Modeling Basics

Model: an abstract of the real world  Structural modeling Task based Flow charts Destructive  Object-oriented modeling Entity based Relationships and responsibilities Constructive

What is the purpose of a financial model?  To transform data into useful information for making financial decisions

Responsibilities of a financial manager  Decisions concerning investments in long-term assets –capital budgeting  Decisions concerning long-term financing –capital structure: use of equity versus debt –Dividend policy  Decisions concerning short-term financing –working capital management inventory management, receivables management, cash management, etc.

Routine versus Non-routine Decisions  Routine decisions –the entities involved and their relationships and responsibilities evolve slowly overtime e.g. short-term financial management  Non-routine decisions –the entities involved and/or their relationships and/or responsibilities differ with each problem e.g. capital budgeting, long-term financing

Who creates financial models?  Off-the-shelf software created by an independent company e.g. inventory management system  Enterprise software created by MIS and/or outside consultants e.g. cash budget forecast  Project software members of the project e.g. capital budgeting

Models for personal finance  Loan analysis mortgage analysis loan refinancing Debt consolidation  Investment management asset allocation  Financial planning retirement planning other financial goals (e.g. college, trust)

Some truths about modeling  Your model WILL change  Simplicity often outweighs completeness  Lack of documentation  job security  The basic economic principle applies to modeling: benefits must be greater than costs

Elements of a model  Input variables (data collection) Discretionary variables Non-discretionary variables  Model Structure (data collection) Relationships or Tasks Formulas  Output variables (information)

Modeling Technique  Flexible Coding –Minimize potential for mistakes E.g. the value of each variable should be entered into the model only once –A properly constructed model allows you to perform different types of analysis such as sensitivity, scenario, and break-even analyses  Organization –Allows for easy modification –Group parameters and formulas into time-varying and non-time- varying  Documentation –Do NOT rely on your memory

Useful Excel Functions  IF() –The IF function can make a model more flexible  MAX(), MIN() –The MAX and MIN function can save a lot of coding E.g. Price limit (cannot be less than zero) Two possible strategies –IF(Price – discount < 0, 0, Price – discount) –MAX(Price – discount, 0)  VLOOKUP() or HLOOKUP() –We will explore these functions later