Introductory Financial Modelling

Elements of Financial Modelling
Devised and Presented by
Duncan Williamson
October 2020
Introduction
This introductory course is suitable for a two day live training course and an eight hour online webinar style
programme. The essence of the course is to provide delegates with an introduction to the basic topics that
everyone with an interest in financial model must be aware of.
The course content and practical exercises are centred around Microsoft Excel and a significant number of Excel
functions and techniques will be reviewed during the course.
Training methodology
The trainer will introduce each topic with a discussion and/or practical exercise and the delegates will then be
provided with a follow up exercise to complete on their own. The final result will be shared with everyone either
by confirmatory discussion during the session or by means of sharing the trainer’s completed Excel file.
All delegates will receive a full set of training notes and Excel files: both delegate and trainer versions. There will
also be PowerPoint slides and other support materials that will form an integral part of the course.
Live Presentation
Because of the physical presence of everyone in the training room, the course will be more organic in nature.
Reactions to topics and exercises, the ability of the trainer to interact directly with delegates during exercise
times and so on will enable the materials to flow both in linear and non linear ways.
Online Presentation
Because of the remote nature of online training, the intimacy of physical presence is lost: there is little chance
for familiarity. Initially, at least, whilst it is relatively easy for the trainer to work in as normal a way as possible,
the remoteness of distance is often a barrier, at least in the initial stages of the course.
Workshop prerequisites
• Delegates should have a good working knowledge of Microsoft Excel: you don’t need to
be an advanced user, just aware of and be confident in the use of basic Excel
• Delegates should also be in possession of their laptops loaded with Microsoft 365/Excel
2016 or 2019
• You will also need to ensure that Power Query and Power Pivot are fully operational: you
will receive a delegates’ pack in advance of the course and full instructions will be given
then
Required Outcomes
After completing this workshop the delegate should be able to:
• Construct financial statement based models together with other financial models using
Excel
• Train, Test and demonstrate the models you are given or that you build.
• Produce output from a model for use at work and in presentations.

Original Materials © Duncan Williamson October 2020
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Course Content: Live Presentation
PART I: Design and Efficiency
In this first Part we will take a specific look at the design of a financial model, providing insight
into the usage of spreadsheet maps, formatting and calculations. This section will provide a
hands on focal point for designing of your own financial model using Excel.
Section One
Producing and Publishing Model Output for effective communication and workability
• Style, formatting and layout
• Fonts colours, backgrounds and borders

• Pivot Tables
• Using symbols and equations
• Using graphs and figures
• Error capturing
• Security and protection of models
• Exporting to other packages for publishing
• Useful new features in 2016 version
• Technical issues to be considered
• Documentation
• File formats and compatibility
• Size and memory consideration
• Object embedding
Part II: Financial Analysis Models
In Part two we undertake a review of data that organisations provide for us: the data normally
comes from the financial reporting process. We then undertake a systematic and interactive
review of the data we have gathered. A comprehensive examination of the key components of
financial statements and financial management will assist in developing effective models that will
be vital as you create a world class financial model using Excel.
Section Two
Systematically analysing financial statements for improved model performance
• Financial Statements
o Appreciating the structure and content of Income Statements and Balance Sheets
o Improving displays by using Power Query and Power Pivot
• Financial Ratios
o Calculating and interpreting financial ratios
o DuPont analysis of Return on Equity
• Financial Forecasting
o An example of forecasting earnings from components of ROE
• Time Value of Money
o PV (Present Value) and FV (Future Value) Calculations
▪ from first principles and using PV and FV functions

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o Deferred and altering cash flows
• Rates of Return
o Arithmetic, Geometric and Continuous Compounding
o Yields on uneven returns
o Internal Rates of Return
Section Three
Highlighting key financial management principles underpinning effective model

development
• Cost of Capital
o Cost of Equity
o Cost of Debt
o Tax impact on Cost of Capital
o Calculating the Weighted Average Cost of Capital (WACC) and Hurdle rates
o Marginal WACC curve and finding break points
• Reviewing Capital Budgeting
o Cash flow modelling
o Decision modelling, including:
o Payback Period
o NPV (Net Present Value): NPV, XNPV
o IRR (Internal Rate of Return): IRR, MIRR, XIRR
o Sensitivity analysis
o Optimum Capital Budget

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Contents
Section One ................................................................................................................................................................ 7

Style, formatting and layout ............................................................................................................................. 7
Fonts colours, backgrounds and borders ........................................................................................................................................7
Formatting ..................................................................................................................................................................................................7
Pivot Tables ............................................................................................................................................................................................ 11
Using symbols and equations........................................................................................................................................................... 13
Avoid Partial Inputs .........................................................................................................................................................................................13
One row, one calculation ..............................................................................................................................................................................14
Use Roll Forward or Corkscrew Calculations.........................................................................................................................................14
Write Robust Formulas ...................................................................................................................................................................................14
Simplify IF statements and Avoid Nested IFs ......................................................................................................................................15
Revolver formula using IF statement.......................................................................................................................................................15
Revolver formula using MIN ........................................................................................................................................................................15
Revolver formula using IF() statement ...................................................................................................................................................16
Revolver formula using MIN() .....................................................................................................................................................................16
Names and named ranges ............................................................................................................................................................................16
Don't Calculate on The Balance Sheet: Link from Supporting Schedules................................................................................17
Using graphs and figures ................................................................................................................................. 17
Labelling figures in your report ..................................................................................................................................................................18
Error capturing....................................................................................................................................................................................... 19
What do we do about capturing such errors? ..........................................................................................................................................19
Security and protection of models.................................................................................................................................................. 20
Exporting to other packages for publishing ................................................................................................................................ 20
Technical issues to be considered ................................................................................................................................................................22
Documentation ..................................................................................................................................................................................................22
File formats and compatibility ........................................................................................................................................................................23
Size and memory consideration ....................................................................................................................................................................23
Object embedding ............................................................................................................................................................................................23
Section Two .............................................................................................................................................................. 27
Financial Statements ......................................................................................................................................... 27
Appreciating the structure and content of Income Statements and Balance Sheets .................................................. 27
Improving displays by using Power Query and Power Pivot ................................................................................................ 28
Power Query ........................................................................................................................................................................................................28
Power Pivot ............................................................................................................................................................................................. 29
Financial Ratios .................................................................................................................................................... 29
Calculating and interpreting financial ratios … ratios tab ...................................................................................................... 29
DuPont analysis of Return on Equity.............................................................................................................................................. 29
Financial Forecasting ......................................................................................................................................... 30
An example of forecasting earnings from components of ROE .......................................................................................... 30
Calculating Degrees of Operational, Financial and Combined (Total) leverage ..................................................... 30
Degree of Operating Leverage ........................................................................................................................................................ 30
Financial Leverage................................................................................................................................................................................ 30
Degree of Financial Leverage ........................................................................................................................................................... 30
Degree of Combined (Total) Leverage ......................................................................................................................................... 31
What is an Appropriate Amount of Financial Leverage? ........................................................................................................ 31
Time Value of Money ......................................................................................................................................... 33
Definitions .............................................................................................................................................................. 33
Simple Interest Calculations ........................................................................................................................... 33
Exercises for you to do ....................................................................................................................................................................... 33
Compound Interest Calculations ................................................................................................................... 34
Tabular Approach to Compound Interest .................................................................................................................................... 35
Data Tables............................................................................................................................................................ 35
Let’s use the Compound Interest Factors .................................................................................................................................... 35
Exercise for you to do ......................................................................................................................................................................... 36
Compounding Monthly or Weekly or Daily … Anything but Annually............................................. 37
Ayala Corporation Debt Schedule ................................................................................................................. 37
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Ayala Annual and Periodic Growth ............................................................................................................... 38
Excel’s Built in Finance Functions ................................................................................................................. 39
Excel’s Built in Finance Functions: Solutions .............................................................................................................................. 40
The True Cost of Giving and Receiving Credit ......................................................................................... 41
Rates of Return .................................................................................................................................................... 42
Arithmetic, Geometric and Continuous Compounding ............................................................................................................ 42
Arithmetic Sequence .........................................................................................................................................................................................42
Geometric Sequences .......................................................................................................................................................................................42
Continuous Compounding ...............................................................................................................................................................................43
Continuous Compounding Formula ..............................................................................................................................................................43
Continuous Compounding Formula Example ............................................................................................................................................43
Yields on uneven returns ................................................................................................................................................................... 44
RRI() Function .....................................................................................................................................................................................................44
Internal Rates of Return..................................................................................................................................................................... 44
Example of Using IRR()....................................................................................................................................................................................44
Highlighting key financial management principles underpinning effective model development
....................................................................................................................................................................................... 46
Section Three........................................................................................................................................................ 46
Cost of Capital ...................................................................................................................................................... 46
Cost of Equity ......................................................................................................................................................................................... 46
Cost of Debt............................................................................................................................................................................................ 47
Tax impact on Cost of Capital .......................................................................................................................................................... 47
Calculating the Weighted Average Cost of Capital (WACC) and Hurdle rates ............................................................... 48
Marginal Cost of Capital and Finding Break Points .................................................................................................................................48
MCC v WACC ........................................................................................................................................................................................ 49
Example .................................................................................................................................................................................................................49
Answer....................................................................................................................................................................................................................49
Marginal WACC curve and finding break points ........................................................................................................................ 53
Reviewing Capital Budgeting ..................................................................................................................... 56
Cash flow modelling ............................................................................................................................................................................ 56
Decision modelling, including: ......................................................................................................................................................... 56
Payback Period ...................................................................................................................................................................................... 56
NPV (Net Present Value): NPV, XNPV ........................................................................................................................................... 58
Present Value Principles ...................................................................................................................................................................................58
NPV Function .......................................................................................................................................................................................... 60
XNPV.......................................................................................................................................................................................................... 62
IRR (Internal Rate of Return): IRR, MIRR, XIRR ...................................................................................................................... 63
Definitions .............................................................................................................................................................................................................63
Syntaxes ................................................................................................................................................................................................................63
Sensitivity analysis ............................................................................................................................................................................... 66
How to conduct sensitivity analysis .............................................................................................................................................................66
Formula ..................................................................................................................................................................................................................67
Example .................................................................................................................................................................................................................67
Solution ..................................................................................................................................................................................................................67
Results of sensitivity analysis .........................................................................................................................................................................70
Graph ......................................................................................................................................................................................................................70
Optimum Capital Budget.................................................................................................................................................................... 71
Definition ...............................................................................................................................................................................................................71
Example .................................................................................................................................................................................................................71
Graph ......................................................................................................................................................................................................................73

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Course Content: Online Presentation
In every two hour session, the first hour will comprise discussion and worked examples and
the second hour will comprise delegate follow up exercise work and conclude with topic
review, including Q&A.
PART I: Design and Efficiency
In this first Part we will take a specific look at the design of a financial model, providing insight
into the usage of spreadsheet maps, formatting and calculations. This section will provide a
hands on focal point for designing of your own financial model using Excel.
Hours 1 - 2
Section One
Producing and Publishing Model Output for effective communication and workability
Style, formatting and layout
Fonts colours, backgrounds and borders
Below, we lay out the key elements of an effectively structured model, most of which will go a
long to way to improve the model's transparency. As a model becomes more complex (due to
higher granularity and flexibility), it naturally becomes less transparent. The best practices below
will help to fix this.
Formatting
Colour coding
Just about everyone agrees that colour coding cells based on whether it holds a hard coded
number or a formula is critical. Without colour coding, it is extremely difficult to visually
distinguish between cells that should be modified and cells that should not ( ie. formulas). Well
built models will further distinguish between formulas that link to other worksheets and
workbooks as well as cells that link to data services.
While different organisations have different house styles, blue is typically used to colour inputs
and black is used for formulas. The table below shows our recommended colour coding scheme.
While everyone agrees that colour coding is very important, keeping up with it can be a pain in
native Excel. It's not easy to format cells based on whether they are inputs or formulas, but it
can be done. One option is to use Excel's Go To Special.

