Financial modelling involves creating a representation of a financial situation through the use

of mathematical models. Here are several types of financial modelling commonly used:

1. Discounted Cash Flow (DCF) Model:

Discounted Cash Flow (DCF) modelling is a financial valuation method used to estimate the
value of an investment based on its expected future cash flows. The DCF model is rooted in
the principle that the value of an asset is the present value of its future cash flows, discounted
at a rate that reflects the riskiness of those cash flows.

Key Components of DCF Modelling

1. Free Cash Flows (FCFs):

o Definition: FCFs are the cash flows generated by a company that are available
for distribution to all securities holders (debt and equity).
o Calculation: Typically calculated as: FCF=EBIT×(1−Tax Rate)
+Depreciation−Capital Expenditures−ΔNet Working Capital\text{FCF} = \
text{EBIT} \times (1 - \text{Tax Rate}) + \text{Depreciation} - \text{Capital
Expenditures} - \Delta \text{Net Working Capital}FCF=EBIT×(1−Tax Rate)
+Depreciation−Capital Expenditures−ΔNet Working Capital Where:
 EBIT: Earnings Before Interest and Taxes
 Tax Rate: Corporate tax rate
 Depreciation: Non-cash charge reflecting the allocation of the cost of
tangible assets over their useful lives
 Capital Expenditures: Funds used by a company to acquire or upgrade
physical assets
 Δ Net Working Capital: Change in current assets minus current
liabilities
2. Forecast Period:
o Duration: Typically 5-10 years, depending on the predictability of the
business.
o Details: Detailed projections of FCFs for each year in the forecast period.
3. Terminal Value:
o Definition: The value of the business at the end of the forecast period.
o Calculation Methods:
 Perpetuity Growth Model (Gordon Growth Model):
Terminal Value=FCFn×(1+g)r−g\text{Terminal Value} = \frac{\
text{FCF}_{n} \times (1 + g)}{r - g}Terminal Value=r−gFCFn×(1+g)
Where:
 FCFn\text{FCF}_{n}FCFn: Free cash flow in the final year of
the forecast period
 ggg: Perpetual growth rate of FCFs (usually 2-3%)
 rrr: Discount rate (WACC)
 Exit Multiple Method: Terminal Value=EBITDAn×Exit Multiple\
text{Terminal Value} = \text{EBITDA}_{n} \times \text{Exit
Multiple}Terminal Value=EBITDAn×Exit Multiple Where:
 EBITDAn\text{EBITDA}_{n}EBITDAn: Earnings Before
Interest, Taxes, Depreciation, and Amortization in the final
year of the forecast period
 Exit Multiple: Based on comparable company analysis
 4. Discount Rate (WACC):
o Definition: The rate of return required by investors to compensate for the risk
of the investment.
o Calculation: WACC=(EE+D)×re+(DE+D)×rd×(1−Tax Rate)\text{WACC}
= \left( \frac{E}{E + D} \right) \times r_e + \left( \frac{D}{E + D} \right) \
times r_d \times (1 - \text{Tax Rate})WACC=(E+DE)×re+(E+DD)×rd
×(1−Tax Rate) Where:
 EEE: Market value of equity
 DDD: Market value of debt
 rer_ere: Cost of equity
 rdr_drd: Cost of debt
 Tax Rate: Corporate tax rate
5. Present Value of Cash Flows:
o Calculation: Each FCF is discounted back to its present value using the
discount rate (WACC). PV=∑t=1nFCFt(1+r)t+Terminal Value(1+r)n\
text{PV} = \sum_{t=1}^{n} \frac{\text{FCF}_{t}}{(1 + r)^{t}} + \frac{\
text{Terminal Value}}{(1 + r)^{n}}PV=t=1∑n(1+r)tFCFt
+(1+r)nTerminal Value
6. Enterprise Value (EV):
o Definition: The sum of the present value of the forecasted FCFs and the
present value of the terminal value.
o Calculation: EV=PV of FCFs+PV of Terminal Value\text{EV} = \text{PV of
FCFs} + \text{PV of Terminal Value}EV=PV of FCFs+PV of Terminal Value
7. Equity Value:
o Calculation: Adjust the enterprise value by adding cash and subtracting debt.
Equity Value=EV+Cash−Debt\text{Equity Value} = \text{EV} + \text{Cash}
- \text{Debt}Equity Value=EV+Cash−Debt

Practical Steps in DCF Modeling

1. Gather Historical Data: Collect historical financial statements to understand the

company’s performance and trends.
2. Project Financial Statements: Develop assumptions for revenue growth, operating
margins, capital expenditures, and changes in working capital.
3. Calculate FCFs: Based on the projected financial statements, calculate the free cash
flows for each year in the forecast period.
4. Determine WACC: Calculate the discount rate using the company’s capital structure
and cost of capital.
5. Estimate Terminal Value: Choose an appropriate method and calculate the terminal
value at the end of the forecast period.
6. Discount Cash Flows: Discount the projected FCFs and terminal value to their
present value using the WACC.
7. Calculate Enterprise and Equity Value: Sum the present values of the FCFs and
terminal value to get the enterprise value, and adjust for cash and debt to find the
equity value.
8. Analyze Sensitivity: Perform sensitivity analysis to understand how changes in key
assumptions impact the valuation.
 import numpy as np

# Step 1: Forecast Free Cash Flows (in millions)

fcf = np.array([500, 550, 600, 650, 700]) # Free Cash Flows for 5 years

# Step 2: Determine the Discount Rate

wacc = 0.10 # 10%

# Step 3: Calculate the Terminal Value

terminal_growth_rate = 0.02 # 2%

terminal_value = fcf[-1] * (1 + terminal_growth_rate) / (wacc -

terminal_growth_rate)

# Step 4: Discount the Cash Flows

def calculate_dcf(fcf, wacc, terminal_value):

discount_factors = np.array([(1 / (1 + wacc)**i) for i in range(1, len(fcf) + 1)])

discounted_fcf = fcf * discount_factors

discounted_terminal_value = terminal_value / (1 + wacc)**len(fcf)

return discounted_fcf.sum() + discounted_terminal_value

# Step 5: Sum the Present Values

enterprise_value = calculate_dcf(fcf, wacc, terminal_value)

print(f"Enterprise Value: ${enterprise_value:.2f} million")

2. Comparative Company Analysis (Comps):

3. Precedent Transactions Analysis:
4. Leveraged Buyout (LBO) Model:
5. Merger and Acquisition (M&A) Model:
6. Budget Model:
7. Three-Statement Model:
8. Option Pricing Models:
9. Monte Carlo Simulation:
10. Sensitivity and Scenario Analysis:
11. Project Finance Model:
12. Startup Financial Model: