Corporate and Project Finance Modeling

Chapter 3General Model Objectives of Structuring Transactions, Risk Analysis, and Valuation

Financial models have three general objectives that should be understood before you start writing any spreadsheet formulas or combing the Internet to support your assumptions. These are: (1) coming up with the expected value of an investment, (2) assessing the risk of the investment, and (3) developing the financial structure of a transaction given its risk. Effective assessment of risk is the centerpiece of valuation, and it is also the most fundamental reason any financial model is created. If you believe that all risks in an investment can somehow be avoided, meaning that you do not need a financial model, you will probably make bad decisions and engage in dangerous activities. Taking measured risk is a fundamental fact of life and an inherent part of just about any economic analysis. The most general objective of any financial model is that it can, one hopes, help with your judgment in accepting risk.

Given the importance of risk analysis in valuation, one of the central objectives in building a model of future cash flows is to assess risk in a transaction, whether the transaction is purchasing a stock, borrowing money, investing in an airport, acquiring a company, or signing a contract. Using a financial model to accept prudent risk can involve evaluating the reasonableness of a host of financial ratios ranging from price/earnings ratios when valuing a stock to the senior loan life ...