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Comments and Notes
In the latest versions of Excel there are now
• Comments
• Notes
Right click on the cell where you want to add the Comment or Note and make your selection.
Comment
Comments are new to Excel and they not only allow us to make a comment in a cell but they
encourage other users of our work to add to the comment.
I started a New Comment and it begins with a box in which I can type my comment. Press Enter
and the comment is recorded, as you can see above. There is now a reply box which other users
of my spreadsheet can use to add to my comment. As you can also see, I am free to Edit my
comment and it records the date and time that I created the comment.
Clicking the ellipsis in the top right hand corner allows us to Resolve the thread or delete it.
Resolving essentially closes the discussion in the thread but if you mouseover the cell with the
comment in, you can still reopen it.
How do we know when a cell has a comment in it? There is a purple marker in the top right
corner of such a cell:
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Inserting comments in cells is critical for adding a footnote to a source and adding clarity to data
in a model.
Note
A note is a traditional comment in a cell and anyone who has used comments before 2016 knows
what they look like.
Right click on a cell and choose New Note.
You can see that the small red triangle in the top corner of a cell is still the marker of a note in
Excel and all that a Note does is to hold a comment. Mouse over a cell with a comment in it to
read what it says. Right click the note cell to edit it.
How and Why do we Use Comments and Notes?
A cell containing an assumption on revenue growth that came from a web search or an article
review should include a comment with a reference to what you found.
There are people who say we should always err on the side of over commenting: I am not sure
about that and I have to say, not only do I rarely use comments and notes; but I don’t see them
very often either. On the other hand, if someone asks how you came up with the number in cell
AA123 and you stare blankly at your ceiling, you might regret not commenting.

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Sign convention
The decision on whether to use positive or negative sign conventions must be made before the
model is built. Models in practice are all over the place on this one. The modeller should choose
from and clearly identify one of the following 4 approaches:
• Convention 1: All income positive, all expenses negative

• Convention 2: All expenses positive; non operating income negative
• Convention 3: All expenses positive except non operating expenses
• Convention 4: All values positive, including revenues
Let’s look at the arguments for an against each one but remember: this is not really about
appearance in a report but it’s about making the programming of functions and formulas as fool
proof as possible.
Convention 1: All income positive, all expenses negative.

Advantage: logical, consistent, makes subtotal calculations less error prone
Disadvantage: Doesn't align with conventions used by public filings, % margin calculations
appear negative
Convention 2: All expenses positive; non operating income negative.

Advantage: Consistent with public filings, % margin calculations appear positive
Disadvantage: Negative non-operating income is confusing, subtotal calculations are error
prone, proper labelling is critical
Convention 3: All expenses positive except non-operating expenses.

Advantage: Avoids negative non-operating income presentation; margins evaluate to positive
Disadvantage: Presentation not internally consistent. Proper labelling is critical.
Convention 4: All values positive, including revenues

Advantage: Avoids any confusion both on the face of a report and in the programming of cells.
To make this convention work, the logic of the report is clearly set out in the report, in this way:
Sales 100,000
less Cost of Sales 65,000
Gross Profit =D1-D2
plus Other Income
Commission 2,500
Interest Earned 3,000 5,500
Operating Profit =D3+SUM(C5:C6)
less Expenses =D3-D7
Administration
General
Sales
Distribution
Total Expenses
Net Profit
Disadvantage: Anyone who is used to any other convention might find this convention

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challenging at first.
I recommend Convention 4 since there is no doubt at all how to enter a number and it really
does clarify the logic and programmability of cells in a spreadsheet. The reduced likelihood of
error from easier subtotalling alone makes this our clear choice. In addition, one of the most
common mistakes in modelling is in being unable to work out how to switch the sign from
positive to negative or vice versa when linking data across financial statements: Convention 4
overcomes that problem.
Pivot Tables
Pivot Tables are an absolute must for financial modellers and for financial modelling. Pivot tables
make the initial, if not the full analysis, of data very easy in many situations, whereas other
methods, such as relying on lists or Excel Tables can make life quite complex. Cross tabulations
driven by formulas can be really handy things to program and use but when it comes to
changing them and updating them, possible nightmare!
We could talk here about a data set with 30 columns and 250,000 rows and its analysis. I
suppose I could illustrate this section with horror stories of how impossible it would be to
manage such analysis. Let’s be friendly, though; and look at the same thing but with a much
smaller footprint.
Here are the first few lines of a data set that shows sales around the country: by sales person by
county by region and so on.
Month Sales Person ID County Region Sales Type Amount (£)

1-Jan Baker 678901 Derbyshire Midlands Hardware 856,004
2-Feb Baker 678901 Derbyshire Midlands Software 560,900
12-Dec Baker 678901 Derbyshire Midlands Software 349,500
7-Jul Baker 678901 Derbyshire Midlands Software 349,500
1-Jan Drury 123456 Yorkshire North East Hardware 789,504
1-Jan Drury 123456 Yorkshire North East Software 255,975
2-Feb Drury 123456 Yorkshire North East Hardware 998,900
2-Feb Drury 123456 Yorkshire North East Software 315,900
Cross Tabs
As part of another exercise, I created three cross tabulations from the Sales data set:
Sales Person Hardware Software

Baker 856,004 1,259,900
Drury 2,365,423 1,799,844
Harrington 3,385,093 1,136,265
Smythe 3,559,809 2,087,482
Williamson 1,594,725 389,850
Sales Person Derbyshire Essex Yorkshire

Baker 2,115,904 - -
Drury - - 4,165,267
Harrington - 4,521,358 -
Smythe - 5,647,291 -
Williamson 1,984,575 - -
Date Baker Drury Harrington Smythe Williamson

January 856,004 1,045,479 1,073,418 800,200 269,775
February 560,900 1,629,369 290,350 133,131 -
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March - - 720,901 1,677,344 1,023,075
April - 965,519 1,001,451 790,545 -
May - - - 133,131 420,825
June - 262,450 - - 135,450
Baker 2,115,904 - -
Drury - - 4,165,267
Harrington - 4,521,358 -
Smythe - 5,647,291 -
Williamson 1,984,575 - -
Date Baker Drury Harrington Smythe Williamson

January 856,004 1,045,479 1,073,418 800,200 269,775
February 560,900 1,629,369 290,350 133,131 -
March - - 720,901 1,677,344 1,023,075
April - 965,519 1,001,451 790,545 -
May - - - 133,131 420,825
June - 262,450 - - 135,450
July 349,500 - 433,689 524,440 -
August - 262,450 283,930 - 135,450
September - - - 364,080 -
October - - - 524,440 -
November - - 283,930 364,080 -
December 349,500 - 433,689 335,900 -
There you are, they work well, don’t they? Imagine now that I want to incorporate Region into
one or more of those Cross Tabulations. Well, it’s not difficult but it would take me at least a
couple of minutes.
Pivot Table
If I had done everything by pivot table, any such change would take me just a few seconds AND
be less error prone than using Cross Tabulation.
I created a new tab for the pivot table, converted the data set into an Excel table, created a
pivot table, placing it next to the data set and … even so, it took me just a minute or so to do all
of that:
Now, the proof of the pudding is in the eating so … let’s create cross tabulation two:
10 seconds to do that!

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Finally, the third cross tabulation as a pivot table:
15 seconds for that.
Now, I am going to create a pivot table that includes the Region variable, a Slicer and a Pivot
Chart
That took more than a minute as I needed to reformat a couple of things, move things
around, format the chart and so on. Easier and quicker than a cross tab, that’s for sure!
I am sure that some of you or your colleagues could be a real whizz at Cross Tabulations and
there is nothing wrong with that! Pivot tables are the smarter way to go, however.
Using symbols and equations
Avoid Partial Inputs
Hard coded numbers should never be embedded into a cell reference. The danger here is that
you'll likely forget there is an assumption inside a formula and when you update it, you miss one
or more of them and that means your model is already flawed.

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Input sections must be clearly separated from calculations: I tend to put my inputs in the top
left hand corner of a worksheet or on a dedicated Inputs worksheet.
One row, one calculation
Many financial models, like the three statement model, rely on historical data to drive forecasts.
Data should be presented from left to right, although accountants have the habit of presenting
their data from right to left. To the right of the historical columns are the forecast columns. The
formulas in the forecast columns should be consistent across the row.
Use Roll Forward or Corkscrew Calculations
Roll-forwards refers to a forecasting approach that connects the current period forecast to the
prior period, like this:
In other words, it represents,
Opening balance
Plus: Interest due in the period
Less: Periodic payment
= Closing Balance
This approach is very useful in adding transparency to how schedules are constructed. Strictly
applying the corkscrew approach improves a user's ability both to read and to audit the model as
well as reducing the likelihood of linking errors.
Write Robust Formulas
There is a temptation when working in Excel to create complicated, even mega, formulas. While
it may feel good to craft a super complex formula, the obvious disadvantage is that no one,
including the modeller, after being away from the model for a while will understand it. Because
transparency should drive structure, complicated formulas should be avoided at all cost. A
complicated formula can often be broken down into multiple rows and/or multiple cells and
simplified.
In my outline for this course, I reported that I recently reviewed the work of a Chartered
Accountant, who created this:
=SUM(C8,C22,C34,C45,C56,C66,C77,C87,C99,C110,C121,C133,C143,C154,C164,C174,C184,C194,C20
4,C214,C225,C235,C245,C255,C268,C279,C290,C300,C311,C321,C331,C341,C351,C361,C371,C382,C
392,C402,C412,C422,C432,C442,C453,C463,C473,C484,C494,C505,C515)
That is clearly ridiculous, so I wrote to that accountant with this alternative:

=SUMIFS(C3:C518,B3:B518,"Players bought") and I got this response in return:

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Thanks Duncan, it’s a hobby so I do it in my spare time but thanks for the tip as working on a project
presently where that suggestion with save me a large measure of time.
Simplify IF statements and Avoid Nested IFs
Simplify IF statements
IF() statements are well understood by most Excel users but they can become long and difficult
to audit. There are several excellent alternatives to IF that modellers frequently use. They
include using Boolean logic along with a variety of reference functions, including
MAX()
MIN()
AND()
OR()
VLOOKUP()
HLOOKUP()
XLOOKUP()
OFFSET()
SUMIFS()
And more
Below is an example of how an IF() statement can be simplified:
Cell F298 uses any surplus cash generated during the year to pay down the revolver credit, up
until the revolver is fully paid off. However, if deficits are generated during the year, we want the
revolver to grow. While an IF statement accomplishes this, a MIN function does it more
elegantly:
Revolver formula using IF statement
Revolver formula using MIN

Page 15 of 73
The revolver formula using MIN as an alternative to IF is more robust when additional complexity
is required. Imagine that there's a limit on the annual revolver draw of $50,000. Look at how we
have to modify both formulas to accommodate this:
Revolver formula using IF() statement
=IF(F306>F297,-F297,IF(F306<-50000,50000,-F306))
Revolver formula using MIN()
=-MIN(MAX(F306,-50000),F297)
While both formulas are challenging to audit, the formula using IF() statements is more difficult
to audit and is more vulnerable to getting completely out of hand with additional modifications.
It uses nested IF statements, which we can easily feel overwhelmed by when there are two,
three or even more nested IF() statements.
Excel has made this somewhat easier in 2016 with the introduction of the IFS() function, but I
do encourage you to keep it as simple as possible.
By the way, spreading complex formulas over several lines is a good way of simplifying a difficult
model; but so is this, for example:
=IF(F306>F297,-F297,IF(F306<-50000,50000,-F306))
Put your cursor in the cell with that formula, in front of the second IF and press Alt+Enter then
press Enter again and you will see this, now:
Names and named ranges
Another way many modellers reduce formula complexity is by using names and named ranges.
Many modellers say we should never use range names but I disagree. I think what they ought to
say is, don’t overuse range names. More than that, in some cases, Excel techniques will not work
so well without range names: the Scenario Manager, for example.

