Weekly Home Learning Plan/Tasks

BUSINESS FINANCE 2021-2022

Quarter 2 - Week 1 & 2

Name: _______________________________________ Date Submitted: ___________________

Grade-Strand and Section: ____________________ Score: _____________________________
Teacher: PATRICK R. NAHIAL
DATE LEARNING TASKS
Investment in Bonds

Bond has been introduced in your previous lesson as one of the sources of long-term funds. It has been mentioned that
a business issued bonds to raise necessary funds through borrowing from another party. In this module, bonds are
explained from the perspective of the buyer of the bond, or the so-called investor.
A bond is an unconditional promise to pay:
a. A specified sum of money at a determinable future time; and
b. Its periodic interest is based on the agreement.
Bond can be classified as follows:
1. term bonds
2. serial bonds
3. callable bonds
4. convertible bonds

Term bonds are bonds that have a single maturity date. For example, on January 1, 2018, the business is authorized to
issue bonds amounting to ₱5,000,000 that will mature on December 31, 2018.
Serial bonds are those that have series of maturity dates. These bonds are payable on installments. For example, the
business is authorized to issue on January 1, 2018 5-year, ₱2,000,000 bonds with the following maturity dates:
Day 1 to 14 December 31, 2018 ₱ 400,000
December 31, 2019 400,000
Valuation of December 31, 2020 400,000
Bonds December 31, 2021 400,000
December 31, 2022 400,000

Callable bonds are bonds that can be called in or redeemed by the issuing company prior on the date of maturity. For
instance, the maturity date of the bond is December 31, 2025, but the issuing company may redeem the bonds before
this date. Oftentimes, the redemption price or callable price is higher than the face value of the bonds. For example, the
face value of the bond is ₱1,000, but it may be redeemed at ₱1,100.

Convertible bonds are those that offer the bondholder the right to convert or exchange the bonds prior to their maturity
date with shares of stock. For instance, the ₱1,000 face value bond may be converted into 10 shares of common stock
with par value of ₱100

Nominal Rate and Effective Interest

Nominal rate refers to the interest rate that appears on the face of the bonds. It is usually expressed on an annual basis.
When nominal rate is multiplied by the face value of the bond, the result represents the interest income on the investment.
The investor receives cash interest income based on the nominal rate of the bond as a percentage of the face value.
The average interest rate in the Philippines from 1985 to 2015 is 9.52%, reaching a very high rate of 56.60% in December
1990 and a very low rate of 3.50% in September 2012.

ILLUSTRATION 1.1

On January 1, 2018, Jenny acquires ₱1,000,000 bonds at 10% interest payable semi-annually on June 30 and December
31. The life of the bonds is five years.

Required: Determine the amount of cash inflow every interest payment date.

Answer: The annual cash inflow in the form of interest from bonds for a period of five years is ₱100,000 (₱1,000,000 x 10%,
or semi-annual interest of ₱50,0000 (₱1,000,000 x 5%).
Thus, every June 30 and December 31 starting June, 2018 and five years thereafter, Jenny will receive ₱50,000
cash as interest income from her bond investment
However, the true semi-annual interest may or may not be equal to ₱50,000. The amount depends on whether
the effective interest rate is equal or not to the nominal rate.
In conclusion, to evaluate the true earnings from investment in bonds, one does not have to rely solely on the
amount of cash received every payment date. The interest rate of the bonds must also be determined.

The effective interest rate, otherwise known as yield to maturity or market rate of interest, is the true or actual rate of
interest that investors earn from the investment in bonds. Three factors influence the effective interest rates of the bonds,
namely:
a. real rate of return
b. inflation premium
c. risk premium

The real rate of return represents the interest charged by the investor to the other party for using the money without
considering the eroding effect of the inflationary changes.

The inflation premium is the amount of interest charged by the investor for the effect of inflation while the money is used
by another party. The average inflation rate in the Philippines from 2009 to 2014 is 3.8 percent.

When the real rate of return is combined with the inflation premium, the result is the risk-free rate.
The risk premium represents the risk associated with the investment. It is comprised of business risk and financial risk, among
others.

Business risk is directly related to the inability of the business to maintain stability and growth in its earnings as a result of
losing its competitive position in the market.

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On the other hand, financial risk is directly related to the liquidity problem of the business, that is, not being able to settle
its obligations as they mature.

When the risk premium is added to the risk-free rate, the result represents the required rate of return. It is the rate of return
considered by the investor when investing in bonds. The required rate of return is equal to the effective interest rate or
the yield to maturity rate.

The effective interest rate on bonds, therefore, is computed as follows:

Real rate of return xxxxx
Add: Inflation premium xxxxx
Risk-free rate xxxxx
Add: Risk premium xxxxx
Effective interest rate xxxxx

In the Philippines, only the Banko Sentral ng Pilipinas (BSP) sets the short-run nominal policy rate that serves as the
benchmark for market interest rates. The BSP cannot set the real interest rate since it cannot set inflation expectations.
However, the action of BSP has a tremendous effect on the real interest rate of funds.

