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FINANCIAL MODELING
FINANCIAL MODELING

Simon Benninga

With a section on Visual Basic for Applications

by Benjamin Czaczkes

Fourth Edition

The MIT Press

Cambridge, Massachusetts
London, England
© 2014 Massachusetts Institute of Technology

All rights reserved. No part of this book may be reproduced in any form by any
electronic or mechanical means (including photocopying, recording, or information
storage and retrieval) without permission in writing from the publisher.

MIT Press books may be purchased at special quantity discounts for business or sales
promotional use. For information, please email [email protected].

This book was set in Times Roman by Toppan Best-set Premedia Limited. Printed and bound in
the United States of America.

Library of Congress Cataloging-in-Publication Data

Benninga, Simon.
Financial modeling / Simon Benninga.—Fourth edition.
pages cm
Includes bibliographical references and index.
ISBN 978-0-262-02728-1 (hardcover : alk. paper)
1. Finance—Mathematical models. 2. Microsoft Visual Basic for applications. I. Title.
HG173.B46 2014
332.01’5118—dc23
2013032409

10 9 8 7 6 5 4 3 2 1
To the memory of our parents:

Helen Benninga (1913–2008)

Groningen, Netherlands – Jerusalem, Israel
Noach Benninga (1909–1994)
Eenrum, Netherlands – Asheville, North Carolina
Esther Czaczkes (1931–2012)
Jerusalem, Israel – Jerusalem, Israel
Alfred Czaczkes (1923–1997)
Vienna, Austria – Jerusalem, Israel
 Contents

Preface xxi

Before All Else 1

0.1 Data Tables 1
0.2 What Is Getformula? 1
0.3 How to Put Getformula into Your Excel Notebook 1
0.4 Saving the Excel Workbook: Windows 4
0.5 Saving the Excel Workbook: Mac 5
0.6 Do You Have to Put Getformula into Each Excel Workbook? 6
0.7 A Shortcut to Use Getformula 6
0.8 Recording Getformula: The Windows Case 7
0.9 Recording Getformula: The Mac Case 10

I CORPORATE FINANCE AND VALUATION 11

1 Basic Financial Calculations 13

1.1 Overview 13
1.2 Present Value and Net Present Value 14
1.3 The Internal Rate of Return (IRR) and Loan Tables 20
1.4 Multiple Internal Rates of Return 27
1.5 Flat Payment Schedules 29
1.6 Future Values and Applications 30
1.7 A Pension Problem—Complicating the Future Value Problem 33
1.8 Continuous Compounding 38
1.9 Discounting Using Dated Cash Flows 42
Exercises 45
2 Corporate Valuation Overview 53
2.1 Overview 53
2.2 Four Methods to Compute Enterprise Value (EV) 53
2.3 Using Accounting Book Values to Value a Company:
The Firm’s Accounting Enterprise Value 54
2.4 The Efficient Markets Approach to Corporate Valuation 58
2.5 Enterprise Value (EV) as the Present Value of the Free
Cash Flows: DCF “Top Down” Valuation 60
viii Contents

2.6 Free Cash Flows Based on Consolidated Statement of

Cash Flows (CSCF) 63
2.7 ABC Corp., Consolidated Statement of Cash Flows (CSCF) 64
2.8 Free Cash Flows Based on Pro Forma Financial Statements 67
2.9 Summary 69
Exercises 70
3 Calculating the Weighted Average Cost of Capital (WACC) 71
3.1 Overview 71
3.2 Computing the Value of the Firm’s Equity, E 73
3.3 Computing the Value of the Firm’s Debt, D 74
3.4 Computing the Firm’s Tax Rate, TC 75
3.5 Computing the Firm’s Cost of Debt, rD 76
3.6 Two Approaches to Computing the Firm’s Cost of Equity, rE 82
3.7 Implementing the Gordon Model for rE 82
3.8 The CAPM: Computing the Beta, β 89
3.9 Using the Security Market Line (SML) to Calculate Merck’s
Cost of Equity, rE 96
3.10 Three Approaches to Computing the Expected Return on the
Market, E(rM) 98
3.11 What’s the Risk-Free Rate rf in the CAPM? 102
3.12 Computing the WACC, Three Cases 102
3.13 Computing the WACC for Merck (MRK) 103
3.14 Computing the WACC for Whole Foods (WFM) 104
3.15 Computing the WACC for Caterpillar (CAT) 106
3.16 When Don’t the Models Work? 109
3.17 Summary 113
Exercises 113
4 Valuation Based on the Consolidated Statement of Cash Flows 117
4.1 Overview 117
4.2 Free Cash Flow (FCF): Measuring the Cash Produced
by the Business 119
4.3 A Simple Example 121
4.4 Merck: Reverse Engineering the Market Value 124
4.5 Summary 126
Exercise 126
ix Contents

5 Pro Forma Financial Statement Modeling 127

5.1 Overview 127
5.2 How Financial Models Work: Theory and an Initial Example 127
5.3 Free Cash Flow (FCF): Measuring the Cash Produced
by the Business 136
5.4 Using the Free Cash Flow (FCF) to Value the Firm and Its
Equity 138
5.5 Some Notes on the Valuation Procedure 140
5.6 Alternative Modeling of Fixed Assets 142
5.7 Sensitivity Analysis 144
5.8 Debt as a Plug 145
5.9 Incorporating a Target Debt/Equity Ratio into a Pro Forma 148
5.10 Project Finance: Debt Repayment Schedules 150
5.11 Calculating the Return on Equity 153
5.12 Tax Loss Carryforwards 155
5.13 Summary 157
Exercises 157
6 Building a Pro Forma Model: The Case of Caterpillar 161
6.1 Overview 161
6.2 Caterpillar’s Financial Statements, 2007–2011 162
6.3 Analyzing the Financial Statements 166
6.4 A Model for Caterpillar 176
6.5 Using the Model to Value Caterpillar 177
6.6 Summary 178
7 Financial Analysis of Leasing 179
7.1 Overview 179
7.2 A Simple but Misleading Example 179
7.3 Leasing and Firm Financing—The Equivalent-Loan Method 181
7.4 The Lessor’s Problem: Calculating the Highest Acceptable
Lease Rental 184
7.5 Asset Residual Value and Other Considerations 187
7.6 Leveraged Leasing 189
7.7 A Leveraged Lease Example 190
7.8 Summary 193
Exercises 193
x Contents

