Excel Alchemy: Mastering Financial Modeling
Edition: 1
Copyright: 2024
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Financial modeling is a critical tool for businesses today. It serves to enable managers to make informed decisions by analyzing financial data, projecting future outcomes, and evaluating potential investments. In today’s high-tech, fast-paced, and ever-changing business environment, financial modeling is more pertinent than ever as it provides a quantitative framework for making sound financial decisions.
Excel Alchemy: Mastering Financial Modeling makes exclusive use of Microsoft’s Excel Spreadsheets that are a powerful platform for financial modeling. It enables businesses to analyze complex financial data utilizing data tables, quantitative formulas, and graphic presentations. Data tables are essential for organizing financial data and performing calculations, while quantitative formulas allow for accurate and efficient calculations of financial metrics. The graphic representations, such as charts, graphs, and histograms, help visualize financial data and identify trends and patterns.
Two important methods used in Financial Modeling are Scenario Analysis and Pro-Forma Statements. Scenario Analysis involves analyzing potential outcomes by changing input variables, such as market conditions, and analyzing the impact on financial metrics. Pro-Forma Statements are forward-looking financial statements that predict future financial performance based on historical data and assumptions about future market conditions.
Discounted Cash Flow (DCF) Analysis and Monte Carlo Simulation are also commonly used in financial modeling. DCF Analysis is used to determine the intrinsic value of an investment by forecasting future cash flows, discounting them back to their present value based on the Required Rate of Return, and summing them up. The introduction of a Monte Carlo Simulation model delivers a range of probabilities to simulate the possible outcomes of an investment or project.
In conclusion, financial modeling is a crucial tool for businesses in a perpetually changing environment. This text serves as a comprehensive guide for financial analysts and business professionals in their evaluation and valuation of financial assets and the corresponding assessment of risk. By mastering financial modeling, better decisions can be made and the achievement of financial goals a reality.
Excel Alchemy: Mastering Financial Modeling explores five major financial areas:
1. Bond Valuation
2. Derivative Valuation
3. Equity Valuation
4. Real Estate Valuation
5. Corporate Finance
About the Author
Preface
Introduction
Part I Bond Analysis
Chapter 1 Essentials of Bond Duration
Essentials of Bond Duration
What is Bond Duration?
What is Modified Bond Duration?
What is a Basis Point as used in Fixed Income Analysis?
How does Bond Duration Differ from Bond Maturity?
What is the Model for the Macaulay Bond Duration?
What is the Model for Modified Duration?
Why is Duration less than Maturity?
Why Duration is Inversely Related to Yield to Maturity?
What is the Modified Duration of a Zero Coupon Bond?
What is the Model for Modified Duration that Shows Price Sensitivity of a Bond to Changes in Interest Rates?
What are the Factors that Affect Bond Duration and Explain?
Macaulay Duration
Exhibit 1.1: Macaulay Duration Model
Exhibit 1.2: Duration and the Current Yield
Exhibit 1.3: Duration and Price Sensitivity
Effects of Coupon Rates, Maturity, and Yield to Maturity on Duration
Exhibit 1.4: Effect of Coupon Rate on Duration
Exhibit 1.5: Effect of Maturity on Duration
Exhibit 1.6: Effect of Yield to Maturity on Duration
Chapter 2 Essentials of Bond Immunization
Essentials of Bond Immunization
What is Bond Immunization?
What is the General Content Behind a Bond Immunization Strategy?
Why is Bond Duration Critical in a Bond Immunization Strategy?
What Factors Influence Bond Immunization?
How do Bond Weights Play a Critical Role in Bond Immunization?
Is it Advantageous to Have Bond Maturities that Exceed the Maturity of the Obligation?
Is it Advantageous to Have Bond Coupon Rates that Exceed the Market Yield?
What is the Desired Relationship Between Bond Duration and the Maturity of the Obligation?
Is it Better to Form a Bond Portfolio or Just Purchase a Single Bond in Order to Immunize a Future Obligation?
Is a Bond Immunization Strategy Similar to an Investor Hedging a Position?
What are the Individual Steps in a Bond Immunization Strategy?
How Does an Investor Purchase a “Portion” of a Bond Portfolio in Order to Achieve Immunization?
Part II 4
Model of Bond Immunization
Practice Problem
Exhibit 2.1: Bond Immunization
Practice Problem
Exhibit 2.2: Scenario Analysis
Chapter 3 Essentials of Bond Convexity
Essentials of Bond Convexity
What is Bond Convexity?
How is Bond Convexity Used in Practice?
What is the Purpose of Calculating Convexity?
What is the Numerical Convexity Model and Explain its Components?
