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How Useful Are Financial Models: The Base Case

1671 words - 7 pages

INTRODUCTION
Financial Model is defined as the model that captures the future operating, investing and financing activities that determines the future profitability, financial position and risk of a business venture (MacMorran, 2009). It is a decision making tool regarding investment, forecasting and valuation of a project or a company. It is an important element in investment decisions which helps to regulate financial activities. According to Janiszewski S. (2011) the importance of financial modelling is to reflect/represent the forecasted financial performance of a business venture. Financial models are mainly used generally in compiling financial projections for a company based on discounted cash flow (DCF) approach and non-valuation financial projections. These are used for management information or accounting purpose.
Financial modelling is practically applied in Corporate finance, Investment banking, Equity Research and Accounting Profession. A financial model can be used in Business Valuation, Project Finance, Mergers and Acquisition, Risk Modelling, Leverage buy out Analysis, Management Decision Making Process, Capital Budgeting, Forecasting, Equity Research and Valuation, Option Pricing and Financial Statement Analysis.
Financial planning model tend to rely on accounting relationships and not financial relationships. The three basic elements usually valuated include the cash flow size, risk and the timing. It does not produce meaningful clues about what strategies are to be put in place, to increase the time value of money instead the association of debt-equity ratio and the firm growth (David Hillier, 2011).
Financial model is used in this report to assess the viability of the computer printer project based on forecasted cash flow to evaluate which of the cases is profitable for the business venture.

THE USEFULNESS OF MODELLING METHODS IN ASSESSING FINANCIAL RISKS
There are different types of financial models that could be used in assessing the financial risk of a project or a company. These include
• Traditional and
• Discounted Cash Flow (DCF) Method

TRADITIONAL METHODS
This is one method used in assessing financial risk that does not put into consideration the time value of money. This method act as a guide in decision making process but does not suggest to the decision maker whether or not to make the investment (Lumby & Jones, 2001).
This method includes:
1. Return on Capital Employed (ROCE) and
2. Payback Period (PBP) method.

RETURN ON CAPITAL EMPLOYED (ROCE)
This method of investment appraisal is calculated as the ratio of the profit generated by an investment project to the capital employed, expressed as a percentage (Ryan, 2007). There are many variations to the way the figures are calculated, but for this report it is calculated as:
Return on capital employed (ROCE) = Profit after tax (PAT) X 100
Capital employed
MERIT AND DEMERIT OF ROCE
This method evaluates the project on the basis of the business...

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