Theory and concepts of creating a financial model - Essay Example

Management should be skeptical of the model assumptions that will be related to the recommendation. There are different types of financial models that are used for various purposes. For example, a cash flow model is regarded as a powerful tool that can assist a financial team with project future performance in a business venture by evaluating the effect of that type transaction such as an an acquisition and LBO(Shim 2007, 67)2. It is also able to calculate returns and perform ration analysis.

Financial models for investment options or product services are often custom developed in excel sheets as they take into account for unique characteristics such as cost structure, product market and competitive situation. The following guidelines should be used: Outline the model the type of model structure that would include the general output and the key components.The weight cost and the advantages of the type of model will also be factored in. The forecasting future method should be used in any financial model (Fernholz 2002, 56).

When constructing a cash flow model there are a number assumptions that must be included. In this kind of financial model, there is a deterministic approach that uses certain simplifications.Among them is the investment of return that is known and does not usually vary from year to year. Another important aspect is that this rate is the same rate that will be used to discount the reserves and the third aspect is that the ultimate loss ration will be accurately predicted. There are some concepts that one has to know when creating a financial model like a cash flow model.

Firstly, you have to have to start with the in mind- This will be inclusive of whether you are pricing options of an investment or building3. With the Cash flow model, you should be able to check for assumptions. From this you would be able to get truthfully generate outputs with a certain number of inputs. This kind of model should be one that you are able to adjust automatically and should be dynamic depending on your inputs. This model does not give room for a formula, like for instance, that will multiply a specific number of units with the determined price (Hambrook 2003, 95).

This gives room in case the price might change in future. If you use a fixed formula and the prices change in the future, you will be forced to go the right cell of the Excel sheet and make changes every time the price changes. One of the major concerns that most investors have is determining the relationship between the risk and the return of a financial asset. This kind of information can be obtained in his portfolio. It is general knowledge that there is a good relationship between the risk and the expected return of a financial asset.

In other words, when the risk of an asset increases, so does its expected return. What this means is that if an investor is taking on a big risk, he is expected to be compensated for doing so with a higher return of sales in the futures. Similarly, if the investor wants to boost or increase the the expected return of the investment, he needs to be prepared to take on more risk. This is the reason why a portfolio is used to give this important relationship. It is important to note that the concept of Modern Portfolio Theory to show the connection between the risk and return of a portfolio of financial assets.

The three types of portfolios that will help us