II PORTFOLIO MODELS 195

8 Portfolio Models—Introduction 197

8.1 Overview 197
8.2 Computing Returns for Apple (AAPL) and Google (GOOG) 197
8.3 Calculating Portfolio Means and Variances 202
8.4 Portfolio Mean and Variance—Case of N Assets 205
8.5 Envelope Portfolios 210
8.6 Summary 213
Exercises 213
Appendix 8.1: Adjusting for Dividends 215
Appendix 8.2: Continuously Compounded Versus Geometric
Returns 218
9 Calculating Efficient Portfolios 221
9.1 Overview 221
9.2 Some Preliminary Definitions and Notation 221
9.3 Five Propositions on Efficient Portfolios and the CAPM 223
9.4 Calculating the Efficient Frontier: An Example 227
9.5 Finding Efficient Portfolios in One Step 234
9.6 Three Notes on the Optimization Procedure 236
9.7 Finding the Market Portfolio: The Capital Market Line (CML) 239
9.8 Testing the SML—Implementing Propositions 3–5 242
9.9 Summary 245
Exercises 246
Mathematical Appendix 248
10 Calculating the Variance-Covariance Matrix 251
10.1 Overview 251
10.2 Computing the Sample Variance-Covariance Matrix 251
10.3 The Correlation Matrix 256
10.4 Computing the Global Minimum Variance Portfolio (GMVP) 259
10.5 Four Alternatives to the Sample Variance-Covariance Matrix 261
10.6 Alternatives to the Sample Variance-Covariance:
The Single-Index Model (SIM) 262
10.7 Alternatives to the Sample Variance-Covariance:
Constant Correlation 264
xi Contents

10.8 Alternatives to the Sample Variance-Covariance:

Shrinkage Methods 266
10.9 Using Option Information to Compute the Variance Matrix 268
10.10 Which Method to Compute the Variance-Covariance Matrix? 271
10.11 Summary 272
Exercises 272
11 Estimating Betas and the Security Market Line 273
11.1 Overview 273
11.2 Testing the SML 276
11.3 Did We Learn Something? 280
11.4 The Non-Efficiency of the “Market Portfolio” 283
11.5 So What’s the Real Market Portfolio? How Can We Test
the CAPM? 285
11.6 Using Excess Returns 286
11.7 Summary: Does the CAPM Have Any Uses? 288
Exercises 288
12 Efficient Portfolios Without Short Sales 291
12.1 Overview 291
12.2 A Numerical Example 292
12.3 The Efficient Frontier with Short-Sale Restrictions 298
12.4 A VBA Program for the Efficient Frontier Without Short
Sales 299
12.5 Other Position Restrictions 302
12.6 Summary 303
Exercise 303
13 The Black-Litterman Approach to Portfolio Optimization 305
13.1 Overview 305
13.2 A Naive Problem 307
13.3 Black and Litterman’s Solution to the Optimization Problem 313
13.4 BL Step 1: What Does the Market Think? 313
13.5 BL Step 2: Introducing Opinions—What Does Joanna
Think? 316
13.6 Using Black-Litterman for International Asset Allocation 324
13.7 Summary 328
Exercises 329
xii Contents

14 Event Studies 331

14.1 Overview 331
14.2 Outline of an Event Study 331
14.3 An Initial Event Study: Procter & Gamble Buys Gillette 335
14.4 A Fuller Event Study: Impact of Earnings Announcements
on Stock Prices 342
14.5 Using a Two-Factor Model of Returns for an Event Study 350
14.6 Using Excel’s Offset Function to Locate a Regression
in a Data Set 355
14.7 Summary 357

III VALUATION OF OPTIONS 359

15 Introduction to Options 361

15.1 Overview 361
15.2 Basic Option Definitions and Terminology 361
15.3 Some Examples 364
15.4 Option Payoff and Profit Patterns 365
15.5 Option Strategies: Payoffs from Portfolios of Options and
Stocks 370
15.6 Option Arbitrage Propositions 372
15.7 Summary 379
Exercises 380
16 The Binomial Option Pricing Model 383
16.1 Overview 383
16.2 Two-Date Binomial Pricing 383
16.3 State Prices 385
16.4 The Multi-Period Binomial Model 389
16.5 Pricing American Options Using the Binomial Pricing Model 395
16.6 Programming the Binomial Option Pricing Model in VBA 398
16.7 Convergence of Binomial Pricing to the Black-Scholes Price 404
16.8 Using the Binomial Model to Price Employee Stock Options 408
16.9 Using the Binomial Model to Price Non-Standard Options:
An Example 417
16.10 Summary 419
Exercises 419
xiii Contents

17 The Black-Scholes Model 425

17.1 Overview 425
17.2 The Black-Scholes Model 425
17.3 Using VBA to Define a Black-Scholes Pricing Function 427
17.4 Calculating the Volatility 430
17.5 A VBA Function to Find the Implied Volatility 434
17.6 Dividend Adjustments to the Black-Scholes 437
17.7 Using the Black-Scholes Formula to Price Structured
Securities 441
17.8 Bang for the Buck with Options 457
17.9 The Black (1976) Model for Bond Option Valuation 459
17.10 Summary 462
Exercises 462
18 Option Greeks 467
18.1 Overview 467
18.2 Defining and Computing the Greeks 468
18.3 Delta Hedging a Call 474
18.4 Hedging a Collar 476
18.5 Summary 485
Exercises 486
Appendix: VBA for Greeks 486
19 Real Options 493
19.1 Overview 493
19.2 A Simple Example of the Option to Expand 494
19.3 The Abandonment Option 497
19.4 Valuing the Abandonment Option as a Series of Puts 503
19.5 Valuing a Biotechnology Project 505
19.6 Summary 511
Exercises 512