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One of the arguments against using range names is that when you name a cell, you no longer
know exactly where it is without going to the name manager. In addition, unless you are
proactively deleting names, Excel will retain these names even when you delete the named cell.
The result is that a file you're using today to build a DCF contains dozens of phantom names
from prior versions of the model, leading to warning messages and confusion. This objection
assumes we lack discipline!
Don't Calculate on The Balance Sheet: Link from Supporting Schedules.
Your financial models will frequently involve the use of financial statements. Ideally, your
calculations are done in schedules separate from the output you're working towards. For
example, in my working files, I import or create my financial data and immediately copy the
worksheet it is on and leave that worksheet alone: it is a back up in case of catastrophe.
Alternatively, save your raw data as a separate file: the back up file.
Using graphs and figures
We might use graphs, charts and figures interchangeably in a financial report. Excel calls them
charts, of course.
You can see already in these materials that I like to use imagery in my work and I am sure you
do too. Especially anyone who is reporting financial results that need to communicate effectively.
Take a look at my final screenshot in which I am selling pivot tables and pivot charts! Here is a
clearer view of my pivot chart from that example:
We see sales values by month in the Midlands Region and by sales person: that’s a lot of
information in one chart: a very basic column chart.
The essence of a chart: simplicity and effectiveness.
Notice how this second chart obeys the rules of charting that the previous screenshot did not:
• A clear and meaningful title

• Axes clearly labelled as necessary
• The units clearly expressed
• A legend if one is needed
• Appropriate use of colour
• Using the most appropriate chart for the message to be conveyed

Page 17 of 73
How about the following three versions of the same chart? Is one more appropriate than the
others or is it simply a matter of colour?
Period Loan Schedule Period Loan Schedule PERIOD LOAN SCHEDULE

300,000.00 300,000.00 300,000.00
250,000.00 250,000.00 250,000.00
Balance b/d
200,000.00 200,000.00 200,000.00
Balance b/d
Balance b/d
150,000.00 150,000.00 150,000.00
100,000.00 100,000.00 100,000.00
50,000.00 50,000.00 50,000.00
- - -
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400
Month Month Month
How about these three versions of the same chart?
Period Loan Schedule Period Loan Schedule PERIOD LOAN SCHEDULE

300,000.00 250,000.00
250,000.00 200,000.00
150,000.00
Balance b/d
200,000.00
100,000.00
150,000.00
50,000.00
100,000.00 -
50,000.00
-
1
18
35
52
69
86
103
120
137
154
171
188
205
222
239
256
273
290
307
324
341
358
Month
Hmm! Not so sure about these three!
Labelling figures in your report
Figures should be clearly labelled so they can be accurately referred to in any written discussion:
each figure should have a title and a number, for example:
Figure 1: The Opening periodic balance on a 30 year loan of $250,000 .
Period Period
Month Balance b/d Interest Payment Balance c/d
1 250,000.00 1,302.08 1,539.29 249,762.79
2 249,762.79 1,300.85 1,539.29 249,524.35
3 249,524.35 1,299.61 1,539.29 249,284.66
4 249,284.66 1,298.36 1,539.29 249,043.72
5 249,043.72 1,297.10 1,539.29 248,801.53
6 248,801.53 1,295.84 1,539.29 248,558.08
7 248,558.08 1,294.57 1,539.29 248,313.36
8 248,313.36 1,293.30 1,539.29 248,067.37
9 248,067.37 1,292.02 1,539.29 247,820.09
10 247,820.09 1,290.73 1,539.29 247,571.53
Table 5: First ten periods of the 30 year loan showing balances, periodic interest and periodic

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total payment
Note in these examples that the number of the figure is presented as a numeral in the title of the
figure. The number of the figure is also presented as a numeral when the figure is referred to in
the text of the report.
Error capturing
There are countless stories of the impact of errors on financial and other models. One of the
most famous, high level errors relates to the model of Reinhart and Rogoff, two very serious
economists who accidentally missed out key variables from their analysis of optimum GDP levels
and FDI which led to the publication of misleading data and advice.
A search for Ray Panko will reveal even more glaring and expensive errors stemming from
spreadsheet errors.
The London Whale: the following is attributed, at least in part, to spreadsheet programming
errors:
In April and May 2012, large trading losses occurred at JPMorgan's Chief Investment Office,
based on transactions booked through its London branch. The unit was run by Chief Investment
Officer Ina Drew, who has since stepped down. A series of derivative transactions involving
credit default swaps (CDS) were entered, reportedly as part of the bank's hedging strategy.
Trader Bruno Iksil, nicknamed the London Whale, accumulated outsized CDS positions in the
market. An estimated trading loss of US$2 billion was announced. The loss amounted to more
than $6 billion for JP Morgan Chase.
https://en.wikipedia.org/wiki/2012_JPMorgan_Chase_trading_loss
What do we do about capturing such errors?
The answer to the above question is, to anticipate them. Simple, short, examples, prove the case. In
the following table, I show periodic principal payments twice: using two different formulas.
Formula 1 =PPMT(B8/12,SEQUENCE(360),B7,-B6,0)
Formula 2 =PPMT(B$8/12,A14,B$7,-B$6,0)
Yet they both give exactly the same answers. Why am I telling you this? Well, in some cases, we trap
errors by calculating results in at least two ways and by comparing the answers, confirm that the
answer is correct or incorrect.
Period Principal
Period Period Period Interest Payment using Period Principal
Month Balance b/d Interest Payment Balance c/d using SEQUENCE SEQUENCE Payment
1 250,000.00 1,302.08 1,539.29 249,762.79 1,302.08 237.21 237.21
2 249,762.79 1,300.85 1,539.29 249,524.35 1,300.85 238.45 238.45
3 249,524.35 1,299.61 1,539.29 249,284.66 1,299.61 239.69 239.69
4 249,284.66 1,298.36 1,539.29 249,043.72 1,298.36 240.94 240.94
5 249,043.72 1,297.10 1,539.29 248,801.53 1,297.10 242.19 242.19
When we discuss capital budgeting, we will evaluate the NPV of a series of projects using both a
tabular and a formula approach and we check the validity of our work by comparing the two sets of
answers, that need to agree with each other.
Alternatively, if we work through a model to find the answer to a problem is X and we know that the
answer should be X, we can easily set up a cell next to or near an answer that might look something
like this:

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Cell H26 =IF(AND(G25=1000,G26=1000),1,0)
That says if both answers to the same question are 1000, then we see the number 1 in the cell H26 if
they do not agree, we flag an error by entering 0 in that control cell, H26. You might even format cell
H26 to be black if it shows 1 and red if it shows 0.
Security and protection of models
Most businesses clearly need to guard their data and information and there are several ways of
doing that
• In Excel, Protect sheets by setting up passwords

• Keep spreadsheet files secret by allowing only certain personnel for working on them
• Keeping highly sensitive data off site
• Using software other than Excel since Excel’s security and protection features are not so
strong
Exporting to other packages for publishing
Let’s take a look at the ways in which we might publish, export, data from Excel.

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That’s 28 possible export types: although some are quite similar to each other in some
ways. For example, we see
• Excel Workbook … xlsx

• Excel Binary Workbook … xlsb
• Excel 97-2003 Workbook … xls
Then there are
• CSV Macintosh
• CSV MS-DOS
• CSV Comma Delimited
• CSV-UTF Comme Delimited
• PDF
• XPS
• Open Document
• Web page
And more
The about this information is that, the destination document may well determine how you should
create and prepare the spreadsheet you are exporting. For example, a CSV file cannot contain
more than one worksheet, it cannot contain objects and images and it cannot contain
formatting.
There are many features of xlsx files that will not work in a 97-2003 xls file because the later
features are not backwards compatible.
In other ways, we can indirectly publish our work to PowerPoint files, Word files, OneNote files
and so on and in that case, formatting might not be a problem. Look at the screenshots I have
used so far, many of which are images of screenshots taken from Excel and pasted into the
Word document.
Microsoft 365
There are several features in Excel for Microsoft 365 that will not appear in any other version of
Excel, such as the Dynamic Array Functions, which we will be using in this course. The dynamic array
functions are
• SORT()
• SORTBY()
• UNIQUE()
• RANDARRAY()
• SEQUENCE()
• FILTER()
These functions and the functionality of other array functions, too, make life even more interesting
for the Excel user.
Enter the name of one or other of the above function in Excel, eg, =SEQUENCE and if your version of
Excel includes it in its intellisense list, you’ve got them and can use them. Try them, although we are
going to use them in this course. In fact, I have already started using them.
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Technical issues to be considered
When building a financial model, you need to consider such matters as
• The version of Excel you are using, for the reasons we have just been discussing
• The memory built into your computer
• Disk storage space
• HDD or SDD?
• Your internet connection and its speed
The subject of your model: is Excel the best solution for them?
• Finance
• Mathematics
• Statistics
• Engineering
• Chemistry
• Biology
Maybe most of all, these days, is the volume of data you are storing or modelling.
• How about your add ins? What do you use?

• Power Query?
• Power Pivot?
Documentation
I meet hundreds of Excel users every year and the big issue I come across time and time again
is that of the documentation of financial and other models. Spreadsheets in general, to be fair.
For reasons that should be blatantly obvious, we really ought to document fully every
spreadsheet model we create, shouldn’t we?
What do I mean by documentation?
All spreadsheets should have sufficient documentation to enable an independent person to

understand and use the spreadsheet model. The documentation should give a clear indication of
• the history of the spreadsheet and

• significant events in the spreadsheets life cycle
This can be achieved by adding a worksheet to the spreadsheet, labelled Documentation, which
should cover a number of aspects (identified below) and must be updated regularly.
This worksheet can then be printed out and kept as a hard copy if necessary and referred to by
the auditors periodically to ensure it is being updated.
How to document spreadsheets
Insert a separate worksheet into all your spreadsheets and document certain key information.
Minimum Requirements in the documentation page

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Filename and path: The name of the file and where it is stored. The easiest way to achieve
this is to put a formula in a cell which says =CELL(“FILENAME”) and it will automatically update
itself with the current storage location and filename.
Date: The current date. The easiest way to achieve this is to put a formula in the cell which says
=NOW() or TODAY(): this is more for printing purposes.
Spreadsheet Owner: The name of the person responsible for the spreadsheet. This may
include a history if the owner has changed over the years.
Overview: This sets out the objectives of the model, its basic structure, the sensitivities and
scenarios that it does and does not perform and any run time performance requirement eg
iterations must be switched on, it operates on manual calculation etc.
How to use the spreadsheet: A description of how to use the spreadsheet. Any unusual
features should be noted eg it has a purposeful circular reference; it works on manual
calculation etc. Should also include a legend explaining the meaning of colours, abbreviations
etc in the spreadsheet.
Output: Describes who the model is intended for, what the model is used for, what types of
reports are generated and what information is on those reports at a high level. This may include
what sections of the spreadsheet are irrelevant (they should be deleted but sometimes
spreadsheets are so intricately linked that staff are scared to delete anything).
Calculations: This describes the functionality of each calculation module, not on a line by line
basis but in sufficient detail for users to understand how the calculations work. A flow diagram
may be useful here.
Input: This lists the required input data eg databases, system owners/business users, files, user
keyed data or messages with a full description of sources and formats of the inputs. Inputs also
refer to assumptions made and indicate the ownership of the data. For links to other
spreadsheets you can use the External links feature in Excel to identify them.
Initial Testing Log: Information required includes the date of testing, who performed it, what
type of tests were performed and summary of corrections made.
Change Log: Changes made to the spreadsheet should be noted within the spreadsheet. In
particular the items to be noted should be the date of change, version of the spreadsheet: full
spreadsheet name as each significant change should result in a new version of the spreadsheet,
person performing the changes, a brief rationale for the changes and confirmation of testing
performed on the changes.
https://www.auditexcel.co.za/article/spreadsheet-documentation-using-only-excels-inbuilt-tools/
File formats and compatibility
Under the heading of Exporting a file from Excel, we saw 28 possible destination file types: rest
assured that some of them are compatible with each other and some most definitely are not.
Size and memory consideration
Again, we have already considered the subject of this heading under Technical issues to be
considered.
Object embedding
You can use Object Linking and Embedding (OLE) to include content from other programs, such as
Word or Excel.
OLE is supported by many different programs and OLE is used to make content that is created in one
program available in another program. For example, you can insert an Office Word document in an
Office Excel workbook. To see what types of content that you can insert, click
Insert … Text … Object
Only programs that are installed on your computer and that support OLE objects appear in the Object
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type box.
Clicking on Object will open this dialogue box:
And more …
Selecting a PowerPoint slide, for example, opens a blank PowerPoint slide that we can edit …
Selecting Microsoft Graph Chart creates this:

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The datasheet and graph in that table are editable: try editing it! I changed the chart type from
Column to Line and I edited the East and West data:
I don’t find that especially attractive and the only time I have ever added such a graph is in a
context such as this one. If I need a datasheet and a graph, I tend to make my own!
Explore the other options, however, such as the SmartDraw option I have on my system, from
which I could export my own Blog Logo:

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Part II: Financial Analysis Models
In Part two we undertake a review of data that organisations provide for us: the data normally
comes from the financial reporting process. We then undertake a systematic and interactive
review of the data we have gathered. A comprehensive examination of the key components of
financial statements and financial management will assist in developing effective models that will
be vital as you create a world class financial model using Excel.
Systematically analysing financial statements for improved model performance
Section Two
Financial Statements
Appreciating the structure and content of Income Statements and Balance Sheets
Income Statement: period statement
Sales
Less COGS
= Gross Profit
Less Expenses
=Net profit before Interest and Taxation
Less Interest
=Net profit before Taxation
Less Taxation
= Net Profit
Less Dividends
Balance Sheet: position statement
Non Current Assets
Tangible
Intangible
Current Assets
Total Assets
Non Current Liabilities

Current Liabilities
Total Liabilities
Shareholders’ Equity
Capital Employed
Statement of Cash Flows: period statements
Cash from Operating Activities

± Cash from Investing
± Cash from Financing
= Cash and Cash Equivalents

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Open the file ratio_analysis_delegates.xlsx which we will use for a variety of tasks as well as
appreciating the basic contents and layout of the three main financial statements … fin_state
tab
Improving displays by using Power Query and Power Pivot
Power Query
Improving displays by using Power Query (PQ) and Power Pivot (PP)
Create a new file. Use Power Query to create New Query … From File … From Folder CL_csv …
CL_IS.csv
CL_BS.csv
CL_CF.csv
- Tidy the data: clean it … Promote First Row …

- Unpivot the value columns
- Rename and format columns if necessary
- Close and Load to Table
Use your new Query to create Pivot Tables …

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Power Pivot
We will use these files and PP to replace any LOOKUP formulations …

fin_report_power_pivot_delegates.xlsx
- Excel Tables first … change the name

- Add to Data Model
- Create Pivot Table … more tables … yes
- Relationships …
Let’s look at Power Pivot to see what it can do and what we can do with it. …
pivot consolidate_delegates.xlsx
- Excel Tables first … change the names

- Consider using fName and lName …
- Add to the first table to the Data Model
- Create Pivot Table … more tables … yes
- Relationships …
combine_tables_power_pivot_delegates.xlsx
- Use the Data Model/Power Pivot, as with the previous example

- Decide which is the fact table and which is the lookup table
- We can/should create some calculated columns …
Financial Ratios
Calculating and interpreting financial ratios … ratios tab
We will continue to use the Colgate data for the tasks under these headings:
- Vertical … including natural language simulation

- Horizontal
Notice the alternative layout of the Vertical analysis … on the is_vertical_alt tab
DuPont analysis of Return on Equity
- DuPont analysis of Return on Equity … ratios tab row 24

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Financial Forecasting
An example of forecasting earnings from components of ROE
- An example of forecasting earnings from components of ROE

- Sensitivity Analyses too … same tab
- Still using the Colgate example, we will build financial forecasts using a combination of
functions and techniques
- We are aiming to create five year forecasts
Calculating Degrees of Operational, Financial and Combined (Total) leverage
Reference: op_leverage_cvp.pptx
Degree of Operating Leverage
The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent change in output
(sales).
Calculating the DOL for a single product or a single-product firm
Calculating the DOL for a multiproduct firm
Financial Leverage
The use of fixed financing costs by the firm.
- Financial leverage is acquired by choice

- Used as a means of increasing the return to common shareholders
Degree of Financial Leverage

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The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in
operating profit:
Calculating the DFL
Degree of Combined (Total) Leverage
The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in
output (sales).
Calculating the DTL
What is an Appropriate Amount of Financial Leverage?
Debt Capacity: The maximum amount of debt (and other fixed-charge financing) that a firm can
adequately service
- Firms must first analyse their expected future cash flows

- The greater and more stable the expected future cash flows, the greater the debt
capacity
- Fixed charges include: debt principal and interest payments, lease payments and
preferred stock dividends

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Time Value of Money
• PV (Present Value) and FV (Future Value) Calculations

o from first principles and using PV and FV functions
• Arithmetic Growth in cash flows
• Geometric growth of cash flows
• Deferred and altering cash flows
Introduction
In this session we will look at simple and compound interest as the foundation of the work of the
finance function
• Then we will build and use data tables including using them to see how to find future
and present values given certain data
• Following that we will review compounding on a basis other than annual: that is, to see
how to find compound interest if the compounding period is a day, a week, a month or
some other period
• Finally, we will apply our learning to Ayala Corp’s Financials and Debt Schedule
Definitions
• Simple interest is a method of calculating interest in which the interest is calculated for
a period on the principal or amount invested or borrowed only.
• Compound interest is a method of calculating interest in which the interest is
calculated for a period and both the principal and the interest earned generate interest.
Simple Interest Calculations
Simple Interest (SI) is among the simplest kind of calculations we can make. Really! You probably
remember something like this formula from school
SI = PRT/100
Where:
SI = Simple Interest
P = Principal, the amount of money
R = Rate of interest
T = Time
We apply this formula this way, where
P = $150,000
R = 8% and
T = 5 years
SI = ($150,000 * 8 * 5) ÷ 100 = $6,000,000 ÷ 100 = $60,000
Note: we use 8% as the number 8 … if you use the interest rate as a decimal, 0.08 in this case then
there is no need to divide by 100. Try that:
SI = $150,000 * 0.08 * 5 = $60,000
Exercises for you to do

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Use the Simple Interest method of calculating interest for the following: use the file
comp_disc_delegates.xlsx to help you with this, FV_interest tab
Compound Interest Calculations
We assess the present and future value money by using the compound interest formula. Look at the
diagram below:
The formula to find the interest earned using compound interest is
P(1 + r)n – P
Again,
P is the principal
r is the rate of interest and
n is time
Where P = $150,000 r = 8% and n = 5 years, the interest earned is:
= ($150,000(1 + r)n) - $150,000

= ($150,000(1 + 0.08)5) - $150,000
= ($150,000 * 1.085) - $150,000
= ($150,000 * 1.4693) - $150,000
= $220,399.21- $150,000
= $70,399.21
Using compound interest, use Excel to find the interest due from the following investments: use the
file comp_disc_delegates.xlsx to help you with this, FV_interest tab

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Tabular Approach to Compound Interest
Expand on Example 2, above, with $6,575 at 3.5% for 6 years, compounded annually, by setting out
in full the calculations year by year to demonstrate how the compound interest formula works.
Set out your table like this: FV_interest_2 tab
Example 2 In full
Year Start of Year Interest Earned End of year
1 6,575.00 230.13 6,805.13
2 6,805.13 238.18 7,043.30
3 7,043.30 246.52 7,289.82
4 7,289.82 255.14 7,544.96
5 7,544.96 264.07 7,809.04
6 7,809.04 273.32 8,082.35
1,507.35
Data Tables
In this section, we will learn how to set up what is called a Data Table in Excel that in this case
takes the compound interest formula and uses Data Table functionality to turn that formula into an
entire table!
All we do is set up the input section, put the appropriate formula in the top left hand cell of the Data
Table and bingo: Excel does everything else!
You will find the template data table in comp_disc_delegates.xlsx file data_tables tab; but here it is
and this is how we build it … all the instructions you need are on the following screenshot, in the
range A8:A14 … you really cannot get lost!
Let’s use the Compound Interest Factors

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Compound interest factors take us from Present Values (PV) to Future Values (FV) and they work in
an uncomplicated way. For example, what is the
• future value of $2,458.67

• five years from now at a
• compound annual interest rate of 4%?
From the compound interest Data Table, see below, which is an extract from our Data Table, the
compound interest factor for 5 years at 4% is 1.2167
We then multiply the factor of 1.2167 by the Present Value of $2,458.67 to give us the Future Value
of $2,991.35
In the Excel file, we will use the following approach to find the answer to this question, too:
Also notice the cell G13 has been shaded green: I have used Conditional Formatting to make that
happen and in turn, that is driven by the contents of cell C8 which, in turn, is driven by the input cells
B3:B4.
The answer in cell H6 has been found by using the HLOOKUP() function …
Exercise for you to do
Find the future values for the situations found in the following schedule by using the Data Table of
compound interest factors from the data_tables tab in the comp_disc_delegates.xlsx file.

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Compounding Monthly or Weekly or Daily … Anything but Annually
a) If interest is charged on a basis other than annual, we find future values by using
the non_annual tab: set up this worksheet for yourself to cope with these forms of compounding
Monthly (1 + r/12)m
Weekly (1 + r/52)w
Daily (1 + r/365)d
b) Feel free to extend this template to cater for compounding on bases other than the ones shown
here
You will find the template for these problems in the comp_disc_delegates.xlsx file pv_fv_egs_2 tab
…
Find the annualised rates of interest from the information that follows … pv_fv_egs_2 tab
Ayala Corporation Debt Schedule
The following schedule illustrates some of the debt holding of Ayala. Create a schedule to show the

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full interest to be paid on these instruments: file debt_schedules_2018`_delegates.xlsx
Use the PV Function to find the present value of each stream of interest payments
Ayala Annual and Periodic Growth
Here is a snapshot of the financial results for Ayala for 2009 – 2018
ayala_financial_statments_IS_BS_CF_delegates.xlsx … difficult to read, I know!
Create the following table of year to year growth rates on the growth tab
Create the following table of 5 year (columns B and C) then 10 year (Column D) compound growth
rates on the compound 5 yr growth tab and watch out for error messages:

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Additional Slides
To be used in the practical session and for homework.
Excel’s Built in Finance Functions
Excel has hundreds of built in functions under various headings that include mathematics,
engineering, logic, text and financial. There are 55 financial functions in Excel 2013 and we will take a
look at 11 of them: all of which are concerned with interest rate calculations in one form or another.
You see in the table below, the name of the 11 functions we will look at together with their syntax:
Future Value: FV(RATE,NPER,PMT,PV,TYPE)

Interest Rate: RATE(NPER,PMT PV,FV,TYPE,GUESS)
Number of Periods: NPER(RATE,PMT,PV,FV,TYPE)
Present Value: PV(RATE,NPER,PMT,FV,TYPE)
Interest Payment for a given period: IPMT(rate,period,nper,pv,fv,type)
Payment based on constant monthly payments and constant interest rates:
PMT(rate,nper,pv,fv,type)
Payment on the principal based on constant monthly payments and constant interest rates:
PPMT(rate,period,nper,pv,fv,type)
Internal Rate of Return: IRR(values, (guess))
Modified Internal Rate of Return: MIRR(values,finance_rate,reinvest_rate)
Net Present Value for a schedule of Cash Flows Received at the year end: NPV(rate,value1,
value2 …)
Net Present Value for a Schedule of Cash Flows: XNPV(rates,values,dates)
For each of the above functions, see the table on the next slide, you will find a fully worked example
in the file fin_func.xlsx and there are additional exercises following this section and here are the
questions we will answer:
FV(RATE,NPER,PMT,PV,TYPE) How much does $1,000 accumulate to after

three years at 7% interest per year?
RATE(NPER,PMT PV,FV,TYPE,GUESS) If $1,000 has accumulated to $2,000 in eight
years, what has been the average annual
growth rate?

