Budgeting Basics and Beyond

18.4. Developing Financial Models

Development of financial models essentially involves definition of variables, input parameter values, and model specification. As far as model specification goes, we will concentrate only on the simulation -type model specification in this section.

Generally speaking, the model consists of three important ingredients:

1. Variables

2. Input parameter values

3. Definitional and/or functional relationships

Definition of Variables

Fundamental to the specification of a financial model is the definition of the variables to be included. Basically, the three types of variables are policy variables (Z), external variables (X), and performance variables (Y).

Policy variables (often called control variables) are those over which management can exert some degree of control. Examples of financial variables are cash management, working capital, debt management, depreciation, tax, merger-acquisition decisions, the rate and direction of the firm's capital investment programs, the extent of its equity and external debt financing and the financial leverage represented thereby, and the size of its cash balances and liquid asset position.

Policy variables are denoted by the symbol Z in Exhibit 18.2.

External variables are the environmental variables that are external to the company and that influence the firm's decisions from outside. Generally speaking, the firm is embedded in an industry environment. This environment, in turn, is influenced by overall general business conditions. ...