IV VALUING BONDS 515

20 Duration 517
20.1 Overview 517
20.2 Two Examples 517
xiv Contents

20.3 What Does Duration Mean? 520

20.4 Duration Patterns 524
20.5 The Duration of a Bond with Uneven Payments 525
20.6 Non-Flat Term Structures and Duration 533
20.7 Summary 536
Exercises 536
21 Immunization Strategies 539
21.1 Overview 539
21.2 A Basic Simple Model of Immunization 539
21.3 A Numerical Example 541
21.4 Convexity: A Continuation of Our Immunization
Experiment 545
21.5 Building a Better Mousetrap 547
21.6 Summary 551
Exercises 551
22 Modeling the Term Structure 553
22.1 Overview 553
22.2 Basic Example 553
22.3 Several Bonds with the Same Maturity 558
22.4 Fitting a Functional Form to the Term Structure 562
22.5 The Properties of the Nelson-Siegel Term Structure 566
22.6 Term Structure for Treasury Notes 569
22.7 An Additional Computational Improvement 571
22.8 Nelson-Siegel-Svensson Model 573
22.9 Summary 574
Appendix: VBA Functions Used in This Chapter 575
23 Calculating Default-Adjusted Expected Bond Returns 579
23.1 Overview 579
23.2 Calculating the Expected Return in a One-Period Framework 581
23.3 Calculating the Bond Expected Return in a Multi-Period
Framework 582
23.4 A Numerical Example 587
23.5 Experimenting with the Example 589
23.6 Computing the Bond Expected Return for an Actual Bond 591
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 Lamps in series are often used to cut down the current for
operating electric toys and trains. The adjustment of the current
should never be left to children, however, but should be attended to
by some one qualified to look after the apparatus. Otherwise an
unpleasant or even dangerous shock may be received. Another
simple form of resistance apparatus is made from the carbon pencils
used for arc lights. Short pieces will answer very well, but if the long
bare ones can be had they will be found preferable. Do not use the
copper-plated ones as they would conduct the current too freely;
they should be bare and black. Now around the ends of each piece
take several turns of copper wire for the terminals and cut-out wires.
Fasten those pencils down on a board (as shown at Fig. 12) by
boring small holes through the board, passing a loop of copper wire
down through the holes, and giving the ends a twist underneath.
The leading wires to and from the contact-points should be insulated
and may be above or below the board. From the descriptions already
given, the connections of this rheostat can readily be understood.
The rheostat shown in Fig. 13 is perhaps the most complete and
practical apparatus that a boy could make or would need. It is
composed of a frame, six porcelain tubes, a switchboard, and the
necessary German-silver and copper wire.
From an electrical supply-house obtain six porcelain tubes
fourteen by three-quarter inch. Porcelain tubes and rods warp in the
firing and are seldom straight; in purchasing these select them as
nearly perfect as possible in shape, size, and length.
 A PANEL RHEOSTAT

Buy, also, twelve small porcelain knobs that are the right size to fit
inside the large tubes. These should have holes bored through them
to admit screws. Construct a frame of hard-wood to accommodate
the tubes, as shown in the drawing, and leave one end loose. With
slim screws make the porcelain knobs fast to the top and bottom
strips of the frame, as shown in Fig. 14. The porcelain rods will fit
over these and will thus be held securely in the frame, one small
knob entering the tube at each end, as indicated by the dotted lines
in Fig. 14.
The first porcelain tube to the left is wound with No. 22 German-
silver wire, the next with No. 20, the third with No. 18, then Nos. 16,
14, and 12; so that in this field a broad range can be had for a
current of 110 volts.
The coils are connected in series, as explained for the other
rheostats, and the leading wires brought down to the back of a
switchboard of which Fig. 13 A is the front and Fig. 13 B the rear
view. The switchboard is made of thin slate or soapstone; or a fibre-
board may be employed. Fibre-board is especially made for electrical
work, and can be had from a large supply-house in pieces of various
thickness, three-eighths of an inch being about right for this board.
Brass bolts and nuts and copper washers are used for the contact-
poles, and when the ends of the leading wires are looped around the
bolts the nuts are to be screwed down tightly so as to make good
contacts. This rheostat may be used when lying on a table, or it can
be hung up by means of two screw-eyes driven in the top of the
frame, as shown in Fig. 13 A.
A convenient form of rheostat for fine wire and high resistance is
shown in Fig. 15. This is on the plan of the well-known Wheatstone
rheostat and does not require a switchboard nor a series of coils.
Two rollers, one of wood the other of metal or brass-covered wood,
are set in a frame, and by means of a handle and projecting ends
with square shoulders, one or the other of the rollers may be turned
so that the wire on one winds up while on the other it unwinds.
 The wooden roller may be made from a piece of curtain-rod one
inch in diameter, and it should have a thread cut on it. This will have
to be done on a screw-cutting lathe, and any machinist will do it for
a few cents. There should be from twelve to sixteen threads to the
inch—no more—although there may be as few as eight. Twelve will
be found a good number, as that does not crowd the coils and the
risk of their touching is minimized. The ends of the roller should
have bearings that will fit in holes made in the end-pieces of the
frame, and at one end of each roller a square shoulder is to be cut,
as shown at A in Fig. 16. A short handle may be made from two
small pieces of wood, as shown at B in Fig. 16. It must be provided
with a square hole so that it will fit on the roller ends. The metal
roller may be made from a piece of light brass tubing one inch in
diameter through which a wooden core is slipped; or it can be a
piece of brass-covered curtain-pole with the ends shaped the same
as the wooden one. The wood roller should have a collar of thin
brass or copper (or other soft metal except lead) attached to the
front end; or several turns of wire may be made about the roller so
as to form a contact-point. A piece of spring brass, copper, or tin
rests on this collar and is held fast under a binding-post, which in
turn is screwed to the wooden frame. A similar strip of spring metal
is held under another post on the opposite side of the frame and
bears on the metal roller.
 German-silver wire is wound on the wooden roller, one end having
been made fast to the metal collar; and when all the thread grooves
on the wood roller are filled the opposite end of the wire is attached
to the rear end of the metal roller. The current entering at binding-
post No. 1 crosses on the strip of spring metal to the collar, travels
along the coil of wire, and crosses to the metal roller and is
conducted out at binding-post No. 2 (see Fig. 15). If the resistance
is too great slip the handle over the end of the metal roller and give
it several turns. The current will then pass with greater freedom as
the wire on the wooden roller becomes shorter. This may be readily
seen by connecting a small lamp in series with a battery and this
rheostat. As the metal cylinder is turned the current flows more
freely and the filament becomes red, then white, and finally burns to
its full capacity. Take care, however, not to admit too much current
as it will burn out the lamp. Some sort of adjustment should be
made to prevent the rollers turning of themselves and thus allowing
the wire coils to slacken. This may be done by boring the two holes
for the rollers to fit in and then, with a key-hole saw, cutting the
stick as shown at C in Fig. 16, taking care not to split it at the ends.
The result will be a long slot which, however, has nothing to do with
the bearings. Down through the middle of the stick make a hole with
an awl, so that the screw-eye will move easily in the upper half but
will hold in the lower half. Under the head of the eye place a small
copper washer; then with the thumb and finger drive the screw-eye
down until the head rests on the washer.
A slight turn of the eye when it is in the right place will draw the
upper and lower parts of the stick together and bind the wood about
the bearing ends of the rollers. The rollers should not be held too
tightly as that would strain the wire when winding it from one to the
other. It should be just tight enough to keep the wire taut.
Two or more of these roller resistance-frames may be made and
connected in series so that a close adjustment can be had when
using battery currents for experimenting.

