The Process of Modeling

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Christiana O’Brien’
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1 Session #3 Page 1 The Process of Modeling Plan Visualize where you want to finish Do some calculations by hand Sketch out a spreadsheet Build Start with a small-scale model Expand the model to full scale Test Try different trial solutions to check the logic Analyze Evaluate proposed solutions and/or optimize with Solver If the solution reveals inadequacies in the model, return to Plan or Build

2 Session #3 Page 2 Prudent Financial Services Pension Payments: Year Pension Payments ($millions) Potential Investments: Current Coupon Rate Maturity Face Value Price Date Bond 1 $980 4% Jan. 1, 2004 $1,000 Bond 2 $920 2% Jan. 1, 2006 $1,000 Bond 3 $750 0% Jan. 1, 2008 $1,000 Bond 4 $800 3% Jan. 1, 2011 $1,000 Money market pays 5% annually.

3 Session #3 Page 3 Visualize Where You Want to Finish What numbers are needed by PFS management? What are the decisions that need to be made? What should the objective be?

4 Session #3 Page 4 Calculate By Hand (A Simple Example) Year Pension Payments ($millions) Current Coupon Rate Maturity Face Value Price Date Bond 1 $980 4% Jan. 1, 2004 $1,000 Bond 2 $920 2% Jan. 1, 2006 $1,000 Money market pays 5% annually. Suppose PFS were to invest $28 million in the money market fund and purchase 10,000 units each of bond 1 and bond 2 on January 1, What is the total initial investment? What payments would be received from bonds 1 and 2 on January 1 of 2004 and 2005? Bond : 2005: Bond : 2005:

5 Session #3 Page 5 Calculate By Hand (A Simple Example) What is the resulting ending balance in the money market fund for the year 2003, 2004, and 2005 after receiving these payments, making pension payments for the year, and depositing any excess into the money market fund? 2003: 2004: 2005:

6 Session #3 Page 6 Sketch a Spreadsheet Model

7 Session #3 Page 7 Good Spreadsheet Models Enter and arrange the data first: let the model structure conform to the data structure as much as possible (use rows and columns consistently, etc.) Enter each unique data value in only one cell Separate data from formulas don't ever enter a number inside a formula (exceptions certain constants, e.g. 7 days, 24 hours, etc.) Use simple formulas and intermediate calculations (e.g. subtotals) Use relative and absolute addressing ($'s) in formulas to facilitate copying and minimize the number of unique formulas Use of power tools (SUMIF, IF, array formulas, data tables, macros ) should be minimized. Keep it simple. Using range names can make formulas easier to interpret range names should correspond to visible labels on the spreadsheet. Acid test: usually it should not be necessary to look inside a formula cell to know what the formula is and if you do look there, it should be easy to see whether the formula is correct

8 Session #3 Page 8 Good Spreadsheet Models The flow of calculations should follow a logical progression to the "bottom line" Use labels, borders, and shading to highlight and document the data, decision variables, and bottom line. For example, o Blue = data o Yellow = changing cells (decision variables) o Orange = target cell (objective function) It should be obvious which cells contain data, decision variables, formulas, etc. Show all constraints on the spreadsheet (include <=, >= or =, and both sides of the constraint) Acid test #2: usually it should not be necessary to open the Solver dialogue box to check the structure of the model.

Session #3 Page 9 A Poor Spreadsheet Model 1 A B C D The Lego Production Problem 2 3 4 5 6 7 8 Tables 2

9 Session #3 Page 9 A Poor Spreadsheet Model 1 A B C D The Lego Production Problem Tables 2 Chairs 2 Profit $ Large Bricks Used 6 Small Bricks Used C 2 2 =20*C4+15*C5 =2*C4+1*C5 =2*C4+2*C5

10 Session #3 Page 10 Tips for Debugging a Spreadsheet Model Pressing ctrl-~ toggles back and forth between showing values and showing formulas in the spreadsheet. Try values of the changing cells for which you know the correct answers (e.g., 0, 1, 1000). Use the auditing tools (from the Tools menu). o Trace dependents shows all the cells with formulas that refer to the current cell. o Trace precedents shows all the cells that are part of the formula for the current cell A B C D E F G The Lego Production Problem Tables Chairs Profit $20.00 $15.00 Bill of Materials Total Used Available Large Bricks <= 6 Small Bricks <= 8 Tables Chairs Total Profit Production Quantity 2 2 $70.00

The Advanced Budget Project Part D The Budget Report

The Advanced Budget Project Part D The Budget Report A budget is probably the most important spreadsheet you can create. A good budget will keep you focused on your ultimate financial goal and help you