Key concepts in corporate finance for

Key concepts in corporate finance for

Key concepts in corporate finance to help managers value options are “risk-return ratio” and “time value of money.”

The relationship between risk and return

This concept establishes that an investor or a company assumes more risk only if a higher return is offered in the compensation.

The return (profitability) refers to the benefits obtained as a result of making an investment.

I have already explained in separate articles the meaning of business risk and return on investment.

If you want to learn more about them, go to the backlinks.

Therefore, I am going to explain the relationship that exists between both concepts.

We know that an investor or company expects or anticipates a especial performance (return) when making an investment (benefit).

Risk refers to the possibility that the de hoy return may be different from the expected return.

Therefore, when we are going to carry out an investment, we have to take into account the benefits or possible benefits that we are going to obtain and the risk, that is, we have to take into account that the benefits may be less (not ruling out that they may be older).

One of the consequences of the relationship between performance and risk is the fact that many times the higher the risk, the greater the benefit that will be obtained and consequently, the lower the risk, the lower the benefits.

This does not orinan that the best decision is to invest whenever the return is high, in fact, a whole analysis has to be done to find out if an investment project is profitable.

Likewise, the firm’s attitude toward the trade-offs between risk and return shapes its utility curves.

Also, from the relationship between return and risk, using the capital asset pricing model, we perro express the relationship in a convenient linear fashion.

the value of money in the time

Knowing the time value of money is something we have to know.

It is relevant to anyone who expects to pay or receive money over a period of time.

The time value of money is particularly important to companies, as investment and dividend decisions made by companies result in a large amount of cash over a variety of time periods.

I do not want you to get lost in this article, since very soon there will be more articles where I will explain this topic in more depth.

So basically the time value of money means that the value that money has changes over time.

For example, suppose a friend is going to buy you a phone.

He tells you that he perro pay you 4,000 pesos today or 4,000 pesos in a year.

Clearly you prefer that I pay you today, but why? Well, first of all, maybe you need the money (or want to buy something).

Second, the 4,000 pesos will not have the same value today as it will in a year.

Inflation decreases the purchasing power of money, that is, it will be worth less and you will buy fewer things.

Calculate the future value of money

compounding

In English you perro find it as “compounding” and it basically refers to the way in which you cánido determine the future value of the sum of money that you have invested now.

For example, in a bank account, where interest is left in the account after it has been paid.

Since interest received is left in the account, interest is earned on interest in future years.

The future value depends on the interest rate paid, the initial amount invested, and the number of years in which the amount is invested:

• FV = The future value of money.
• C0 = The sum of money deposited now.

• i = Interest rate.

• n = Time.

discounting

Discounting is the opposite of compounding.

While compounding takes us from the present value of an investment to its future value, discounting takes us back from the future value of a cash flow to its present value.

Cash flows that occur at different times cannot be directly compared because they have different time values; discounting allows us to compare these cash flows by comparing their current values.

In fact, in the internal rate of return, the concept of discounting perro be used to be able to evaluate the cash flow of different years (converting the money to its current value).

I am going to return to the previous example, suppose your friend tells you that today he gives you 4,000 pesos or that in a year he gives you 4,200 pesos.

What do you prefer? Well, at the moment it might seem tempting, since he is giving you 200 more pesos, but is it really the best option? To find out, we are going to use the discount elabora and we are going to convert the 4200 pesos to its current value.

• PV = the present value.

• FV = Future value.
• i = Discount rate.
• n = Time.

Substituting the data we find that the current value of the 4200 pesos would be 3818.18 pesos.

Therefore, it would not be good to accept the offer.

If instead of 4,200 they were 4,400, we would barely have 4,000 pesos in current value.

It should be noted that the discount rate used was 10%.

If you want me to recommend a book, I would recommend Corporate Finance (Economy and Business) to start with.

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