Financial Modelling, Simulation, and Optimisation

Abstract

A financial model is a model designed to represent in mathematical terms the relationships among the variables of a financial problem so that it can be used to make projections and/or answer ‘what if’ questions. In particular, financial modeling can be combined with optimization modeling to analyze corporate financial decisions and constraints in order to enhance firm value. Further, uncertainty in key factors such as sales, interest rates, and foreign currency exchange rates can be examined by optimizing over multiple scenarios.

This paper discusses a stochastic programming approach towards financial modeling, combining it with simulation and optimization. As a case study, it applies this approach to identify a financial recovery strategy for a MSE which had been badly affected by the global recession. The stochastic programming model is used to determine the optimal ranges of leverage (debt-equity ratio) and liquidity (current ratio) to target in order to optimize firm value. The random input considered for the study is the rate of growth of sales. The case study highlights a trade-off between leverage and liquidity, and suggests that liquidity considerations may mediate optimal capital structure decisions.

Keywords: financial modeling, optimization modeling, simulation, stochastic programming, trade-off between leverage and liquidity, optimal capital structure

JEL Classification: G30, G31, G32