CHAPTER

1

Introduction to Financial Modeling

W

hat is a financial model? What is the difference between a financial model and the spreadsheet solutions you create or VBA programs you write all the time to answer financial questions or solve financial problems? A simple, practical answer is that a financial model is designed to represent in mathematical terms the relationships among the variables of a financial problem so that it can be used to answer “what if” questions or make projections. Some of the spreadsheet solutions that people create capture some of these relationships as well and, therefore, can answer “what if” questions to some extent. But because they are not primarily designed with these objectives in mind, they do not try to capture as many of these interdependencies as possible, and their structures often make it cumbersome to answer “what if” questions or make projections with them. This may sound a little abstract. So let us look at a simple, concrete example. Suppose you are using a spreadsheet to calculate, based on your taxable income, what your after-tax income was last year. Income tax rates vary in steps (brackets) for different income levels. So you cannot simply calculate your taxes by multiplying your taxable income by one tax rate (30%, for example) and subtracting it from your taxable income to get the after-tax income. Consider two approaches to setting up a spreadsheet to calculate the aftertax income. In the first approach, you can enter your taxable income in a cell, calculate the tax on the income (using a hand calculator and the tax rates for the different tax brackets), and enter it in the cell below. Then you can write an equation in another cell to calculate your after-tax income by subtracting the tax in the second cell from the taxable income in the first cell. This spreadsheet solution will give you the answer to your immediate question, but it is not a useful...