A) Questions
In a Word document, respond to the following. Number your responses 1–3.
Explain the concept of cash flow in corporate finance.
Cash flow refers to the total amount of cash and cash equivalents that are being transferred into and out of business (Murray, 2018). The fundamental objective of financial reporting involves assessing the amounts, timing, and uncertainty of cash flows. It is very significant to understand the cash flow statement of a firm as it is crucial in evaluating the flexibility, liquidity, as well as, overall financial performance of a company. There are numerous types of cash flows, and all are utilized differently for running a firm and also for performing financial analysis.
Cash from Operating Activities: Typically, this refers to the net cash inflow that is stated in the first section of cash flows. It normally emphases on the cash inflows and cash outflows from a firm’s chief doings of purchasing and selling products, providing services, etc.
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Free Cash Flow to Equity: This refers to capital expenditures. i.e., cash that is available after reinvesting in the business.
Free Cash Flow to the Firm: This is used in financial valuation and modeling and is a measure that assumes a company has no debt (leverage).
Net Change in Cash: Found at the end of Cash Flow Statement.
Explain how the present value and future values are related.
The Future Value (FV) of an asset equals the Present Value (PV) of the asset plus the interest earned by having ownership of the asset (Woodruff, 2018). In other words, it refers to the amount that the PV will grow over a given period. Contrariwise, the Present Value of an asset refers equals the future value of that asset less the interest that resulted from the ownership of the asset (Woodruff, 2018). In other words, it refers to the value of money today if the same amount was to be received some specified period in the future. FV is computed by multiplying the PV by the accumulation function. Mathematically, the FV and PV are related as shown below (Lumen, 2018);
Rewriting the formula, we get the formula for PV;
As seen in the equation, PV and FV are related by the measure of interest rate.
Explain how present values are affected by changes in interest rates.
Present value (PV) refers to the current value of a sum of money in the future at a given rate of return. Future cash flows are discounted at the discount rate, and there is an inverse relationship between the present value and the interest rate. Thus, the higher the interest rate, the lower the present value. This is illustrated in the example shown below. Present value is a function of cash inflow and accumulation function, i.e.
Assuming the other variables remain constant; let’s determine the present value of $1,000 after three years at different interest rates to prove that the PV decreases when the interest rate is increased.
At 10%:
At 20%:
At 30%:
Therefore, the present value decreases when the interest rate is increased.
B) Problems
1. 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? Recalculate the account balance using a 6 percent interest rate and a 7 percent interest rate.
I) Present Value,
II) Present Value,
III) Present Value,
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?
What is the annual rate of return for an $8,000 investment if in five years it grows to $12,500? Assuming the growth occurred in six years and then eight years, recalculate the rate of return for these two scenarios.
Making r the subject of the formula;
References
Lumen. (2018). Additional Detail on Present and Future Values. [Online]. Available at: https://courses.lumenlearning.com/boundless-finance/chapter/additional-detail-on-present-and-future-values/ . Accessed 27th No 2018.
Murray, J. (2018). What is Cash Flow? [Online]. Available at: https://www.thebalancesmb.com/cash-flow-how-it-works-to-keep-your-business-afloat-398180 . Accessed 27th Nov 2018.
Woodruff, J. (2018). Future Value vs. Present Value. [Online]. Available at: https://smallbusiness.chron.com/future-value-vs-present-value-77714.html . Accessed 27th Nov 2018.