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NPER(RATE,PMT,PV,FV,TYPE) If I deposit $100,000 and can earn 14% per
annum, how many years will it take me to
become a millionaire?
PV(RATE,NPER,PMT,FV,TYPE) If I have $10,573.45 in my account and I
have earned 1% interest per month for 12
months, what was the original deposit?
IPMT(rate,period,nper,pv,fv,type) At an annual rate of 10%, what is the
interest earned in the 100th period of a 120
period deposit of $100,000 that has a future
or final value of $250,000?
PMT(rate,nper,pv,fv,type) Same details as with the IPMT exercise …
PPMT(rate,period,nper,pv,fv,type) Same details as with the IPMT exercise , as
appropriate …
IRR(values, (guess)) What is the IRR of a project that has an
initial outlay of $100,000 and cash outflows
at year ends 1 to 4 of $50,000, 30,000,
27,500, 23,250 respectively?
MIRR(values,finance_rate,reinvest_rate) The same details as with the IRR example
except that the reinvestment rate is 9%
NPV(rates,values,dates) As with the IRR example except that the cash
flows
XNPV(rates,values,dates) As with the IRR example except that the cash
flows beyond year 0 are 31/12/2015,
30/6/2016, 5/4/2017 and 30/9/2017
Excel’s Built in Finance Functions: Solutions
The solutions are in the fin_func.xlsx file, where there are additional exercises for the FV and RATE
functions and here are just four of them:
The first exercise concerns the FV() function which is the function to solve P(1+r) n
B15=FV(RATE,NPER,PMT,PV,TYPE) How much does $1,000 accumulate to

after three years at 7% interest per year?
B16=Present value 1000
B17=Rate 0.07
B18=Years 3
B19=Function Applied: Future Value C19=FV(C17,C18,,-C16) = $1,225.04
B59=IPMT(rate,period,nper,pv,fv,type) At an annual rate of 10%, what is the

interest earned in the 100th period of a
120 period deposit of $100,000 that has a
future or final value of $250,000?
B60=Rate (annual ... Make it monthly) 0.1
B61=Period (months) 100
B62=NPER 120
B63=PV 100000
B64=FV 250000
B65=Function Applied: IPMT =IPMT(C60/12,C61,C62,-C63,C64) = $1,766.30
B91=MIRR(values,finance_rate The same details as with the IRR example

,reinvest_rate) except that the reinvestment rate is 9%
B92=initial cost of asset -100000

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B93=cash flows generated by 50000
asset year 1
B94=year 2 30000
B95=year 3 27500
B96=year 4 23250
B97=finance rate 0.1
B98=reinvest rate 0.09
B99=Function Applied: MIRR =MIRR(C92:C96,C97,C98)`= 11.33%
B110=XNPV(rates,values,dates) As with the IRR example except that the

cash flows beyond year 0 are
31/12/2015, 30/6/2016, 5/4/2017 and
30/9/2017
B111=1/1/2015 -100000
B112=31/12/2015 -100000
B113=30/6/2016 50000
B114=5/4/2017 30000
B115=30/9/2017 27500
B116=r 0.1
B117=Function Applied: XNPV =XNPV(C116,C111:C115,B111:B115) =
(102,227.22)
The True Cost of Giving and Receiving Credit
Have you ever stopped to think about the cost of giving or receiving credit? You know, you are
offering your customers 2% if they pay after 10 days but within 30 days … Look at the apr tab in the
file comp_disc.xlsx
Let’s consider the first of the three examples that are in that tab:
The formula in cell B8=(B4/(100%-B4))*(365/(B6-B5))
Let’s analyse that formula in two parts:
• Part 1 =(B4/(100%-B4)) … this gives us 0.0204 which grosses up the 0.02 or 2% per
month to 0.02/0.98
• Part 2 =(365/(B6-B5)) … the number of times in a year that the discount will be paid
assuming that customers take the full credit period.
This gives us the grossed up APR for example one of 37.24%. In other words, whilst an apparently
very small discount of 2% is awarded for early payment, in reality it costs 37.24% per year: very
expensive.

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Take a look at the other two examples from the apr tab and appreciate why their APRs are 55.58%
and 26.74% respectively.
In conclusion, you should realise that 1% per month maybe more appropriate if you are giving credit
but of course 2% and 2.5% are acceptable if you are receiving the credit!
Rates of Return
Arithmetic, Geometric and Continuous Compounding
We have already done some work on rates of return but let’s consolidate it now by looking at
arithmetic and geometric returns and then continuous compounding.
We will explore the differences and implications of arithmetic v geometric growth
Arithmetic Sequence
Example: 1, 3, 5, 7, 9, 11 (common difference is +2)

or 25, 20, 15, 10, 5 (common difference is -5)
colgate_palmolive_bonds_peers_delegates.xlsx
Geometric Sequences
Example: 50, 100, 200, 400, 800 (common ratio is 2)

or 800, 400, 200, 100, 50 (common ratio is 1/2)
A good example of the use of arithmetic return is simple interest and the following graph shows the
results of an investment returning 0.5208% per period over 36 periods, with the balance b/d on the
left hand Y axis and the monthly simple interest earned on the right hand, secondary, Y axis:
Geometric return is a good example of compounding, which we have already seen in this course.
Turning the previous simple interest example into a compound interest example, gives us this graph:

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Continuous Compounding
By continuous compounding we mean that interest accrues not only every minute, not only ever
second but every possible time period … infinite!
The continuous compounding formula is used to determine the interest earned on an account that is
constantly compounded, essentially leading to an infinite number of compounding periods.
The continuous compounding formula takes this effect of compounding to the furthest limit. Instead
of compounding interest on a monthly, quarterly or annual basis, continuous compounding will
effectively reinvest gains perpetually.
Continuous Compounding Formula
Continuous Compounding Formula Example
A simple example of the continuous compounding formula would be an account with an initial balance
of $1,000 and an annual rate of 10%. To calculate the ending balance after 5 years with continuous
compounding, the equation would be
$1,000 * e(0.1)(5)
= $1,000 * e(0.5)
This will return a balance of $1221.40 after the two years and $1,648.72 after five years. For
comparison, an account that is compounded annually will return a balance at the end of year two of
$1,210 and at the end of five years, $1,610.51.
What is e and how can we make this work in Excel?
e is the base of Natural Logarithms and it approximately equals 2.718282
To find the balance of our investment at the end of year five in Excel using continuous compounding:
=Initial Investment*EXP(Rate*Years)
=$1000*EXP(0.1*5)
= $1,648.72
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Yields on uneven returns
I talk about the CAGR from time to time in my courses, the Compound Annual Growth Rate. This is a
finance measure that is used to assess how well an investment has done or is doing over a number of
periods or years.
RRI() Function
There is an Excel function to help with the CAGR that is called RRI(). The syntax of the function is
RRI(nper, pv, fv) and an example of how to use RRI() is
=RRI(10,70,12154) … 10 years with a present value of 70 and a future value at the end of 10 years
of 12,154. The RRI is 0.67.48 or 67.48%. That means the CAGR is 67.48%
Internal Rates of Return
The Internal Rate of Return, IRR, is a well known concept in capital budgeting and we will review it
further later in this course.
One definition of the IRR is that it is the cost of capital that makes the NPV of a project exactly equal
to zero. There are essentially two ways to find the IRR of an asset and they are
- By trial and error

- Using the IRR() function in Excel or other software
Let’s not bother with the trial and error method because we are blessed with Excel!
Example of Using IRR()
We found the IRR of the investment to be 33.41% to two places of decimals and when we entered
that in the NPV function, we found that at that cost of capital, the NPV = 0. That is how to find the
IRR of a conventional investment.
Alternatively, we can create an NPV Profile such as the following, based on the example we have just
been discussing:

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Highlighting key financial management principles underpinning effective model
development
Section Three
Cost of Capital
The Cost of Capital is defined as:
The weighted average of the cost of equity and after tax cost of debt, weighted by the market values
of equity and debt:
Cost of Capital = Cost of Equity (E/(D+E)) + After tax Cost of Debt (D/(D+E))
For the weights, we use cumulated market values for the entire sector.
Cost of Equity
By equity we mean the share capital of an organisation or the stock capital. By the cost of capital, we
mean exactly how much it has cost an organisation to issue and maintain its share capital over a
period. Alternatively, the cost of equity is the required rate of return on equity demanded by
shareholders.
Let’s look at the required rate of return version first: the Capital Asset Pricing Model (CAPM).
Cost of Equity = Riskfree Rate + Beta (Risk Premium)
Beta is defined as
- For US firms: Estimated by regressing weekly returns on stock against S&P 500, using 2
years and 5 years of data.
- For all other firms: Estimated by regressing weekly returns on stock against the local
index (generally the most widely followed index in that market - CAC in France, Sensex in
India and Bovespa in Brazil), using 5 years of data. I use a composite of the two year
regression beta and the five year regression beta, weighting the former 2/3rds and the
latter 1/3rds.
- Beta = (2/3) 2 year regression beta + (1/3) 5 year regression beta
- If the five year regression beta is missing, I replace it with one. I also apply an
aggregate check to ensure that the global average across all the companies is close to
one.
The bottom up beta for the sector is used, adjusted for a company's debt to equity ratio. We use the
long term treasury bond rate as the risk free rate and a 5.5% risk premium. You can change these
inputs in the excel spreadsheet.
Aswath Damodaran provides a wide range of data sets for teachers, students and practitioners every
year and his example data include the following, for emerging markets:
After-tax Cost of Cost of Capital
Industry Name Number of Firms Beta Cost of Equity E/(D+E) Std Dev in Stock Cost of Debt Tax Rate Debt D/(D+E) Cost of Capital (Local Currency)
Advertising 103 1.50 12.31% 87.46% 43.41% 4.47% 15.28% 3.30% 12.54% 11.18% 16.11%
Aerospace/Defense 89 1.18 10.09% 80.05% 33.50% 4.07% 12.54% 3.01% 19.95% 8.68% 13.49%
Air Transport 86 1.11 9.64% 42.79% 28.73% 4.07% 14.03% 3.01% 57.21% 5.85% 10.54%
Apparel 907 0.75 7.13% 71.50% 35.89% 4.07% 14.37% 3.01% 28.50% 5.95% 10.65%
Auto & Truck 83 1.38 11.51% 63.52% 32.33% 4.07% 12.25% 3.01% 36.48% 8.41% 13.21%
Auto Parts 459 1.20 10.24% 78.25% 33.69% 4.07% 15.65% 3.01% 21.75% 8.67% 13.48%
Bank (Money Center) 449 0.66 6.50% 41.80% 21.09% 3.52% 21.19% 2.60% 58.20% 4.23% 8.85%
Banks (Regional) 95 0.73 6.99% 21.61% 24.70% 3.52% 18.18% 2.60% 78.39% 3.55% 8.14%
Beverage (Alcoholic) 120 1.02 8.99% 96.35% 28.14% 4.07% 19.75% 3.01% 3.65% 8.78% 13.60%
Beverage (Soft) 31 0.39 4.63% 83.61% 23.72% 3.52% 16.38% 2.60% 16.39% 4.29% 8.92%

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I have shared Prof Damodaran’s files with you, waccemerg.xlsx in this case.
Ayala data are included in Prof Damodaran’s waccemerg file, under the Industry names
- Diversified
- Real Estate (General Diversified)
Real Estate
Industry Name Diversified (General/Diversified)
Number of Firms 212 245
Beta 0.79 1.07
Cost of Equity 7.41% 9.33%
E/(D+E) 39.16% 54.48%
Std Dev in Stock 24.64% 28.18%
Cost of Debt 3.52% 4.07%
Tax Rate 15.66% 13.05%
After tax Cost of Debt 2.60% 3.01%
D/(D+E) 60.84% 45.52%
Cost of Capital 4.48% 6.45%
Cost of Capital (Local
Currency) 9.11% 11.17%
Cost of Debt
The after tax cost of debt is:
Either After tax cost of debt = Pre tax Cost of debt (1 — Marginal tax rate)
Or After tax cost of debt = Pre tax Cost of debt (1 — tax rate)
The average effective tax rate for the sector is used for this computation.
The pre tax cost of debt is
This is estimated by adding a default spread to the risk free rate. To estimate the default spread, I
first check to see if the company has a bond rating and if it does, I use that rating to get a default
spread. If it does not, I use the standard deviation in stock prices over the last 5 years to estimate a
default spread; the higher the standard deviation, the higher the default spread. If the company
operates in a risky country (with default risk), I add the country default spread to get a consolidated
spread.
Standard deviation in prices (equity): The standard deviation in weekly stock prices, estimated
using two years of data. The number is annualised.
Tax impact on Cost of Capital
Consider the following table that includes the adjustment made for the tax rate on the cost of debt
and thereby on the cost of capital