Liquid Resistance
Apart from metallic, mercurial, or carbon resistance a form of
liquid apparatus is frequently used in laboratory and light
experimental work.
 This style of resistance equipment is the least expensive to make,
and will give excellent satisfaction to the boy who is using light
currents for induction-coils, lamps, galvanometers, and testing in
general. The simplest form of liquid resistance is made by using a
glass bottle with the upper part cut away. The cutting may be done
with a steel-wheel glass-cutter. The bottle should then be tapped on
the cut line until the top part falls away. Go over the sharp edges
with an old file to chafe the edge and round it; then solder a tin,
copper, or brass disk to a piece of well-insulated wire and drop it
down in the bottom of the receptacle, as shown at Fig. 17. Cut a
smaller disk of metal, or use a brass button, and suspend it on a
copper wire which passes through a small hole in a piece of wood at
the top of the jar. Notches should be cut at the under side of this
wood cross-piece so that it will fit on top of the jar and stay in place.
The jar is to be nearly filled with water, having a teaspoonful of
sulphate of copper dissolved in it. This will turn the water a bluish
color and make it a slightly better conductor, particularly when the
button is lowered close to the round disk. If a high resistance is
desired the copper may be omitted leaving the water in its pure
state. The wires leading in and out of the jar should be connected
between the apparatus and the battery so that the proper amperage
can be had by raising or lowering the button. A series of these liquid
resistance-jars may be made of glass tubes an inch in diameter and
twelve inches long. One end of them may be stopped with a cement
made of plaster of Paris six parts, ground silex or fine white sand
two parts, and dextrine two parts. Mix the ingredients together when
dry, taking care to break all small lumps in the dextrine; then add
water until it is of a thick consistency like soft putty. Solder the ends
of some copper wires to disks of copper or brass and set them on
the middle of bone-buttons; these in turn are to be imbedded in the
mixture after the wire has been passed through a hole in the
bottom.
Their location can be seen in the bottom of the tubes Fig. 18, and
Fig. 19 A is an enlarged figure drawing of the plate, button, and
wire. The wires are brought out under the lower edge of the tubes,
and enough of the composition is floated about the bottom and
outer edge of the tube to form a base, as shown in the drawing. A
base-board is made six inches wide and long enough to
accommodate the desired number of tubes. Two pieces of wood one
inch wide and three-quarters of an inch thick have hollow notches
cut from them at one side, as shown at Fig. 19 B. In these notches
the tubes are gripped. Screws are passed through one stick and into
the other so as to clamp the wood and tubes securely together. The
rear stick is supported on two uprights which are made fast to the
rear edge of the base-plate with screws and glue.
Along the front of the base-board small metal contact plates, or
binding-posts, are arranged (see Binding-posts, chapter iii.) and the
wires led to them from the tubes, as shown in the drawing. The top
or drop wires in the tubes are provided with metal buttons at the
ends; or the end of the wire may be rolled up so as to form a little
knob. The manner of connecting the wires was freely explained in
the resistance-coil descriptions and may be studied out by examining
the drawing closely. In this resistance-apparatus there are two ways
of cutting out a medium—first, by lowering the wire in the tube so
that both contact-points meet; and second, by cutting out the first
tube altogether by connecting the incoming wire with the second
binding-post. Then again the resistance may be regulated quite
accurately by raising or lowering the wires in the liquid.
For example, there is too much resistance if the current has to
travel through all the tubes. If it is too strong when one tube is cut
out, the wire in tube No. 1 is lowered so that the contacts are an
inch apart. Then the more accurate adjustment is made by dropping
the wire in the second tube, as shown in Fig. 18. The wires leading
out at the top of the tubes are pinched over the edge to hold them
in place. They should be cotton insulated and the part that is in the
liquid should be coated with hot paraffine.
The water may be made a slightly better conductor if a small
portion of sulphate of zinc, or sulphate of copper, is added to each
tubeful.
 Hittorf’s resistance-tube is one of the oldest on these lines, and
two or more of them are coupled in series, as described for this
water-tube resistance; glass tubes are employed that have one end
sealed with a permanent composition, as described for Fig. 18. A
metallic cadmium electrode is placed at the bottom of the tube, and
the tube is then filled with a solution of cadmium iodide one part
and amylic alcohol nine parts, and then corked. A wire passing down
through or at the side of the cork is attached to another small piece
of metallic cadmium, which touches the top of or is suspended a
short distance in the liquid.
As the alcohol is volatile the cork cannot be left out of the tube,
and the wire must be drawn through the cork with a needle so that
no opening is left for evaporation. A number of these tubes may be
made and coupled in series and the wires led down to the contact-
points of a switch.