How Does the Bond Analyst Assess the Results of Convexity and What is the Significance of a Relatively High or Low Measurement?
What are the Factors that Impact Bond Convexity and What is Their Relationship with Convexity?
What are the Steps Necessary to Model Bond Convexity?
Why is the Use of Convexity Better than Just Relying on Duration?
Comparing Bond Values by Duration and Convexity
Graph of Bond Convexity
Duration, Convexity, and the Convexity Adjustment
Practice Problem
Exhibit 3.1: Convexity and the Convexity Adjustment
Practice Problem
Exhibit 3.2: Immunization and Convexity
Part II Derivative Analysis
Chapter 4 Essentials of Derivative Analysis
Essentials of Derivative Analysis
Why Are Options Referred to as Derivatives?
What is an Option?
Is an option a Security?
What Are the Two Types of Options?
How Are Options Used in Practice?
How Does an Option Start to Exist?
How Does an Option Cease to Exist?
How Does an Investor Actually Exercise an Option?
What are the American and European Options?
What are the Three Common Prices Used in Options?
What is the Intrinsic Value of Calls Versus Puts?
What is the Moneyness of an Option?
What are Directional Trades with Options Versus Directional Trades with Stocks?
Why the Time Value of the Call Option Decreases as a Call Option Gets Deeper In the Money?
Practice Problem
Exhibit 4.1: Why the Time Value of a Call Option Decreases as the Option Moves Deeper In the Money
Practice Problem
Exhibit 4.2: Buyer of Call Option’s Value and
Practice Problem
Exhibit 4.3: Writer of a Call Option’s Value and Payoff
Practice Problem
Exhibit 4.4: Buyer of a Put Option
Practice Problem
Exhibit 4.5: Writer of a Put Option
Chapter 5 Essentials of Hedging With Option Strategies
Essentials of Hedging With Option Strategies
What is the Concept of Hedging?
How is a Financial Option Hedge Created?
What are the Four Option Strategies Used in Hedging?
Briefly Describe and Explain Each of the Option Strategies
What are the General Objectives in the Study of These Option Strategies?
What is the Framework for Creating Specific Option Strategies?
The Four Possible Payoffs Concerning Single Options
The Four Possible Profit(Loss) Situations
Straddle Option Strategy
Strangle Option Strategy
Iron Butterfly Option Strategy
Iron Condor Option Strategy
Modeling Option Hedge Strategies in Excel
Practice Problem
Exhibit 5.1: Long Straddle Option Strategy
Iron Condor Strategy
Practice Problem
Exhibit 5.2: Iron Condor Option Strategy
Data Visualization of the Iron Condor Option Strategy
Analysis of Iron Condor Graph
Chapter 6 Essentials of the Black Scholes Option Pricing Model
Essentials of the Black Scholes Option Pricing Model
What is the Black Scholes Option Pricing Model?
What is the Purpose of the Black Scholes Model?
How is the Black Scholes Model Used in Practice?
What are the Components of the Black Scholes Model?
What are the Assumptions of the Black Scholes Model?
Assumptions About the Risky Asset
Assumptions About the Riskless Asset
Assumptions About the Option
Assumptions About the Market
What Variables Comprise the Black Scholes Option Pricing Model and What is Their Role in Explaining What the Black Scholes Option Pricing Model is Attempting to Accomplish?
Why is the Cumulative Standard Normal Distribution Found in the Black Scholes Option Pricing Model?
Example of Pricing of a “Real” Option with the Black Scholes Model
Practice Problem
Exhibit 6.1: Discounted Cash Flow Investment Analysis
Practice Problem
Exhibit 6.2: Valuation of a Real Option With the Black Scholes Option Pricing Model
Chapter 7 Essentials of the Put-Call Parity Option Valuation Model
Essentials of the Put-Call Parity Option Valuation Model
What is the Put-Call Parity?
Why is the Put-Call Parity Important to Option Investors?
What are Synthetic Positions and How are they Used?
What is a Synthetic Long Call?
What is a Synthetic Short Put?
What are the Components of the Put Call Parity Model?
Do the Put-Call Parity and the Black Scholes Option Pricing Models Measure the Same Thing?
Practice Problem
Exhibit 7.1: Put-Call Parity Model
Part III Equity Valuation Analysis
Chapter 8 Essentials of Equity Valuation Models
Part 1
What is the Concept of the Constant Growth Equity Valuation Model?
Is there a Practical Use of the Constant Growth Equity Model?
What are the Components of the Constant Growth Equity Model?
How is the Capital Asset Pricing Model Used in the Valuation of Equity?
