degree of risk and uncertainty than short run decision.

4.5 Cost of Capital

The definition of cost of capital simply means the cost of funds the company uses to fund and
finance its operations. The cost of capital is often divided into two separate modes of financing:
debt and equity.

Cost of capital tells the company its hurdle rate. The hurdle rate refers to the minimum rate of
return the company must achieve to be profitable or to generate value.

Each company has its own cost of capital. Different factors influence the cost of capital and
these include things such as the operating history of the business, its profitability and credit
worthiness.

The figure is one of the most essential parts of a business’ financing strategy, as it can help the
company to make better funding and investment decisions and thus boost its overall financial
health.

In case the company is solely financed through equity, the cost of capital would refer to the
cost of equity. On the other hand, companies funded by debt alone have cost of capital refer to
the cost of debt.

As most companies rely on a combination of debt and equity, their overall cost of capital is
derived from a weighted average of all capital sources. This refers to the average cost of capital
(WACC).

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Weighted Average Cost of Capital

As we mentioned above, company financing hardly ever relies on a single source. Therefore,
the cost of capital is often calculated by using the weighted average cost of capital (WACC).
Since it analyses both equity and debt financing, it provides a more accurate picture of how
much interest the company owes for each operational currency it finances (per each US dollar,
British pound and so on).

It gives a proportional weight to the different costs of capital, such as equity and debt, to derive
a weighted average cost. Each capital component will be multiplied by its proportional weight
and the sums will be added together.

When companies refer to the cost capital, they often would have calculated it based of the
WACC method. The following sections will look at the calculations methods in more detail,
but here’s a quick example of what WACC means.

Consider that a business has a lender, which requires a 10% return on its money. Furthermore,
the shareholders of the business require a further minimum of a 20% on their investments. On
average then, the company’s capital must have a return of 15% to satisfy both the debt and
equity holders, meaning the WACC or cost of capital is 15%.

This means the company would need to invest in projects that would provide an annual return
of 15% in order to continue paying back to both their shareholders and creditors.

4.5 CALCULATING THE COST OF CAPITAL

Now that you understand the definition of cost of capital and the importance of calculating it,
it’s time to look at the calculating methods.

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First, we’ll go through the formulas for calculating both the cost of equity and debt, as they’ll
be used in the final calculations of WACC. Naturally, if the business only uses either debt or
equity alone, you can also use the formulas as the basis for calculating the cost of capital.

Calculating the cost of debt

First, lets look at how you can calculate the cost of debt. Debt in this formula includes all forms
of debt the company uses in order to finance its operations. These could be various bonds, loans
and other such forms of debt.

As mentioned earlier, there are two formulas for calculating the cost of debt. This is because it
deals with interest, which can be deducted from tax payments. Thus, the alternatives are to
calculate the cost of debt either before- or after-tax. Generally, the after-tax cost is more widely
used.

The before-tax rate can be calculated by two different methods. First, you can calculate it by
multiplying the interest rate of the company’s debt by the principal. For instance, a $100,000
debt bond with 5% pre-tax interest rate, the calculation would be: $100,000 x 0.05 = $5,000.

The second method uses the after-tax adjusted interest rate and the company’s tax rate.

Even if you use the after-tax rate, you’ll still need the above before-tax rate. The formula for
calculating the after-rate tax is:

Cost of debt (after-tax rate) = before-tax rate * (1 – marginal tax rate)

Keep in mind the before-tax rate is also often referred to as the yield-to-maturity on long-term
debt.

Calculating the cost of equity

There are also two ways of calculating the cost of equity: the more traditional dividend
capitalization model and the more modern capital asset pricing model (CAPM).

The dividend capitalization model uses the following formula:

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Cost of equity = (dividends per share [for next year] / current market value of stock) + growth
rate of dividends

More recently, many companies have started to the use the CAPM method. Under this method,
the idea is that investors need a minimum rate of return, which is equal to return from a risk-
free investment, as well as a return for bearing extra risk.

The formula is as follows:

Cost of equity = risk free rate + beta [i.e. risk measure] * (expected market return – risk free
rate)

Calculating WACC

If the company has used different methods of financing, then the cost of capital is calculated
by the weighted average cost of capital. The above formulas are also needed in this method.