Chapter VIII

THE TELEPHONE

F
or direct communication over short or moderately long
distances, nothing has been invented as yet that will take the
place of the telephone. A few years ago, when this instrument
was first brought out, it was the wonder of the times, just as
wireless telegraphy is to-day. Starting with the simple form of the
two cups with membranes across the ends, and a string or a wire
connecting them, we have to-day the complex and wonderful electric
telephone, giving perfect service up to a distance of two thousand
miles. Some day inventors in the science of telephony will make it
possible to communicate across or under the oceans, and when the
boys of to-day grow to manhood they should be able to transact
business by ’phone from San Francisco to the Far East, or from the
cities near the Atlantic coast to London, Paris, or Berlin.
It is hardly necessary to enter into the history of telephones, as
this information may be readily found in any modern encyclopædia
or reference work. But the boy who is interested in electricity wants
to know how to make a telephone, and how to do it in the up-to-
date way, with the wire and ground lines, switches, cut-outs, bell
connections, and other vital parts, properly constructed and
assembled. In this laudable ambition we will endeavor to help him.
The general principle of the telephone may be explained in the
statement that it is an apparatus for the conveyance of the human
voice, or indeed any sounds which are the direct result of vibration.
Sound is due to the vibrations of matter. A piano string produces
sound because of its vibration when struck, or pulled to one side and
then released. This vibration sets the air in rapid motion, and the
result is the recording of the sound on our ear-drums, the latter
corresponding to the film of sheepskin or bladder drawn over the
hollow cup or cylinder of a toy telephone. When the head of a drum
is struck with a small stick it vibrates. In this case the vibrations are
set in motion by the blow, while in the telephone a similar
phenomenon is the result of vibratory waves falling from the voice
on the thin membrane, or disk of metal, in the transmitter. When
these vibrations reach the ear-drum the nervous system,
corresponding to electricity in the mechanical telephone, carries this
sound to our brains, where it is recorded and understood. In the
telephone the wire, charged with electricity, carries the sound from
one place to another, through the agencies of magnetism and
vibration.
Over short distances, however, magnetism and electricity need not
be employed for the transmission of sound. A short-line telephone
may be built on purely vibratory principles. Almost every boy has
made a “phone” with two tomato-cans over which a membrane is
drawn at one end and tied. The middle of the membrane is
punctured, and a button, or other small, flat object, is arranged in
connection with the wires that lead from can to can.

A Bladder Telephone
A really practical talking apparatus of this simple nature may be
made from two fresh beef bladders obtained from a slaughter-house
or from the butcher. You will also need two boards with holes cut in
them, two buttons, some tacks, and a length of fine, hard, brass,
copper, or tinned iron wire. The size should be No. 22 or No. 24. The
boards should be ten by fourteen inches and half an inch in
thickness. Cut holes in them eight inches in diameter, having first
struck a circle with a compass. This may be done with a keyhole saw
and the edges sand-papered to remove rough places. Prepare the
bladders by blowing them up and tieing them. Leave them inflated
for a day or two until they have stretched, but do not let them get
hard or dry.
When the bladders are ready, cut off the necks, and also remove
about one-third of the material, measuring from end to end. Soak
the bladders in warm water until they become soft and white.
Stretch them, loosely but evenly, over the opening in the boards,
letting the inside of the bladder be on top, and tack them
temporarily all around, one inch from the edge of the opening. Test
for evenness by pushing down the bladder at the middle. If it
stretches smoothly and without wrinkles it will do; otherwise the
position and tacks must be changed until it sets perfectly smooth.
 The bladder must now be permanently fastened to the board by
means of a leather band half an inch wide and tacks driven closely,
as shown in Fig. 1. With a sharp knife trim away the rough edges of
the bladder that extend beyond the circle of leather. Attach a piece
of the fine wire to a button, as shown in Fig. 2, and pass the free
end through the centre of the bladder until the button rests on its
surface. Then fasten an eight-pound weight to the end of the wire
and set in the sun for a few hours, until thoroughly dry, as shown at
Fig. 3.
When both drums are complete, place one at each end of a line,
and connect the short wires with the long wire, drawing the latter
quite taut. The course of the main wire should be as straight as
possible, and should it be too long it may be supported by string
loops fastened to the limbs of trees, or suspended from the cross-
piece of supports made in the form of a gallows-tree or letter F. To
communicate it will be necessary to tap on the button with a lead-
pencil or small hard-wood stick. The vibration will be heard at the
other end of the line and will attract attention.
By speaking close to the bladder in a clear, distinct tone, the
sound will carry for at least a quarter of a mile, and the return
vibrations of the voice at the other end of the line can be clearly
recognized.

A Single (Receiver) Line

The principal parts of the modern telephone apparatus are the
transmitter, receiver, induction-coil, signal-bell, push-button,
batteries, and switch. The boxes, wall-plates, etc., etc., are but
accessories to which the active parts are attached.
The first telephone that came into general use was the invention
of Graham Bell, and the principle of his receiver has not been
materially changed from that day to this, except that now a double-
pole magnet and two fine wire coils are employed in place of the
single magnet and one coil. A practical form of single magnet
receiver that any boy can easily construct is shown in Fig. 4, and Fig.
5 is a sectional drawing of the receiver drawn as though it had been
sliced or sawed in two, from front to rear.
It is made from a piece of curtain-pole one inch and an eighth in
diameter and three inches and a half long. A hole three-eighths of
an inch in diameter is bored its entire length at the middle, and
through this the magnet passes. At one end of this tube a wooden
pill-box (E) is made fast with glue, or a wooden cup may be turned
out on a lathe and attached to the magnet tube. If the pill-box is
employed it should be two inches and a half in diameter, and at four
equidistant places inside the box small lugs of wood are to be glued
fast. Into these lugs the screws employed to hold the cap are driven.
The walls of pill-boxes are so thin that without these lugs the cap
could not be fastened over the thin disk of metal (D) unless it were
tied or wired on, and that would not look well. If the cup is turned
the walls should be left thick enough to pass the screws into, and
the inside diameter should then be one inch and three-quarters.