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Calculating the Weighted Average Cost of Capital (WACC) and Hurdle rates
WACC formula
• The marginal cost of capital (MCC) is the cost of the last dollar of capital raised,
essentially the cost of another unit of capital raised. As more capital is raised, the marginal
cost of capital rises.
Imagine a company's weighted average cost of capital is:
• WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%
• So the WACC is 8.4% and it will remain unchanged as new debt, preferred stock and retained
earnings are issued until the company's retained earnings are depleted.
• Example: Marginal Cost of Capital
Once retained earnings are depleted, the company decides to raise new equity. Assume the
company's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2 and the
company expects to pay out 30% of its earnings. Additionally, assume the company has a
flotation cost of 5%. The company's cost of new equity (kc) is therefore 12.263%:
• kc =2/(40*(1-0.05))+0.07 = 0.12263, or 12.263%

Answer:
Using this new cost of equity, we can determine the WACC as follows:
• WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC =(0.4)*(0.07)*(1-0.4)+(0.05)*(0.021)+(0.55)*(0.12263)
WACC = 0.0853, or 8.53%
• The WACC has been increased from 8.4% to 8.53% given the company's need to raise new
equity.
Marginal Cost of Capital and Finding Break Points

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MCC v WACC
The marginal cost of capital is simply the weighted average cost of the last dollar of capital raised. In
making capital decisions, a company keeps with a target capital structure. There comes a point,
however, when retained earnings have been depleted and new common stock has to be used. When
this occurs, the company's cost of capital increases. This is known as the break point and can be
calculated as follows:
Example
For our company, assume we expect it to earn $50 million next year. As mentioned in our previous
examples, Newco's payout ratio is 30%. What is Newco's breakpoint on the marginal cost curve, if we
assume wce = 55%?
Answer
Break point = (50*(1-0.3))/0.55 = $63.64 million
So, after the company raises roughly $64 million of total capital, new common equity will need to be
issued and the WACC will increase to 8.6%.
Factors that affect the cost of capital can be categorised as those that are controlled by the company
and those that are not.
Sometimes, such as when comparing two projects in different tax regimes, it's advantageous to
evaluate projects or companies pre tax. This is where mistakes get made. If I have a project with a
post tax NPV of $700 and a tax rate of 30%, many will calculate the pre tax NPV to be $1,000, being
$700 divided by (1 - 30%). This is incorrect.
It is common practice that if you discount pre tax cash flows at the pre tax discount rate, the NPV of
this calculation must equal the NPV of evaluating the post tax cash flows at the post tax discount
rate. This is a fundamental principle that many are either unaware of or else forget. Don't make such
a mistake.
The problem is, how do you calculate the pre tax cost of equity? It's an estimate and is not equal to:
Pre tax cost of equity = Post tax cost of equity ÷ (1 - tax rate).
As model auditors, we see this formula all the time, but it is wrong. Pre tax cash flows don't just
inflate post tax cash flows by (1 — tax rate). Some cash flows do not incur a tax charge, and there
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may be tax losses to consider and timing issues. And that's just for starters. No, the pre tax cost of
equity is a balancing figure. It's the rate that generates the correct pre tax WACC so that the pre tax
and post tax NPVs are equal.
If you have more than four periods in your DCF, there's a mathematical result from a topic called
Galois theory that proves you cannot solve this formulaically. (I'll leave you to prove that!) We have
to "guess" the answer, and to do that we'll need to use Excel's Goal Seek functionality if we are using
Excel as our valuation software of choice.
So how do we do this?
I will demonstrate as follows (download the Excel file if you'd like to follow along). Let's use the
figures shown in the "Financing Assumptions" screenshot.
The post tax WACC has been calculated using the formula (and range names):
=(PreTax_Cost_of_Debt*(1 tax_Rate)*Proportion_of_Debt) +
(PostTax_Cost_of_Equity*(1-Proportion_of_Debt))
where the inputs (above) have been given the range names shown in grey (to the right in the
"Financing Assumptions" screenshot). It's the Excel equivalent of our formula cited above.
Financing assumptions
There's more, though:
- The terminal value is an amount applied in the final period of a cash flow to represent
the value of future cash flows after this point in time. It is typically calculated in
perpetuity and uses the formula shown in the screenshot "Terminal Value Formula".
- Some valuers will use a different discount rate for this calculation, but this is highly
debatable. (I will use the same rate, the WACC, throughout)
- The cash flow in the final period may have to be adjusted to smooth out capital
expenditure and depreciation (for tax calculations), but that is a story for another day.
What is important to understand is that the final period's cash flow before creating a
terminal value should have achieved a "steady state".
- The tolerance is simply an indicator for an alert check: it's dangerous to place too much
value in the terminal value. I have used the rather unrealistic 90% here as the amount
that the present value of the terminal value may be of the overall NPV before an alert is
triggered. A more common tolerance might be 60%, for example.
Terminal value formula

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The model requires further assumptions, as shown in the screenshot Model Assumptions.
Model assumptions
I have just used 100 as my relevant cash flow (ie, not including any costs of financing, as this is
already included in the discount rate) for each period, but it's the other assumptions that require
further discussion.
The number of periods is used to determine how many periods of DCFs there will be (the explicit
forecast period) before adopting the terminal value (the implicit forecast period) for further periods.
My downloadable Excel file will calculate for up to 20 periods, even allowing for a shorter first period
(as the valuation will start from the Model_Start_Date). In the Model Assumptions screenshot, the
number of periods has been set to eight (8). In the downloadable file, you can find this input in cell
G33 (its range name is Number_of_Periods) of the "Pre tax Cost of Equity Example" worksheet.
The tax delay assumption is used to build in a delay for the payment of tax. It's important to realise
that DCFs are calculated using cash flows and it has to be when the tax is paid, not when the liability
arises.
The timing of the cash flows can be the start, middle or end, as discussed earlier. Consequently,
three discount rates have been computed, as shown in the screenshot Calculated Discount Rates.
Calculated discount rates
These cells use the formula:
=(1+PostTax_WACC)^(#Days_From_Valuation_Date/Days_in_Year).
The Days_From_Valuation_Date is calculated as:
The number of days between the valuation start date (here, this is the Model_Start_Date) and the
first day of the period when the timing of the cash flows is at the start of the period.
The number of days between the valuation start date and the final day of the period when the timing
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of the cash flows is at the end of the period.
The average of the above when the timing of the cash flows is in the middle of the period.
I then used INDEX MATCH to select the appropriate discount rate for the valuation:
=IF(Counter<=Number_of_Periods,INDEX(Discount_Factors_for_Period,MATCH(Timing_of_CashFlow
s,Labels,0)),"")
We can then calculate our NPV, as shown in the screenshot Post tax NPV Calculation.
Post tax NPV calculation
Note that I have calculated this longhand. That's because when we use dates and periods of unequal
lengths, the Excel function XNPV may not always give the right answer … DW note: this is only
true, as far as I know, when leap years are involved.
And even if it did, this is clearer.
As stated earlier, the TV Tolerance just checks that the terminal value (here, 1,050), when considered
in its present value form, is not an excessive amount of the total NPV.
Now, I know what the NPV is for this scenario. I also know the pre tax cash flow, the pre tax cost of
debt, and the mix of debt to equity. The only thing missing is the pre tax cost of equity, so, given
there are more than four periods, this will have to be solved for using Excel's Goal Seek feature, as
shown in the screenshot Pre tax NPV Calculations.

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Pre tax NPV calculations
https://www.fm-magazine.com/issues/2019/aug/microsoft-excel-calculating-pre tax-cost-of-
equity.html
Marginal WACC curve and finding break points
Marginal cost of capital is the weighted average cost of the last dollar of new capital raised by a
company. It is the composite rate of return required by shareholders and debt holders for financing
new investments of the company. It is different from the average cost of capital which is based on
the cost of equity and debt already issued.
The weighted average cost of capital (WACC), the most common measure of cost of capital used in
capital budgeting and business valuation, is the weighted average of the marginal cost of common
stock, marginal cost of preferred stock and marginal after tax cost of debt.
The distinction between average cost of capital and marginal cost of capital is important. The
marginal cost of capital rises as the company raises more and more capital. This is because capital is
scarce, just like any other factor of production and must be compensated through a higher required
return. The return available on new projects must be compared with the marginal cost of capital and
not the average cost of capital and the projects should be accepted only when the expected return is
higher than the required return.
Marginal cost of capital increases in steps and not linearly. This is because a company can finance a
certain portion of new investments by reinvesting earnings and raising enough debt and/or preferred
stock to maintain the target capital structure. The reinvestment of earnings comes without any
increase in cost of equity. However, as soon as the expected capital exceeds the combined amount of
retained earnings and debt and/or preferred stock raised to maintain the target capital structure, the
marginal cost of capital increases.
Break Point

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Break point is the total amount of new investments that can be financed and the new capital that can
be raised before a jump in marginal cost of capital is expected. It is the point at which the marginal
cost of capital curve breaks out from its flat trend.
The break point can be worked out by dividing the retained earnings for the period by the weight of
the retained earnings in the target capital structure. The retained earnings in a period equals the
product of net income for the period and the retention rate (also called plow-back rate), which equals
1 minus the dividend payout ratio.
The following equation can be used to calculate the break point:
NI × (1 - DPR)
Break Point =
We
Where
NI is the net income for the period

DPR is the dividend payout ratio, ie the dividends declared dividend by net income and
We is the weight of retained earnings in the target capital structure.
The break points are helpful in creating the marginal cost of capital curve, a graph that plots capital
raised on the X axis and marginal weighted average cost of capital on the Y axis.
Your company's marginal cost of capital was 10% at the start of 2017. Its net income for the year
was $30 million, 30% of which was paid out in dividends. Retained earnings form 45% of the target
capital structure of the company.
The company's break point equals retained earnings for the period divided by proportion of retained
earnings in target capital structure.
Retained earnings for the period equals $21,000,000 (ie $30,000,000 × (1 – 30%)).
$21,000,000
Break Point = = $46.67 million
0.45
The new marginal cost of capital once $46.67 million of capital is raised is 12%.
Using the above data, the marginal cost of capital curve can be graphed as follows:
Investment Opportunity Schedule

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Investment opportunity schedule is the table/graph of cumulative investment opportunities and their
expected return. It plots the expected return on the Y axis and the initial investment required on the
X axis. The investment opportunity schedule is a downward sloping curve because investment
opportunities are rare and each new opportunity is expected to generate a diminishing returns.
Let's say the following is a list of potential investment opportunities available to your company and
their expected return:
Project Initial Investment Expected Return

A $25,000,000 25%
B $40,000,000 18%
C $25,000,000 12%
D $15,000,000 8%
The investment opportunity schedule can be plotted as follows:
Optimal Capital Budget
A company's optimal capital budget is the point at which its marginal cost of capital equals the
incremental expected return. A company should raise new capital as long as the marginal cost of
capital is lower than or equal to the available return.
The following chart plots the marginal cost of capital and investment opportunity schedule. The point
of intersection of the marginal cost of capital curve and investment opportunity schedule is the
optimal capital budget.
by Obaidullah Jan, ACA, CFA and last modified on Apr 17, 2019
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at
studyingalpha.com
https://xplaind.com/157121/marginal-cost-of-capital

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Reviewing Capital Budgeting
Cash flow modelling
In reality, cash flow forecasts can be extremely complex as they relate to an entire organisation and
all of its activities. This is so because every activity is driven by the need for money to be spent
and/or received. Here is an example of the final aspect of cash flow forecasting in which we move
from a simple cash forecast to one that includes allowance for debtors and creditors, debts written off
and so on:
The above does not allow for bad or doubtful debts: say how you know that and the following
screenshot shows the cash flow forecast with debtor and creditor transactions fully accounted for.
Decision modelling, including:
Payback Period
The Payback Period (PB) tells us when the cumulative cash flow of a project equals zero. There is no
single Excel function that calculates PB but it can be found quite easily with a formula.

