Business questions and financial models
Financial modeling lets us evaluate very specific sets of circumstances and make decisions based on those situations. Since the kind of decisions we make in business differ under various circumstances, the models that we use to evaluate those decisions differ as well. There's a few major types of financial models that you'll encounter in a business setting.
The first of these is what we call a corporate financial model, or a three statement model. The goal in a corporate model or three statement model is just to understand how the firm is performing and how it's expected to perform in the future. So it helps us to evaluate where the firm is going if things continue as they have been in the past. To build this kind of model, we're gonna use the corporation's history. All firms generally have a history unless they're a brand new startup. We assume that that corporation will last indefinitely in the future. Now that probably won't happen in reality of course, but it does mean that we can make an assumption about the firm's terminal value in the end. So we take the firm's historical cash flow figures, project them for a period of time, and then assume that at some point in the future we just wanna have the corporation sold or shut down or closed, and the terminal value is the value at the conclusion of our financial model.
The second type of financial model we'll encounter is a project finance model. This is typically built around what we call a DCF or discounted cash flow model. A project finance decision involves a company looking at a particular investment option. Be it a new R and D project, a new piece of equipment, perhaps building a new facility, et cetera. All of these different kinds of projects have different phases. An investment phase, a revenue generation phase, and then a closing phase. So we buy a new piece of equipment for example, we have to install that equipment, it operates for a while, and then eventually the equipment wears out, and we throw it away or scrap it or sell it. So we have no history in the case of a DCF model. Instead we're just gonna focus on our projected cash flows of the future, and we're gonna project them throughout the entire history of that particular project or investment. And that'll let us make a decision about whether this investment is a good choice or a bad choice.
Third, we have what we call a leverage buyout model. Leveraged buyout models are closely related to M and A or merger and acquisition models. These kinds of models involve a defining transaction for a company. One company buying another. These have important characteristics. For example, what is the purchase price for the acquired company? What's the holding period for this company investment? And then do we sell or exit that investment in the future? These kinds of models need to show how any alternative financing sources are repaid. Are we borrowing money from the bank? Or issuing bonds, perhaps. Those kinds of financing decisions need to be taken into account by the model. We also need to demonstrate the return earned by an equity investor. Following up on an M and A model, we have what we call an integrated consolidation model. These will compute the earnings per share and other financial ratios before and after an acquisition. And this lets us get a better handle on whether that acquisition was successful, and whether or not we have successfully combined the two companies as we initially intended to.