The cap (B) is made from thin wood, fibre, or hard rubber. It is
provided with a thin rim or collar to separate its inner side from the
face of the disk (D). Four small holes are bored near the edge of this
cap, so that the screws which hold it fast to the cup (E) may pass
through them. The magnet (M) is a piece of hard steel three-eighths
of an inch in diameter and four inches and a quarter long. This may
be purchased at a supply-house, and if it is not hard enough a
blacksmith can make it so by heating and plunging it in cold water
several times. It may be magnetized by rubbing it over the surface
of a large horseshoe magnet, or if you live near a power station you
can get one of the workmen to magnetize it for you at a trifling cost.
Should you happen to possess a bar magnet of soft iron with a
number of coils of wire, and also a storage-battery, the steel bar
may be substituted for the soft iron core and the current turned on.
After five minutes the steel can be withdrawn. It is now a magnet,
and will hold its magnetism indefinitely.
Now have a thin, flat spool turned from maple or boxwood to fit
over one end of the rod, and wind it with a number of layers of No.
36 copper wire insulated with silk. This is known in the electrical
supply-houses as “phone”-receiver insulated wire, and will cost
about fifty cents an ounce. One ounce will be enough for two
receivers. It should be wound evenly and smoothly, like the strands
of thread on a spool, and this may be done with the aid of the
winder described on page 58.
When the wire is in place a drop of hot paraffine will hold the end
so that the wire will not unwind. The ends of this spool-winding
should be made fast to heavier wires, which are run through small
holes in the tube (A) and project out at the end, as shown at F F.
The magnet, with its wire-wound spool on the end, is then pushed
through the hole in A until the top end of the rod is slightly below
the edges of the cup (E), so that when the metal disk (D) is laid over
the cup (E) the space between the magnet and disk, or diaphragm
(D), is one-sixteenth of an inch (see Fig. 5). Put some shellac on the
magnet, so that when it is in the right place the shellac will dry and
hold it fast.
The cap (B) holds the disk (D) in place, and protects the spool and
its fine wire from being damaged and from collecting dust. After
giving the exterior a coat of black paint and a finishing coat or two
of shellac, the receiver will be ready for use.
The original telephone apparatus was made up of these receivers
only—one at each of a line in connection with a battery, bell, push-
button, and switch. On a window-casing, or the wall through which
the wires passed, a lightning-arrester was arranged and made fast.
Using receivers only, it was necessary to speak through the same
instrument that one heard through, and for a few years this unhandy
method of communication was the only one possible. Then the
transmitter was invented.
 Plan of Installation
Many of these single-receiver lines are still in use, and as they
require but a small amount of constructive skill a diagram of the
wiring and the plan of arrangement is shown in Fig. 6.

At the left side, R is the receiver at one end of the line and R 2
that at the other, line No. 1 being a continuous wire between the
two receivers. When the boy at R wishes to call his friend at R 2 he
uses his push-button (P B), and the battery (B B) operates the
electric bell (E B 2) at the other end. In order to have the bell
connections operative, the switch (S 2) must be thrown over to the
left when the line is “quiet,” while the switch (S) should be thrown to
the right. With the switches in this position the boy at either end
may call his friend at the opposite end.
With the switch (S 2) thrown to the left (the position it should be
in, except when talking over the line), the boy at the other end
pushes his button (P B), first throwing switch S to the left. This
makes connection for the battery (B B), and the circuit is closed
through wires that join line No. 1 and line No. 2 at 1 and 2. The
branch lines to the bell (E B 2) join the main lines at 3 and 4,
through switch S 2, when the bar is thrown to the left. The circuit
being complete, the batteries (B B) at one end of the line ring the
bell (E B 2) at the other end of the line.
In the reverse manner, when the switch (S) is thrown to the right,
the boy at the opposite end rings the bell (E B) by pressing on the
button (P B 2), first throwing switch S 2 over to the right. If the boy
at the left is calling up the boy at the right, the switch (S) should be
thrown to the left, and he keeps ringing until the other operator
throws switch S 2 over to the right. If now he has the receiver (R)
up to his ear he can hear the vibration of the bell (E B 2) ringing
through the receiver (R) at his end of the line. But when the boy
summoned to R 2 takes up the receiver and places it to his ear, he
throws switch S 2 over to the right side, and the boy at R leaves
switch S over on the left side. This brings the lines into direct
connection with the receivers in series. Be careful, when setting up
this line, to have the batteries (B B) in series with B 2 B 2; otherwise
there would be counter-action. The carbon of one cell should be
connected with the zinc of the next cell, and so on.
Another receiver is shown at Fig. 7. The tube (A) and the cup are
turned from one piece of wood, and the cap (B) from another piece.
The length of the receiver is five inches, and the cap is two inches
and a half across. The shank, or handle, through which the magnet
is passed measures one inch and a quarter in diameter.
These wood parts will have to be made by a wood-turner; and
before the long piece is put in a lathe the hole, three-eighths of an
inch in diameter, should be bored. It must be done carefully, so that
the wood shell will be of even thickness all around the hole. Also two
small holes should be made the entire length of the handle, through
which the wires leading from the coil to the binding-posts may pass.
 The spool for the fine insulated wire coil is turned from box-wood
or maple, and wound as described in chapter iv., on Magnets and
Induction-coils. Small binding-posts (F F) with screw ends should be
driven down into the holes at the end of the handle and over the
bare ends of the wires that project out of the holes. The magnet (M)
is three-eighths of an inch in diameter, and is provided with the
spool and coil (C) at the large end of the receiver.
The disk (D) is of very thin iron, and is held in place by the cap (B)
and four small brass screws driven through the edge of B and into
the cup end of A. A screw-eye should be driven into the small end of
the receiver from which it may hang from a hook. If a double hook
and bar is employed the receiver will hang in the fork, being held
there by the rim of wood turned at the small end of A.

A Double-pole Receiver
Another form of receiver is shown at Fig. 8. This is a double-pole
receiver, with the coils of fine wire arranged on the ends of a bent
band of steel and located in the cup (A), so that the ends of the
magnet are close to the diaphragm (D). Fig. 8 is a sectional view of
an assembled receiver, but a good idea can be had from the
drawings of the separate parts. The magnet (M) is of steel one-
eighth of an inch thick and five-eighths of an inch wide. A blacksmith
will make this at a small cost. It should measure two and one-half
inches wide, two and one-half inches long, the ends being five-
eighths of an inch apart.
 Thin wooden spools are made from wood or fibre to fit over the
steel ends, and are wound with No. 36 silk-insulated wire. A wooden
cup, or shell (A), is turned from cherry, maple, or other close-grained
wood, and at the back a hole is cut just large enough for the magnet
ends to slip through exclusive of the coils wound on them. A plug of
wood (A A) is driven between the ends of the magnet to hold them
in place. Some shellac on the edges of the hole and the plug will
harden and keep the parts in place.
The coils (C C) are placed on the magnet ends, and the fine wires
are made fast to the binding-posts (E E), the latter being screwed
fast to the shell (A). The diaphragm (D) is then arranged in place
and held with the cap (B) and the small screws which pass through
it and into the shell (A).

