Explain the concept of cash flow in corporate finance.
In corporate finance, cash flow refers to the increases or decreases of cash owned by a business or financial institution. Essentially, the cash flow of a business is the amount of money that the business has been using within a specified period. According to Weston and Weaver (2001) , the concept was adopted in 1987 by the FASB under the Statement of Financial Accounting Standards No. 95, Statement of Cash Flows (FASB 95). There are three types of cash flows: cash flow for financing, cash flow for investments, and cash flow for operations. Cash flows for businesses are recorded in cash flow statements.
Explain how present value and future values are related.
When learning about the time value of money, the present value of money dictates that a given amount of money is worth more than the same amount of money in the future. The amount’s worth in the future is its future value. The future value of an amount is calculated by taking the present value times one and adding the interest raised to the nth power (n represents the number of years that the money is being compounded) ( Weston & Weaver, 2001) . Similarly, the present value of an amount can be calculated by diving the future value by one plus the interests put to the nth power.
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Explain how present values are affected by changes in interest rates.
Changes in interest rates affect the present value factors and the present values of money. This is indicative of the fact that growth in the discount rate of a value would decrease both its present value and its present value factor. The key reason is that raising the rate of interest implies that the investor would have to put money aside presently to make a specific sum of money in the future.
If you deposited $250 in your savings account today, and the bank pays 4 percent interest per year, how much would you have in your savings account after 9 years?
In the calculation of the future value of an amount, it is important to consider the principal (initial amount), the rate of interest, the total value of interest earned, and the period in consideration ( Weston & Weaver, 2001 ).
In this scenario, we can use the formula A = P (1+r/n) n*t , where A represents future value, P represents the present value, r represents the interest rate, n represents the number of times compounded per year, and t represents the time in years. Therefore, the solution is:
A = 250 (1 + 0.04/1) 1*9 = 250 (1.04) 9 = $355.83.
Recalculate the account balance using a 6 percent interest rate and a 7 percent interest rate.
A = 250 (1 + 0.06/1) 1*9 = 250 (1.06) 9 = $422.37.
A = 250 (1 + 0.07/1) 1*9 = 250 (1.07) 9 = $459.61.
A $450 deposit earns 6 percent interest in the first year, 3 percent interest in the second year, and 7 percent interest in the third year. What is the future value at the end of the third year?
In this question, we can apply the formula to each year.
For year one, A = 450 (1 + 0.06/1) 1*1 = 250 (1.06) 1 = $477.
For year two, A = 477 (1 + 0.03/1) 1*1 = 477 (1.03) 1 = $491.31.
For year three, A = 491.31 (1 + 0.07/1) 1*1 = 491.31 (1.07) 1 = $525.7.
What is the annual rate of return for an $8,000 investment if in five years it grows to $12,500?
From the formula above, A=$12,500, P=$8000, t=5 years, n=1.
12500 = 8000 (1+r/1) 5, which is the same as 12500/8000 = (1+r/1) 5, hence, 1.5625 = (1+r/1) 5
Therefore, the fifth root of 1.5625 = (1+r/1), meaning that 1.0934 = 1 + r/1
Thus, r = 0.0934 = 9.3%.
Assuming the growth occurred in six years and then eight years, recalculate the rate of return for these two scenarios.
A=$12,500, P=$8000, t=6 years, n=1.
12500 = 8000 (1+r/1) 6 , which is the same as 12500/8000 = (1+r/1) 6 , hence, 1.5625 = (1+r/1) 6
Therefore, the sixth root of 1.5625 = (1+r/1), meaning that 1.0772= 1 + r/1
Thus, r = 0.0772 = 7.7%.
A=$12,500, P=$8000, t=8 years, n=1.
12500 = 8000 (1+r/1) 8 which is the same as 12500/8000 = (1+r/1) 8 , hence, 1.5625 = (1+r/1) 8
Therefore, the eighth root of 1.5625 = (1+r/1), meaning that 1.0574= 1 + r/1
Thus, r = 0.0574 = 5.7%.
References
Weston, J. F., & Weaver, S. C. (2001). Finance and accounting for nonfinancial managers . McGraw-Hill.