The method for calculating WACC is often expressed in the following formula:

WACC = percentage of financing that is equity * cost of equity + percentage of financing that
is debt * cost of debt * (1 – corporate tax rate)

In order to calculate the percentage of financing that is equity, you need the following formula:

Percentage of financing that is equity = market value of the firm’s equity / total market value
of the firm’s financing (equity and debt)

To calculate the percentage of financing that is debt, you can use the following formula:

Percentage of financing that is debt= market value of the firm’s debt / total market value of the
firm’s financing (equity and debt)

The WACC will increase if the beta (risk measure) and the rate of return on equity increase. This is
because a growing WACC denotes a drop in valuation and a growth in risk

Ascertaining the discount rate is crucial to valuation and it plays a vital role in valuation. To
ascertain the discounting factor, either cost of capital can be used or weighted average cost of
capital can be used for arriving at the rate at which the present value of future cash flow can
be ascertained.

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rate of return of an asset. The formula for cost of equity is

Cost of equity = Risk free rate + Beta*market premium

Where, the market premium is the difference between the market rate of return for a security
less the risk free rate.

After arriving at the discounting factor, the same is used for finding out the present value of
future cash flows.

Example:

Particulars Rs. Cost

Equity Capital 200000 15%
Preference Capital 500000 12%
Debentures 3000000 6%

Calculate cost of capital?

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4.6 FORCASTING METHODS
Forecasting is the process of making predictions of the future based on past and present data
and most commonly by analysis of trends. A commonplace example might be estimation of
some variable of interest at some specified future date. Prediction is a similar, but more general
term. Both might refer to formal statistical methods employing time series, cross-
sectional or longitudinal data, or alternatively to less formal judgmental methods. Usage can
differ between areas of application: for example, in hydrology the terms "forecast" and
"forecasting" are sometimes reserved for estimates of values at certain specific future times,
while the term "prediction" is used for more general estimates, such as the number of times
floods will occur over a long period.

Risk and uncertainty are central to forecasting and prediction; it is generally considered good
practice to indicate the degree of uncertainty attaching to forecasts. In any case, the data must
be up to date in order for the forecast to be as accurate as possible. In some cases the data used
to predict the variable of interest is itself forecasted.

 Moving Average
 Exponential smoothing
 Trend analysis

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Moving average
The moving average is extremely useful forforecasting long-term trends. You can calculate it
for any period of time. ... An average represents the “middling” value of a set of numbers.
The moving average is exactly the same, but the average is calculated several times for several
subsets of data A moving average is a technique to get an overall idea of the trends in a data
set; it is an average of any subset of numbers. The moving average is extremely useful
for forecasting long-term trends. You can calculate it for any period of time. For example, if
you have sales data for a twenty-year period, you can calculate a five-year moving average, a
four-year moving average, a three-year moving average and so on. Stock market analysts will
often use a 50 or 200 day moving average to help them see trends in the stock market and
(hopefully) forecast where the stocks are headed.

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 4.7 Exponential Smoothing
Exponential smoothing of time series data assigns exponentially decreasing weights for
newest to oldest observations. In other words, the older the data, the less priority (“weight”)
the data is given; newer data is seen as more relevant and is assigned more weight. Smoothing
parameters (smoothing constants)— usually denoted by α— determine the weights for
observations.
Exponential smoothing is usually used to make short term forecasts, as longer term forecasts
using this technique can be quite unreliable.

 Simple (single) exponential smoothing uses a weighted moving average with

exponentially decreasing weights.
 Holt’s trend-corrected double exponential smoothing is usually more reliable for
handling data that shows trends, compared to the single procedure.
 Triple exponential smoothing (also called the Multiplicative Holt-Winters) is usually
more reliable for parabolic trends or data that shows trends and seasonality.

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4.8 Trend Analysis Forecasting
Trend analysis uses a variety of statistical tools, all of which are accessible to business owners.
At the most basic level, you can plot data points for visual identification of trends to clarify
relationships between variables and identify “outliers,” or random points that don't fit a pattern.
Data points can then be converted into moving averages to smooth random fluctuations. A
business owner can use spreadsheet software to “fit” trend lines on charted data or build
regression models. These allow her to include more variables to predict sales more accurately
and forecast the impact of rising interest rates and seasonal changes.

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