The Transmitter
With any one of these receivers a more complete and convenient
telephone can be made by the addition of a transmitter and an
induction-coil.
Following the invention of the receiver, several transmitters were
designed and patented, among them being the Edison, Blake,
Clamond, Western Union, and Hunning. The Edison and Hunning are
the ones in general use, and as either of them can easily be made
by a boy a simplified type of both is shown in Figs. 9 and 11.
 SIMPLIFIED TYPE OF TRANSMITTER

Some small blocks of wood, tin funnels, small screws, granulated

or powdered carbon, some thin pieces of flat carbon, and a piece of
very thin ferrotype plate will be the principal things needed in
making a transmitter similar to the one shown in Fig. 9. All that is
visible from the outside is a plate of wood screwed to a block of
wood, and a mouth-piece made fast to the thin board.
In Fig. 10 an interior section is shown, which when once
understood will be found extremely simple. The block (A) is of pine,
white-wood, birch, or cherry, and is two inches and three-quarters
square and five-eighths or three-quarters of an inch thick. A hole
seven-eighths of an inch in diameter is bored in the centre of this
block, half an inch deep, and a path is cut at the face of the block
one inch and a half in diameter and one-eighth of an inch deep. Be
careful to cut these holes accurately and smoothly, and if it is not
possible to do so, it would be well to have them put in a lathe and
turned out.
The face-plate (B) is two inches square, with a three-quarter-inch
hole in it, and the under-side is cut away for one-eighth of an inch in
depth and one inch and a half in diameter. The object of these
depressions in block A and face-plate B is to give space for the
diaphragm (D) to vibrate when the voice falls on it through the
mouth-piece (C).
From carbon one-eighth of an inch in thickness two round buttons
are cut measuring three-quarters of an inch across. A small hole is
bored in the centre of each button, and one of them is provided with
a very small brass screw and nut, as shown at F F. One side of the
button-hole is countersunk, so that the head of the screw will fit
down into it and be flush with the face of the carbon. With a small
three-cornered or square file cut the surface of the buttons with
criss-cross lines, as shown at F F. When the buttons are mounted in
the receiver these surfaces will face each other. Cut a small washer
from felt or flannel, and place it in the bottom of the hole in block A.
Line the side of the hole with a narrow strip of the same goods; then
place the button (F F) in the hole, pass the screw through the hole
and through the block (A), and make it fast with the nut, as shown
at F. Place a thin, flat washer under the nut, and twist a fine piece of
insulated copper wire between washer and nut for terminal
connections, taking care that the end of the wire under the nut is
bare and bright, so that perfect contact is assured. Since the practice
of telephony involves such delicate and sensitive vibratory and
electrical phenomena, it is best to solder all joints and unions
wherever practicable, and so avoid the possibility of loose
connections or corrosion of united wires.
From very thin ferrotype plate cut a piece two inches square, and
at the middle of it attach the other carbon button by means of a
small rivet which you can make from a piece of copper wire. Or a
very small brass machine screw may be passed through the button
and plate; then gently tapped at the face of the plate to rivet it fast,
as shown at E. Lay the block down flat and partly fill the cavity with
carbon granules until the button is covered. Do not fill up to the top
of the hole. Over this lay the disk (D), so that the carbon button at
the under side of it will fit in the top part of the hole between the
sides of felt or flannel. Make the disk fast to the block (A) with small
pins made by clipping ordinary pins in half and filing the ends.
A slim bolt (G) is passed through the block (A), and a wire
terminal is caught under a nut and between a washer at the back of
the block, as described for F. The japan or lacquer must be scraped
away from the disk (D) where the bolt-head touches it, so that
perfect electrical contact will be the result.
A small tin funnel is cut and made fast to the face-plate (B), or if
an electrical supply-house is at hand a mouth-piece of hard rubber
or composition may be had for a few cents. The block (B) is then
screwed fast to A, forming the transmitter shown at Fig. 9. When
this transmitter stands in a vertical position the granules, or small
particles of carbon, drop down between the buttons of carbon,
packing closely at the bottom of the cavity. At the middle they are
loosely placed, and at the top there are none. As the high or low
vibrations of the voice fall on the disk (D) they act accordingly on
the carbon granules, which in turn conduct the vibrations to the rear
carbon button, and, by the aid of electricity reproduce the same
sound, in high or low tone, through the receiver at the other end of
a line.
This improved transmitter makes it possible to talk in a moderate
tone of voice over distances up to one thousand miles, while with
the old form of the instrument it was necessary to talk very loud in
order to be heard only a few miles away. Where a portable
apparatus is desired, this block may be attached to a box or an
upright staff.
This transmitter will not work when on its back or so that the
funnel is on top, because the particles of carbon would settle on the
rear button and not touch the front one. It is essential that the
carbon grains should touch both buttons at the same time, and at
the lower part of the cavity they should lie quite solid. It is not
necessary, however, to pack it in, for the vibratory action of the
voice, or other sounds, will cause the particles to adjust themselves
and settle in a compact mass.

