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 changeSimplicity often outweighs completenessLack of documentation job securityThe 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