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Unit 4

The document discusses key financial modeling concepts including time value of money, capital budgeting models like NPV, IRR and payback period, cost of capital, leverage, and earnings per share. Formulas and Excel functions are provided for each concept along with examples.

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Piyush Gola
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7 views

Unit 4

The document discusses key financial modeling concepts including time value of money, capital budgeting models like NPV, IRR and payback period, cost of capital, leverage, and earnings per share. Formulas and Excel functions are provided for each concept along with examples.

Uploaded by

Piyush Gola
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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1.

Time Value of Money (TVM):


Definition: Time Value of Money is the concept that a certain amount of money has a
different value today compared to its value in the future, due to the potential earning capacity
or interest rates.
Formulas:
 Present Value (PV): PV = FV / (1 + r)^n
 Future Value (FV): FV = PV * (1 + r)^n
Discount Rate (r): The rate used to discount future cash flows.
Applications:
 Discounting future cash flows in valuation models.
 Evaluating investment opportunities by comparing present and future values.
Certainly! Below are the Excel formulas or syntaxes for each financial modeling concept
along with examples:

Time Value of Money (TVM) (in Excel)

Present Value (PV)


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

Example:
=PV(10%, 5, 0, 1000, 0)

Future Value (FV):


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

Example:
=FV(5%, 10, -200, -1000, 0)

2. Capital Budgeting Models:

Definition: Capital budgeting involves analyzing and evaluating potential long-term


investments to determine their feasibility and profitability.

Techniques:

Net Present Value (NPV): NPV is the present value of the expected cash flows generated
by an investment, minus the initial cost of the investment. It assesses the profitability of an
investment by discounting all expected future cash flows to their present value using a
specified discount rate.

NPV = Σ (CF / (1 + r)^t) - Initial Investment


 CF: represents the cash flow at time
 r is the discount rate.
 t denotes the time period.
A positive NPV indicates that the investment is expected to be profitable.

Internal Rate of Return (IRR): The discount rate that makes the NPV of an investment zero.
IRR is the discount rate at which the NPV of an investment becomes zero. It represents the
rate of return that an investment is expected to generate.

Formula:
IRR = Rate at which NPV = 0
IRR is the discount rate that equates the present value of expected cash inflows with the
initial investment.
A higher IRR suggests a more attractive investment, typically compared against a predefined
hurdle rate.

Payback Period: The time it takes for the initial investment to be recovered. Payback Period
is the time required for the initial investment in a project to be recovered through the project's
cash inflows.

Formula: Payback Period = Annual Cash Inflow / Initial Investment

It's a simple measure to assess how quickly an investment can be recouped. Typically used
for quick evaluation of liquidity and risk. A shorter payback period is generally preferred, but
it doesn't account for the time value of money.

Accounting Rate of Return (ARR): ARR is a measure of the profitability of an investment,


calculated as the average accounting profit divided by the average investment.

Formula:
ARR= Average Investment / Average Accounting Profit

Average Accounting Profit: Total Accounting Profit over the project’s life / Number of years

Average Investment: (Initial Investment + Residual Value) / 2

Higher ARR is generally preferred, as it suggests a higher percentage return on the average
investment.

Capital Budgeting Models:

Net Present Value (NPV):


=NPV(rate, cashflow1, [cashflow2, ...])

Example:
=NPV(10%, -1000, 300, 400, 500, 600)

Internal Rate of Return (IRR):


=IRR(values, [guess])

Example:
=IRR(-1000, 300, 400, 500, 600)

Payback Period and Accounting Rate of Return:


Calculate manually or use a formula to find the payback period.

3. Cost of Capital:
Cost of Capital represents the cost a company incurs to finance its operations, consisting of
both debt and equity.

Components:
Cost of Debt: Interest rate on company debt.
Cost of Equity: Required rate of return by equity investors.
Weighted Average Cost of Capital (WACC): WACC = (E/V * Re) + (D/V * Rd * (1 - Tax Rate))

Significance:
- Used as a discount rate in valuation models.
- Determines the minimum return required by investors.

Cost of Capital Calculation:

Weighted Average Cost of Capital (WACC):


=WACC = (E/V * Re) + (D/V * Rd * (1 - Tax Rate))

Example:
=WACC(0.6, 0.4, 0.1, 0.05, 0.3)

4. Leverage:

Definition: Leverage involves using various financial instruments or borrowed capital to


increase the potential return of an investment.

Types:
Operating Leverage: Fixed operating costs in a company's income structure.
Financial Leverage: Use of debt to amplify returns.
Combined Leverage: The effect of both operating and financial leverage.

Implications:
- Amplifies both gains and losses.
- Higher leverage increases risk and potential returns.

5. Earnings Per Share (EPS):

Definition: EPS is a financial metric that represents the portion of a company's profit
allocated to each outstanding share of common stock.

Formulas:
- Basic EPS: (Net Income - Preferred Dividends) / Weighted Average Common Shares
Outstanding

Significance:
 Key indicator for investors and analysts.
 Reflects a company's profitability on a per-share basis.

5. Earnings Per Share (EPS) Calculation:

Example:

= (500,000 - 20,000) / 100,000

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