Practice Problem
Exhibit 8.1: Constant Growth Model
Practice Problem
Exhibit 8.2: Possible Mispricing of a Stock—The Alpha Value
Part 2
What is the Concept of the Zero-Growth Equity Valuation Model?
What are the General Assumptions of the Model?
Part 3
What is the Concept of the Variable Growth Valuation Model?
What is the Process of Creating a Variable Growth Valuation Model?
Practice Problem
Exhibit 8.3: Variable Growth Valuation model
Part 4
What is the Two-Stage Growth Model?
What is the Justification of Using the Two-Stage Growth Model Over the Variable Growth Model?
Practice Problem
Exhibit 8.4: Two-Stage Growth Model
Chapter 9 Essentials of the Present Value of Growth Opportunities Model
Essentials of the Present Value of Growth Opportunities Model
What is the Present Value of Growth Opportunities Model?
What is the Difference Between the Present Value of Growth Opportunities and the Dividend Discount Model?
How Does the Present Value of Growth Opportunities Model Proxy for Its Critical Components?
How is Growth Measured in the Present Value of Growth Opportunities Model?
What are the Implications of the Present Value of Growth Opportunities Model?
Practice Problem
Exhibit 9.1: Application of the Present Value of Growth Opportunities Model
Chapter 10 Essentials of the PRAT Equity Valuation Model
Practice Problem
Application of the PRAT Equity Valuation Model
Part IV Monte Carlo Simulation and Discounted Cash Flow Analysis (DCF)
Chapter 11 Essentials of the Monte Carlo Simulation in Excel
Essentials of the Monte Carlo Simulation in Excel
What is a Monte Carlo Simulation?
What are Some Misconceptions of the Monte Carlo?
A Monte Carlo Simulation Guide to Use in Excel
Stage 1
Stage 2
What is the NORMINV Function and What is Its Relationship with Monte Carlo?
Stage 3
Stage 4
Stage 5
Stage 6
Stage 7
Stage 8
Stage 9
Graph of NPV Analysis
Graph of Normal Distribution (Bell Curve)
Graph of Frequency
Summary
Chapter 12 Essentials of Discounted Cash Flow Scenario Analysis
Essentials of Discounted Cash Flow Scenario Analysis
Scenario Analysis
Practice Problem
Stage 1
Stage 2
Stage 3
Stage 4
Stage 5
Stage 6
Stage 7
Stage 8
Chapter 13 Essentials of Real Estate Valuation Modeling
Essentials of Real Estate Valuation Modeling
Part 1: Base Rents and their Adjustments
What is the Relationship Between Base Rent and Pass Throughs?
What is an Expense Stop?
What is the Purpose of the Expense Stop?
What are the Differences Among the Expense Reimbursement, Expense Recovery, and the Expense Stop?
Part 2
What are the Common Area Maintenance Charges?
Part 3
What are the Three Common Types of Property Leases?
Part 4
What is the Contrast Between Usable and Rentable Square Footage?
What is the Load Factor and How is it Used in Determining the Rental Liability?
Part 5
Practice Problem
Part V Corporate Finance Issues
Chapter 14 Essentials of the Altman Z Bankruptcy Score
Essentials of the Altman Z Bankruptcy Score
What are the Components of the Altman Z Multi-Discriminate Model?
Multiple Discriminant Analysis
What are the Altman Z Ratios and Their Implications of Bankruptcy?
Example of the Altman Z Analysis
Practice Problem
Observations
Chapter 15 Essentials of Constructing a Pro-Forma Financial Statement
Target Financial Statements 2018 to 2023 (Fiscal Years)
Exhibit 15.4: Projection of Sales for the Target Corporation
Exhibit 15.5: Income Statement Model Parameters
Exhibit 15.6: Balance Sheet Model Parameters
Exhibit 15.7: TGT Pro Forma Income Statement
Exhibit 15.8: TGT Pro Forma Balance Sheet
Steven Lifland holds a PhD from Old Dominion University in Virginia. He is the director of finance and a professor of finance at High Point University in North Carolina. In 2013, he was awarded an endowed professorship, the Carl Maneval Smith Professor of Accounting and Finance. He teaches the core course in financial modeling and an elective course in investment analysis. His current research interests include Stochastic Equity Valuation Models, Real Option Valuation, Corporate Innovation: R&D and Patents, REITs, Working Capital Management, and Financial Pedagogy. He has published in the Journal of Accounting and Finance, Journal of Higher Education Theory and Practice, Advances in Business Research, Review of Business, Journal of Academy of Business and Economics, Journal of Managerial Finance, and the Global Journal of Economics and Finance.