Question

1. Explain the concept of cash flow in corporate finance.
2. Explain how present value and future values are related.
3. Explain how present values are affected by changes in interest rates.

Answer 1

Part a.

Cash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe how much cash (currency) is produced or consumed in a given period of time.

There are several forms of CF, with various essential applications to operate a company and to conduct financial analysis. There are different types of Cash Flow:

Types of cash flow include:

1. Cash from Operating Activities – Cash that is generated by a company’s core business activities – does not include CF from investing. This is found on the company’s Statement of Cash Flows (the first section).
2. Free Cash Flow to Equity (FCFE) – FCFE represents the cash that’s available after reinvestment back into the business (capital expenditures). Read more about FCFE.
3. Free Cash Flow to the Firm (FCFF) – This is a measure that assumes a company has no leverage (debt). It is used in financial modeling and valuation. Read more about FCFF.
4. Net Change in Cash – The change in the amount of cash flow from one accounting period to the next. This is found at the bottom of the Cash Flow Statement.

Lets understand how it is different from Income. Income is focused on accrual accounting principles that smooth out spending and adapt income to the timing of delivery of products / services.

Because of revenue accounting policies and the matching concept, a company's taxable profit, or net profits, will actually vary significantly from its cash flow.

Part b.

The future value (FV) measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV is calculated by multiplying the present value by the accumulation function. The value does not include corrections for inflation or other factors that affect the true value of money in the future. The process of finding the FV is often called capitalization.

On the other hand, the present value (PV) is the value on a given date of a payment or series of payments made at other times. The process of finding the PV from the FV is called discounting.

PV and FV are related , which reflects compounding interest (simple interest has n multiplied by i, instead of as the exponent). Since it's really rare to use simple interest, this formula is the important one.

FV = PV * (1+i)^n

PV and FV vary directly: when one increases, the other increases, assuming that the interest rate and number of periods remain constant.

The interest rate (or discount rate) and the number of periods are the two other variables that affect the FV and PV. The higher the interest rate, the lower the PV and the higher the FV. The same relationships apply for the number of periods. The more time that passes, or the more interest accrued per period, the higher the FV will be if the PV is constant, and vice versa.

The formula implicitly assumes that there is only a single payment. If there are multiple payments, the PV is the sum of the present values of each payment and the FV is the sum of the future values of each payment.

Part c.

The higher the interest rate, the faster money grows.

In the following example we’ll see that for different interest rates we should deposit different sums of money in order to reach $1,000 in three years.

When the annual interest rate is 10%, $751 must be invested today. When the annual interest rate is 20%, it is sufficient to invest $579 today, and when the annual interest rate soars to 30%, $455 is sufficient.

• When the annual interest rate is 10%, the present value of $1,000 in 3 years is $751.

• When the annual interest rate is 20%, the present value of $1,000 in 3 years is $579 (a decrease).

• When the annual interest rate is 30%, the present value of $1,000 in 3 years is $455 (another decrease).

In conclusion:

As the interest rate increases, the present value decreases.

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