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Here are the cash flow profile and cost of capital data for a single project:
Initial investment -100000

CF1 35000
CF2 45000
CF3 50000
CF4 47500
CF5 52500
Cost of capital 7.50%
Our task is to find the payback period for this project, let’s do it this way:
Year Cash Flow Cumulative Cash Flow

0 -100000 -100000
1 35000 -65000
2 45000 -20000
3 50000 30000
4 47500 77500
5 52500 130000
I have reformatted the table and added the cumulative cash flow column: that column tells us that
the PB takes place in the 3rd year: greater than 2 years, less than three years. How do I know that?
Well, PB happens when the cumulative cash flow = $0 and at the end of year 2, it is -$20,000 but at
the end of year 3 it is $30,000. So, we conclude that PB where negative cumulative cash flow flipped
to being positive happened in that third year.
We could combine the cumulative column and the PB column but for demonstration, I will add a PB
column that shows the final PB value by itself.
Actually, the PB calculation is more complex than we might expect, as you can see. I programmed
that formula in cell D4 and filled it down to the end of the project, D9. How does it work?
First of all, IF(C4*C5>0 … the turning point from negative to positive will, when the two values are
multiplied together, give us a negative number. -20000 * 30000 = -600,000,000. That tells us we
have gone from negative to positive in this case.
Just check other examples,
-65000 * -20000 = 1,300,000,000 … a positive number

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77500 * 130000 = 10,750,000,000 … a positive number
So, if the result of that multiplication is positive, do nothing because we are not at the turning point.
If the result is negative, we have arrived at the year with the PB in it and the final calculation is:
Current year + ABS(current year’s cumulative cash flow)/next year’s cash flow
ABS() tells Excel to ignore the minus sign in front of the -20,000, the absolute value
We divide 20000 by 50000 because, to get to Cumulative cash flow = 0, we need all of the 20000 in
the cumulative column and that 20000 is coming out of year three’s cash flows of 50000 therefore,
we conclude, assuming cash inflows are linear that the PB is
2 + 20000/50000 = 2 + 0.4 = 2.4 years
Find the PB for the following project:
NPV (Net Present Value): NPV, XNPV
The Net Present Value, NPV, of a project or asset is the present value of an initial investment
together with a resulting stream of earnings.
Present value reflects the time value of money and tells us, for example, how much the future value
of an amount of money is worth today. This might sound complicated but it’s quite simple, really,
following on from our discussion of the time value of money and compound interest.
Present Value Principles
If I know that in two years’ time my bank would pay me $10,000: that is a guaranteed amount from
a timed deposit, I can work out how much I need to give the bank today, if interest rates are 5% per
annum at the moment.
FV 10000
r 0.05
n 2
PV 9,070.29 =B13/(1+B14)^B15
- We are working backwards: we know the future value, FV, $10,000

- We know with compound interest that to go from present values, PV, to the FV, we
multiply by the compound factor (1 + r)n

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- Therefore, to go back from the FV to the PV we should divide FV by the compound factor
$10,000/(1+0.05)2
= $10,000/1.1025
= $9,070.29
That means, my PV is $9,070.29. Alternatively, if I put $9,070.29 in the bank today and leave there to
earn interest at the rate of 5% per year compound, it will grow to $10,000 after exactly two years.
Find the present values of the following cases:
Case 1 Case 2 Case 3 Case 4 Case 5

FV 10,000 100,000 2,000 50,000 68,751
r 5.00% 7.50% 10% 1.25% 3.50%
n 2 5 10 15 3
Compound Interest Factor 1.1025
PV 9,070.29
In an NPV project, it is normal for there to be multiple year cash flows, along the lines we have been
working with in the previous sections. Let’s turn our attention there, then. We are going to find the
NPVs of three mutually exclusive projects: what that means is that we can invest in only one of the
three projects and not more.
In the file we are working on for this section, the NPV tab contains a template for you:

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- What is a discount factor? Remember Data Tables? We dealt with them there, remind
yourself if necessary. If you remember, then all they are is 1/(1+r) n
- PV Cash Flow X is the cash flow for that year for that project multiplied by the discount
factor for that year.
- NPV is the sum of all of the Present Values for a project, including the year 0 PV
Your answers should be:
- NPV Project 1 $83,883.49

- NPV Project 2 $45,778.20
- NPV Project 3 -$9068.00
The big question now is, what do they tell us and what do we do with this information?
- For a project to be financially acceptable, its NPV must be >$0

- For a project to be chosen from two or more projects, the higher the NPV the better
In this case, Project 3 must be rejected outright since its NPV <0
Project 1’s NPV is positive and higher than that of Project 2 so we choose to invest in Project 1.
Determine which of the following four mutually exclusive projects you should invest in.
NPV Function

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The NPV() function allows us to condense much of the work we have done to find the NPVs of the
projects we have been working on. We can apply the function in one cell and get the answer
directly. That’s a real time saver, with one proviso: the NPV() function does not work!
Let’s go back to our three project example and see how we can find the NPV of each project and
make the NPV() function work at the same time.
There are two points to make here:
The NPV results we have just obtained agree exactly with the NPV results we got when we used the
tabular method.
Secondly, we do use the NPV function but notice we have manually to add the initial, year 0, cost to
the value of the NPV function to get the right answer. That means, we use the cash flows for years 1
to 5 in the NPV function and the year 0 cash flow as an addition to the NPV result.
When we are asked to rank the three projects, as we did before, we say:
- Recommend project 1 because its NPV is positive and by far the highest of the three
projects
- Project 2 is an acceptable project because its NPV is positive but it is smaller than the
NPV of project 1
- Reject project 3 because the NPV is negative
Us the NPV function with the year 0 cash flow addition method to show the NPV for all four
projects and say why you accept or reject each of the projects on the basis of their NPV results.

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To help you with your decision making, consider using
RANK() to put your results in 1, 2, 3, 4 order of preference

Create an IF() statement to tell the reader whether, overall, each project is acceptable or rejected.
XNPV
The XNPV() function works properly and it lets us use dates in our examples rather than year
numbers. That means we can set up an example like the following:
The solutions are in the screenshot above and the formula I used for project 1, in cell F12 is
=XNPV(B$11,B4:B9,A$4:A$9)
The syntax for XNPV() is
=XNPV(rate,values,dates)
- Note: whenever you open my file, it will always say today’s date in cell A4 … how did I
do that?
- Notice also, Project 2 is now ranked first, then project 1 and project 3 is still rejected.
- Finally, do note that if you are working with projects that span leap years, the results you
get from using XNPV() will be a little different to the results of using NPV().
As with the previous example, did you use the RANK() function and an IF() statement to help you to
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communicate these results?
Finally, who needs XNPV(()? If ever you look at promotions for real estate sales, especially when
looking at new builds, you will notice that plots, floors or buildings are often to be paid for in
tranches such as
• Deposit on signature
• Stage one payment after three months
• Stage two payment after another nine months
• and so on
The XNPV() function is ideally suited to such examples.
IRR (Internal Rate of Return): IRR, MIRR, XIRR
We have already discussed the IRR(), MIRR() and XIRR() functions when we explored some of the
finance functions that Excel offers us. That discussion was a little abstract so let’s look at them in the
context of a more realistic setting.
Definitions
- IRR is the cost of capital that gives us an NPV of $0

- MIRR is the IRR taking into account the cost of capital and the reinvestment rate
- XIRR is the IRR allowing for the use of dates rather than year numbers: it is the
equivalent of the XNPV() function
Syntaxes
IRR(values,[guess])
MIRR(values,finance_rate,reinvest_rate)
XIRR(values,dates.[guess])
Consider the following example, the three project example we have already worked on but notice this
time there is a cost of capital and a reinvestment rate provided.
Create your own Dates list to replace the numbers in the Year column
Build in a way to illustrate the ranking of the projects

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Repeat the four project exercise for the IRR(), MIRR() and XIRR() functions.
I have already provided the list of dates in this case and I have given you just one suggestion for
how you might show the ranking of the projects.
NPV v IRR v RRR … in plain English!
- NPV is the Net Present Value

- IRR is the internal rate of return
- RRR is the required rate of return.
NPV
What the NPV essentially does is to tell us one thing that we can look at in two ways:
- A project promises me, say, $100,000 cash to be received in three years’ time: the Future
Value of a cash flow
- If I want to receive $100,000 three years from now, how much should I put into a bank
account today to pay for that? That is the Present Value of a cash flow
The table below confirms that we are looking at two sides of the same coin here and for simplicity I
assume an interest rate of 10% per year:
Present and Future Values
r 10%
n 3
Future Value Interest Present Value

100,000.00 0.7513 75,131.48
Present Value Interest Future Value

75,131.48 133.10% 100,000.00
With all formula showing:

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Present and Future Values
r 0.1
n 3
Future Value Interest Present Value

100000 =1/(1+B3)^B4 =C7*D7
Present Value Interest Future Value

=E7 =(1+B3)^B4 =C10*D10
Taking matters a step further:
You know that the formula for the discount factor is
=1/(1+B$3)^A6
and that the Present Value is
=B6*C6
So, you can easily derive that table and find the NPV to be the sum of
NPV = -500000+227273+165289+131480 = 24,042
Which gives us the definition of NPV which is
How much should I put into an account now when the interest rate is, say, 10% to ensure that I can
buy an asset or another company and, having paid $500,000 for it today, earn cash flows of
$250,000 after one year, $200,000 at the end of two years and $175,000 at the end of three years?
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IRR
The IRR is the discount rate or cost of capital that gives an NPV of zero.
=IRR(B6:B9)
I have already included the value of the IRR in the previous screenshot but let’s prove that it is the
cost of capital that forces NPV to be zero. Just put 12.89% in cell B3 and the NPV value in cell D10
should become $0 … plus or minus a rounding error … 12.89% won’t work properly so I used the IRR
to four decimal places and that worked, as you can see below:
Normally there’s just one IRR however, in some cases, there is no IRR, sometimes there are multiple
IRRs.
RRR
The RRR is the required rate of return and it is the return a company requires on its projects in
order to proceed with them. The RRR is an arbitrary number and differs from company to company
and there is no general formula for it.
Sensitivity analysis
Sensitivity analysis is used to evaluate how sensitive the output variable is to the change in one of the
variables while other input variables remain unchanged. Sensitivity analysis is widely used in capital
budgeting decisions to assess how the change in such inputs as sales, variable costs, fixed costs, cost
of capital, and marginal tax rate will affect such outputs as net present value (NPV) of a project,
internal rate of return (IRR), and discounted payback period. It also provides a better understanding
of the risks associated with a project.
How to conduct sensitivity analysis
Several steps are involved in sensitivity analysis of a project.
1 Determine input and output variables.

2 Calculate the baseline value of the output variable using the baseline input variables value.
3 Change the value of one of the input variables while others remain constant and calculate
the new value of the output variable.
4 Calculate the percentage change of both output and input variable compared to baseline
values.