Another Form of Transmitter

In Fig. 11 another style of transmitter is shown. It is assembled on
the front of a box. This front or cover swings on hinges, and can be
opened so that the mechanism in the interior of the box may be
gotten at easily.
A sectional view of this transmitter is shown in Fig. 12. A hole one
inch and a half in diameter is cut in the cover (A). A round or square
block (B) two inches and a quarter across and half an inch thick is
made fast to the rear of the cover, and in this a hole is bored seven-
eighths of an inch in diameter and one-quarter of an inch deep.
The sides and bottom of this hole are lined with flannel or felt,
and a carbon button with roughened surface, as shown at F F, is
made fast in it by a small machine screw and nut (F). A diaphragm
(D) is cut from thin ferrotype plate, and a carbon button is made fast
to the middle of it by a small machine screw or a rivet made from
soft copper or brass. When the block (B) has been screwed fast to A,
place some granules of carbon in the space (H); then lay the
diaphragm over the opening, and make it fast with small screws or
pins driven around the edge.
From a small tin funnel and a tin-can cap make a mouth-piece (C)
by cutting a hole in the cap and slipping the funnel through it, then
cutting the end of the funnel that projects through the hole and
bending back the ears so that they lap on the inner side of the cap.
These small ears may be soldered to the cap so as to hold the
mouth-piece securely in place. From felt or flannel cut a washer the
size of the can top and about three-eighths of an inch in width. Lay
this over the diaphragm; then place the mouth-piece on it and
fasten it to the door (A) with small screws. The use of this washer is
to prevent any false vibrations in the mouth-piece affecting the
sensitive diaphragm. Make a small hole through A and B and pass a
bolt (E) through this hole, taking care to lap a thin piece of sheet-
brass on the diaphragm (D), bending it over so that it will lie under
the head of the bolt (E). The diaphragm must be scraped where the
metal touches it, so as to make perfect electrical connection
between D and E. At the rear end of E arrange a washer and nut
(G), so that the current passing in at G travels through E and D, then
through the carbon buttons and granules, and out at F.
From pine or white-wood one-quarter or three-eighths of an inch
thick make a box four inches wide, six inches high, and two inches
and a half deep. To the front of this attach a cover, which should
measure a quarter of an inch larger all around than the width and
height of the box. Use brass hinges for this work so that the cover
may be opened. Fasten a transmitter to the front of the cover, or
make one on the cover, as shown in Fig. 11, and attach the box to a
back-board or wall-plate five inches wide and seven inches high
made of pine or white-wood half an inch in thickness (see Fig. 13).
 At the left side of the box cut a slot through the wood, so that a
lever and hook may project and work up and down. The end of this
lever is provided with a hook on which a receiver may be hung, as
shown in Fig. 13, and the inside mechanism is arranged as shown at
Fig. 14. A is an angle-piece of brass or copper, which acts as a
bracket and which is screwed fast to the inside of the box. B is the
lever and hook, which is cut from a strip of brass. The attached end
is made wider, and an ear (C), to which a wire is soldered, projects
down beyond the screw.
A view looking down on this lever and bracket is shown at Fig. 15.
A is the bracket, B the lever, and E the screw or bolt holding the two
parts together, with a thin copper washer between them to prevent
friction. When the lever and bracket are made fast to the box, a
spring (D) should be arranged, so that when the receiver is removed
from the hook the lever will be drawn up to the top of the slot. A
small contact-plate (F) is made of brass, and fastened at the lower
end of the slot. On this the lever should rest when the receiver is on
the hook. A contact-wire is soldered to this plate, which in turn is
screwed fast to the inside of the box. This mechanism is part of a
make-and-break switch to cut out and cut in the bells or telephone,
and will be more clearly understood by referring to the diagram in
Fig. 17. At the right side of the box a small push-button is made fast,
and this, with two binding-posts at the top and four at the underside
of the box, will complete the exterior equipment of one end of a line.
The construction of the push-button is shown in Fig. 16, A being
the box and B the button which passes through a small hole made in
the side of the box. C is a strip of spring-brass screwed fast to the
box. It must be strong enough to press the small bone or hard
rubber button towards the outside of the box. A wire is caught under
one screw-head, and another one is passed under the screw-head
which holds the other spring (D) to the box. When the button (B) is
pushed in, it brings spring C into contact with D, and the circuit is
closed. Directly the finger is removed from B the spring (C) pushes it
out and breaks the circuit. This button is used only in connection
with the call-bells, and has nothing to do with the telephone. The
wires leading from the interior of the box pass through the wall-plate
and along in grooves to the foot of the binding-posts, which are
arranged below the box on the back-board, as shown in Fig. 13.
A buzzer or bell is made fast to the inside of the box, unless it is
too large to fit conveniently, in which case it may be attached to the
wall above or below the box.

The Wiring System

Fig. 17 shows the wiring system for this outfit, which, when
properly set up and connected, should operate on a circuit or line
several miles in length, provided that the batteries are strong
enough.
This system may be installed in the box shown in Fig. 13, the
flexible cord containing two wires being attached to the binding-
posts at the top of the box and to the posts at the end of the
receiver. This system differs from the one shown in Fig. 6 only in the
addition of receivers T and T 2, and in the substitution of the
automatic lever-switches (L S and L S 2) for the plain switches (S
and S 2) in Fig. 6. When the line is “quiet” the receiver (R) should be
hanging on the lever-switch (L S), which rests on the contact-plate
(A). At the opposite side of the line the receiver (R 2) hangs on the
lever-switch (L S 2), which in turn rests on the contact-plate (A A).
This puts the bell circuit in service.

PLAN OF TELEPHONE CIRCUIT, COMPRISING RECEIVERS, TRANSMITTER,

ELECTRIC BUZZERS OR BELLS, LEVER-SWITCHES, PUSH-BUTTONS AND
BATTERIES FOR STATIONS NOT OVER FIVE MILES APART.
 If the boy at the left wishes to call up the boy at the right he
removes the receiver (R) from the hook (L S) and presses on the
button (P B). This closes the circuit through the battery (C C C), and
operates the electric buzzer or bell (E B 2) at the other end of the
system, through line No. 1 and line No. 2. The operation may be
clearly understood by following the lines in the drawing with a
pointer. The boy at the left may keep on calling the boy at the right
so long as the receiver (R 2) hangs on the lever (L S 2) and holds it
down against the plate (A A). But directly the receiver (R 2) is
removed, the lever (L S 2) flies up—being drawn upward by the
spring (D) shown in Fig. 14—and closes the telephone circuit
through the spring-contact (B B), at the same time cutting out the
bell circuit. The boy at the left having already removed his receiver,
the telephone circuit is then complete through lines Nos. 1 and 2
and batteries C C C and C 2 C 2 C 2, the boys at both ends speaking
into the transmitters and hearing through the receivers. The
contacts B and B B are made from spring-brass or copper, and are
attached inside the boxes at the back, so that when the levers are
up contact is made, but when down the circuit is broken or opened.
In Fig. 18 an interior view of a box is shown, the door being thrown
open and the receiver left hanging on the hook.
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