Risk and rate of return have a direct relationship in investment. This means that when the risk on investment is high, the
rate of return is high as well. In similar manner, when the risk on investment is low, the rate of return is also low.

ILLUSTRATION 1.2
The average real rate of return is determined at 2.80%. The inflation premium or expectation is determined at 3.40%, and
the risk premium covering both business risk and financial risk is set at 3%.
Required: Compute the risk-free rate and the effective rate of interest.
Answer: The risk-free rate is computed as follows:

Rate of return 2.80%

Add: Inflation premium 3.40%
Risk-free rate 6.20%

The effective rate of interest is computed as follows:

Risk-free rate 6.20%

Add: Risk premium 3.00%
Effective interest rate 9.20%

Valuation of Bonds
Valuation of funds refers to the value of the bonds at the time of investment. It is the amount that the investor is willing to
pay the issuing company. The value of the bonds at the time of investment may or may not be equal to their face value.
The value of the bonds is equal to the market price at the time of investments.
How is market price determined?

The market price of the bond is equal to the sum of the following:
a. present value of cash flows of the principal on maturity date
b. present value of all future cash flows from interest

The basic procedure to compute the purchase price of the bonds or their market value is outlined in the following steps:

Step 1 Compute the present value of the cash flows on principal by applying the present value of single amount. Use
the effective interest rate and not the nominal interest rate.
Step 2 Compute the present value of all cash flows from interest by applying the present value of annuity. Use the
effective interest rate and not the nominal interest rate.
Step 3 Add the results of Steps 1 and 2. The sum is equal to the market price of the bonds at the time of investment.

To reiterate, the value of the bonds at the time of investments is equal to the present value of all future cash flows. The
expected cash flows are coming from:
a. the regular payment of interest based on nominal rate; and
b. the payment of the principal at the time of the bonds’ maturity.

In the most instances, however, the value of the bonds or their market value does not equal their face value. It happens
because the nominal rate on the bonds is not always equal to its effective interest rate.

If the nominal rate appearing on the face of the bond is lower than its effective interest rate (or the effective rate is higher
than the nominal rate), the purchase price or the market price of the bond is lower than its face value.

The difference between the market price and the face value of the bonds is called discount on bonds. Discount on bonds
indicates gain on the part of investor since he/she pays less than the face value of the bonds at the time of investments,
and receives an amount equal to the face value at the time of maturity.

ILLUSTRATION 1.3

Yvone acquires bonds with ₱3,000,000 face value dated January 1, 2018. The bonds have a life of 3 years and earn an
interest of 6% payable annually on December 31. The bonds are acquired at cost of ₱2,845,300 which will yield an 8%
interest rate.

Required: Compute the discount on bonds.

Answer: Since the market price is lower than the face value, the discount is computed as follows:

Rate of return ₱ 3,000,000

Add: Inflation premium 2,845,300
Risk-free rate ₱ 154,700

The discount of ₱154,700 represents a gain for Yvone. She invested ₱2,845,300 but will receive ₱3,000,000 after three years,
notwithstanding the amount of annual interest ₱180,000. It can be observed that the effective interest rate is higher than
the nominal rate of interest.

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If the nominal rate of the bond is higher than the effective interest rate (or the effective rate lower than the nominal rate),
the market price of the bond is higher than the face value.

In this situation, the difference between the market price and the face value of the bond is called bond premium. Bond
premium is a loss to the investor since the amount of money to be received in the future, which is equal to the face value,
is less than the amount of money invested.

ILLUSTRATION 1.4

On January 1, 2018, Nicanor has acquired bonds with ₱3,000,000 face value for ₱3,210,500. The bonds bear an interest of
8% payable semi-annually on June 30 and December 31. The life of the bonds is four years. The bonds will yield an effective
interest rate of 6%.

Required: Compute the premium on bonds.

Answer: Since the purchase price of the bond amounting to ₱3,210,500 is higher than its face value of ₱3,000,000, there
is a premium of ₱210,500.
The premium of ₱210,500 on bond investment represents a loss for Nicanor since he has invested ₱3,210,500 but
will receive only ₱3,000,000 at the time of maturity.