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5 Calculate the sensitivity of the output variable to the change in the input variable using the
formula below.
Formula
% change in output
Sensitivity =
% change in input
- Steps three to five should be repeated for the other input variables.
- Sensitivity analysis allows identification of input variables that represent the greatest
vulnerability for the project.
Example
A company is considering a project with initial costs of $500,000 involving purchase of new machinery
which has a useful life of 5 years. The after tax cost of capital is 16% and the marginal tax rate is
30%. The other key parameters of a project are presented in the table below.
My worksheet:
Initial Capital Cost: $ -500000

Useful economic life of machine: years 5
After tax cost of capital 16%
Marginal tax rate 30% 176,805
Year 1 Year 2 Year 3 Year 4 Year 5

Sales Units 20,000 22,000 27,000 25,500 23,000
Selling Price per Unit: $ 35 36 38 41 45
Variable Cost per Unit: $ 22 22 23 25 28
Fixed Costs: $ 100,000 102,000 105,000 109,000 115,000
Depreciation, included in Fixed Costs 40,000 40,000 40,000 40,000 40,000
Our task is to conduct sensitivity analysis of a project.
Solution
Step 1
The net present value (NPV) and the internal rate of return (IRR) are the outputs of our model and
analysis while our inputs are:
- Fixed costs
- Sales units
- Selling price per unit
- Variable costs per unit
Step 2
Let’s find the baseline NPV and IRR. The calculation of discounted cash flows is shown in the table
below.

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0 1 2 3 4 5
Sales (S) 700,000 792,000 1,026,000 1,045,500 1,035,000
Total variable costs (TVC) 440,000 484,000 621,000 637,500 644,000
Fixed costs (FC) 100,000 102,000 105,000 109,000 115,000
Earnings before tax (EBT) 160,000 206,000 300,000 299,000 276,000
Tax expense (T) 48,000 61,800 90,000 89,700 82,800
Net income (Nl) 112,000 144,200 210,000 209,300 193,200
Net cash flow (NCF) (500,000) 152,000 184,200 250,000 249,300 233,200
Present Value of Net Cash Flow (500,000) 131,034 136,891 160,164 137,686 111,030
$152,000
Present Value of Net Cash Flow, year 1 = = $131,034
(1+0.16)1
The baseline net present value of a project is as follows:
Baseline NPV = $176,805

The baseline IRR is 29.03%.
Step 3
Let’s assume that fixed costs will be 5% higher than baseline values. Provided other inputs remain
constant, the discounted net cash flows will be as follows:
FC Increase 5%
0 1 2 3 4 5
Sales (S) 700000 792000 1026000 1045500 1035000
Total variable costs (TVC) 440000 484000 621000 637500 644000
Fixed costs (FC) 105,000 107,100 110,250 114,450 120,750
Tax expense (T) 46,500 60,270 88,425 88,065 81,075
Net income (Nl) 108,500 140,630 206,325 205,485 189,175
Net cash flow (NCF) -500000 148,500 180,630 246,325 245,485 229,175
NPV 164,757
NPV Change % -6.81%
Sensitivity of NPV (1.3629)
This means that with an increase in fixed costs of 1%, the NPV of the project will decrease by
1.362%, and vice versa, if fixed costs are reduced by 1%, the NPV will increase by 1.362%.
IRR 28.17%
IRR Change % -2.94%
Sensitivity of IRR (0.5882)
Similarly, with the change in the IRR, an increase in fixed costs of 1%, the IRR of the project will
decrease by 0.5882%. Vice versa if fixed costs are reduced by 1%.
Step 4
Let’s assume that sales in units will be 5% higher than baseline values. Provided other inputs remain
constant, the discounted net cash flows will be as follows:

Page 68 of 73
Sales Units Increase 5%
0 1 2 3 4 5
Sales (S) 735,000 831,600 1,077,300 1,097,775 1,086,750
Fixed costs (FC) 100,000 102,000 105,000 109,000 115,000
Tax expense (T) 51,900 66,420 96,075 95,820 88,665
Net income (Nl) 121,100 154,980 224,175 223,580 206,885
Net cash flow (NCF) (500,000) 161,100 194,980 264,175 263,580 246,885
NPV 216,145
NPV Change % 22.25%
Sensitivity of NPV 4.4501
Thus, an increase in sales by 1% will cause an increase in NPV by 4.4501% and vice versa.
IRR 31.73%
IRR Change % 9.31%
Sensitivity of IRR 1.8627
Step 5
Let’s assume that the sales price of a unit will be 5% higher than baseline values. Provided other
inputs remain constant, the discounted net cash flows will be as follows:
Sales Price Increase 5%

0 1 2 3 4 5
Sales (S) 735,000 831,600 1,077,300 1,097,775 1,086,750
Fixed costs (FC) 100,000 102,000 105,000 109,000 115,000
Tax expense (T) 58,500 73,680 105,390 105,383 98,325
Net income (Nl) 136,500 171,920 245,910 245,893 229,425
Net cash flow (NCF) (500,000) 176,500 211,920 285,910 285,893 269,425
NPV 278,989
NPV Change % 57.79%
Sensitivity of NPV 11.5589
An increase in the sales price by 1% will result in an increase in the NPV by 11.558%, and if the sales
price drops by 1%, the NPV of a project will decrease by 11.558%.
IRR 35.95%
IRR Change % 23.85%
Sensitivity of IRR 4.7691
Step 6
Let’s assume that variable costs per unit will be 5% higher than baseline values. Provided other
inputs remain constant, the discounted net cash flows will be as follows:

Page 69 of 73
Variable Costs per Unit Increase 5%
0 1 2 3 4 5
Sales (S) 700,000 792,000 1,026,000 1,045,500 1,035,000
Fixed costs (FC) 100,000 102,000 105,000 109,000 115,000
Tax expense (T) 41,400 54,540 80,685 80,138 73,140
Net income (Nl) 96,600 127,260 188,265 186,988 170,660
Net cash flow (NCF) (500,000) 136,600 167,260 228,265 226,988 210,660
NPV 113,961
NPV Change % -35.54%
Sensitivity of NPV (7.1089)
An increase in the variable costs per unit by 1% will result in a decrease in the NPV by 7.109% and
vice versa.
IRR 24.57%
IRR Change % -15.35%
Sensitivity of IRR (3.0693)
Results of sensitivity analysis
Sensitivity analysis shows that the NPV and IRR of a project are most vulnerable to the change in the
sales price and variable costs per unit and less vulnerable to the change in fixed costs and sales in
units.
NPV after -10% NPV after -5% Baseline NPV after 5% NPV after 10%
Change Change NPV Change Change
Summary Results -10% -5% 0 5% 10%
Sales Price (27,563) 74,621 176,805 278,989 381,173
Sales Units 98,126 137,465 176,805 216,145 255,485
Fixed Costs 200,901 188,853 176,805 164,757 152,709
Variable Costs 302,494 239,650 176,805 113,961 51,117
Graph
The results of sensitivity analysis in the example above is illustrated in the graph below.

Page 70 of 73
As we can see, management of a company should estimate the sales price and variable costs as
accurately as possible because they have the greatest impact on the net present value of a project.
Reference: http://financialmanagementpro.com/sensitivity-analysis-in-capital-budgeting/
Optimum Capital Budget
The following diagram, already seen above, helps us to find our optimal capital structure
Definition
The optimal capital budget is an amount of investment that allows shareholder value to be
maximised. It can be determined by plotting the marginal cost of capital (MCC) schedule and the
investment opportunity schedule (IOS) on the same graph. The intersection point of the MCC curve
and the IOS curve is the optimal capital budget.
Example
A company is considering the capital budget for the next financial year. The investment opportunity
schedule is shown in the table below.
Projects Initial cost Cumulative cost IRR IRR2

Project A 6,115,000 6,115,000 20.21% 20.21%
Project G 5,440,000 11,555,000 17.75% 17.75%
Project E 6,358,000 17,913,000 14.49% 14.49%
Project B 3,716,000 21,629,000 11.40% 11.40%
Project C 4,990,000 26,619,000 8.11% 8.11%
Let’s plot the investment opportunity schedule.

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As we can see, Project A has the highest priority and Project C the lowest. A company will need to
raise additional capital of $26,619,000 to undertake all five projects.
In turn, the Treasury Department prepared the following schedule of a company’s cost of capital,
assuming that the target capital structure is 40% of debt and 60% of equity.
After tax Cost of

Amount of new debt in US$ cost of debt Amount of new equity in US$ equity
up to $3,600,000 5.00% up to $5,400,000 14.00%
from $3,600,000 to $7,800,000 6.25% from $5,400,000 to $11,700,000 16.50%
from $7,800,000 to $11,200,002 8.50% from $11,700,000 to $16,800,000 21.50%
The weighted marginal cost of capital (WMCC) of the first $9,000,000 ($3,600,000+$5,400,000) is
WMCC = 0.4×5.00% + 0.6×14.00% = 10.40%
The company can then raise another $10,500,000, ie., $4,200,000 of debt ($7,800,000-$3,600,000)
and $6,300,000 of equity ($11,700,000-$5,400,000).
WMCC = 0.4×6.25% + 0.6×16.50% = 12.40%
Finally, the company can raise the last $8,500,000, ie., $3,400,000 of debt ($11,200,000-$7,800,000)
and $5,100,000 of equity ($16,800,000-$11,700,000).
WMCC = 0.4×8.50% + 0.6×21.50% = 16.30%
Now the marginal cost of capital schedule can be plotted.

Page 72 of 73
Graph
The optimal capital budget can be determined by plotting the investment opportunity schedule and
the marginal cost of capital schedule in one graph as illustrated below.
The point of intersection of the MCC curve and the IRR curve indicates that the company should
undertake Project A, Project G, and Project E because their internal rate of return exceeds the
marginal cost of capital. Project B and Project C must be rejected since their IRR is lower than the
MCC; hence, they have a negative net present value (NPV).
Thus, the optimal capital budget for the next financial year is $17,913,000, ie the sum of the initial
cost of Project A, Project G, and Project E. If the company undertakes these three projects,
shareholder value will be maximised.
http://www.financialmanagementpro.com/optimal-capital-budget/

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Introductory Financial Modelling

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Introductory Financial Modelling

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Elements of Financial Modelling

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After completing this workshop the delegate should be able to:

Elements of Financial Modelling

PART I: Design and Efficiency

• Style, formatting and layout

• Fonts colours, backgrounds and borders

Part II: Financial Analysis Models

Systematically analysing financial statements for improved model performance

Elements of Financial Modelling

Highlighting key financial management principles underpinning effective model

Elements of Financial Modelling

Section One ................................................................................................................................................................ 7

Elements of Financial Modelling

PART I: Design and Efficiency

Style, formatting and layout

Fonts colours, backgrounds and borders

Elements of Financial Modelling

In the latest versions of Excel there are now

Right click on a cell and choose New Note.

How and Why do we Use Comments and Notes?

Elements of Financial Modelling

• Convention 1: All income positive, all expenses negative

Convention 1: All income positive, all expenses negative.

Convention 2: All expenses positive; non operating income negative.

Convention 3: All expenses positive except non-operating expenses.

Convention 4: All values positive, including revenues

Elements of Financial Modelling

Month Sales Person ID County Region Sales Type Amount (£)

Sales Person Hardware Software

Sales Person Derbyshire Essex Yorkshire

Date Baker Drury Harrington Smythe Williamson

Date Baker Drury Harrington Smythe Williamson

Elements of Financial Modelling

15 seconds for that.

Using symbols and equations

Avoid Partial Inputs

Elements of Financial Modelling

One row, one calculation

Use Roll Forward or Corkscrew Calculations

In other words, it represents,

Write Robust Formulas

That is clearly ridiculous, so I wrote to that accountant with this alternative:

Elements of Financial Modelling

Simplify IF statements and Avoid Nested IFs

Below is an example of how an IF() statement can be simplified:

Revolver formula using IF statement

Revolver formula using MIN

Elements of Financial Modelling

Revolver formula using IF() statement

Revolver formula using MIN()

Names and named ranges

Elements of Financial Modelling

Don't Calculate on The Balance Sheet: Link from Supporting Schedules.

Using graphs and figures

The essence of a chart: simplicity and effectiveness.

• A clear and meaningful title

Elements of Financial Modelling

Period Loan Schedule Period Loan Schedule PERIOD LOAN SCHEDULE

200,000.00 200,000.00 200,000.00

How about these three versions of the same chart?

Period Loan Schedule Period Loan Schedule PERIOD LOAN SCHEDULE

Hmm! Not so sure about these three!

Labelling figures in your report