Market Price Computation

In the two preceding illustrations, the purchase price or the value of the bonds which is equal to its market value has been
given. However, by applying the present value of single amount and the present value of annuity, the market value of
the bonds can also be determined. The computation appears as follows:
Market price of bonds in Illustration 1.3:
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1 1−((1+𝑟𝑟)𝑛𝑛)
𝑃𝑃𝑃𝑃 = 𝐹𝐹𝐹𝐹 𝑥𝑥 𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑥𝑥
(1+𝑟𝑟)𝑛𝑛 𝑟𝑟

Present value of ₱3,000,000

₱3,000,000 x 1÷ (1.08)3 or ₱3,000,000 (0.7938) ₱ 2,381,400

Present value of ₱180,000 annuity

₱180,000 x [1 – 1÷ (1.08)3] ÷ 0.08 or
₱180,000 x (2.5771) 463,878
Market price of the bond ₱ 2,845,278

The market price or the purchase price of the bonds in illustration 1.3 is rounded off, for simplification, to ₱2,845,300.
Market price of bonds in Illustration 1.4:

Present value of ₱3,000,000 for 8 periods

₱3,000,000 x 1÷ (1.03)8 or ₱3,000,000 (0.7894) ₱ 2,368,200
Present value of ₱120,000 annuity
₱120,000 x [1 – 1÷ (1.03)8] ÷ 0.03 or
₱120,000 x (7.0197) 842,364
Market price of the bond ₱ 3,210,564

The market price or the purchase price of the bonds in illustration 1.4 is rounded off to ₱3,210,500.

ILLUSTRATION 1.5

On January 1, 2018, Angel has purchased bonds with ₱5,000,000 face value and with the following additional information:

Date of bond issuance January 1, 2018

Date of bond maturity January 1, 2022
Nominal interest rate 10%
Effective interest rate 9%
Payment of interest Quarterly

Required: Compute the purchase price or the market price of the bonds.
Answer: The market price or purchase price of the bonds is equal to the present value of cash inflows arising from interest
payment and the payment of the principal.

The life of the bonds is four years. Since the interest payment is quarterly, the total number of interest date is 16
(4 years x 4). The periodic effective interest rate is 2.25% (9% ÷ 4). From this data, the market price of bonds is computed
as follows:

Present value of ₱5,000,000 at 2.25% for 16 periods

₱5,000,000x 1÷ (1.0225)16 or ₱5,000,000 (0.7005) ₱ 2,368,200

Present value of ₱125,000 annuity at 2.25%

₱125,000 x [1 – 1÷ (1.0225) 16] ÷ 0.225 or

₱125,000 x (13.3126) 1,664,075
Market price of the bond ₱ 5,166,575

There is a bond premium of ₱166,575 on the investment since the effective interest rate is lower than the nominal interest
rate. This amount represents a loss for the investor.

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 Written Task #1: PROBLEM SOLVING

Direction: Read the problem carefully and solve the required data. Use separate sheet of paper for your answers.
(10 points each)

PROBLEM 1

The real rate of return of JENNY Corporation has been averaging at 3.2% for the past 6 years. The risk premium
associated with investment on JENNY’s bonds has been determined at 2.9% Statistics indicated the inflation rate will reach
3.9%
Required: Determine the following

1) Risk-free rate of bond investment

2) Bond effective interest rate

PROBLEM 2

The bonds of YVONE Corporation are selling in the market at an effective interest rate of 12%. Investors are risking
their investment on YVONES’s bonds at rate of 3.3%. Statistics revealed that inflation rate is expected to remain AT 3.7%.
Required: Determine the following:
1) Risk-free rate of bond investment
2) Real rate of interest bonds

PROBLEM 3

Nicanor plans to invest on bonds with a ₱4,000,000 face value on January 1, 2018. The bond has a life of 4 years
starting January 1, 2018 and pays an interest rate of 7% semi-annually every June 30 and December 31. The bonds’
effective interest rate is 8%.

Required: Determine the following:

1) Expected market price of the ₱4,000,000 bonds
2) Amount of premium or discount on bond investment

PROBLEM 4

Angel is considering investing in bonds. Some data are as follows:

Face value of bonds ₱5,000,000.00

Date of bond issuance January 1, 2018
Date of bond maturity January 1, 2023
Interest payment date Semi-annual
Nominal interest rate 9%
Effective interest rate 12%

Required: Compute the following:

1) Expected market price of the ₱5,000,000 bonds

2) Amount of premium or discount on bonds

PROBLEM 5

Princess is investing on 4-year ₱4,000,000 bonds with an interest of 14% on January 1, 2018. The bonds will yield
an effective interest rate of 12%. Interest on the bonds is payable every quarter.

Required: Compute the following:

1) Expected market price of the ₱4,000,000 bonds

2) Amount of premium or discount on bonds

Check the box:

 Completely done.
 Incompletely done. Reason: _______________________________________________________________________

____________________________
Parent’s Signature

Comments and Suggestions for week 1 & 2:

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Parent’s Signature

Prepared by: Checked by: Reviewed by: Noted by:

PATRICK R. NAHIAL EVELYN A. LAZO ALMIDA T. CAMITAN MILDRED M. DE LEON

Teacher III Master Teacher II Head Teacher IV Principal III
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