BUSINESS FINANCE

MODULE 5
Basic Long Term Financial Concept

Time Value of Money

“A peso today is worth more than a peso tomorrow”. All individuals and businesses face the same two basic finance-
related problems:

1. Where to put the money?

2. Where to get the money?

The first problem is called the “investment” decision; the second, the “financing” decision. In addressing the investment
problem, individuals and companies choose from a wide range of real and financial assets. They can opt to put their funds in
real states that represent their various projects. Real asset investments include purchasing equipment and machinery with the
purpose of generating revenues across the useful lives of these assets. This could also take the form of adding a new wing
to their office building or factory. The acquisition on license brands is also considered a real asset investment. Financial assets
include investing in the shares of another company. Lending money to others and purchasing fixed income instruments such
as government-issued Treasury securities and corporate bonds are also considered financial investments.

A common characteristic of this investment is that, most of the time, the expected returns from these assets do not happen
overnight or even within the current year. Cash flows related to these assets occur at multiple time periods and may happen
over an extended period of time.

Addressing the financing problem requires businesses to seek out funding sources such as equity infusion by investors
or borrowing from financial institutions such as banks. The cash inflows in acquiring the funds and outflows related to the
payment of dividends to the owners and the repayment of principal and interest to creditors are likely to occur in the long term.

Because cash flows occur at extended periods of time, the time value of money must be considered in making the
appropriate investment and financing decision. Individuals prefer to receive a peso now instead of later because of the
following main reasons: (a) it can invest the peso now and earn a return from this investment (b) a peso expected to be
received in the future is the riskier and less certain. We consider the time value of money to make these cash flows
comparable. We either determine their future value at a common future date or compute for their present value today so as
not to compare “apples” against “oranges”.

The Concept of Interest

When you deposit money into a savings account at a bank you expect the bank to pay you additional money on top
of your saving. The extra money is called interest. Interest is also paid by borrower to a lender for the loan borrowed.

The most basic finance-related formula is the computation of interest is computed as follows:
I=PxRxT

where:
I = Interest
P = Principal
R = Interest Rate
T = Time Period
There are two methods to calculate interest:

Simple Interest
is a method to calculate the amount of interest charged on a sum at a given rate and for a given period of time. If the interest
earned or incurred is always based on the original principal, then simple interest is assumed.

Simple Interest is calculated using the following formula Where:

S.I = Simple Interest
P = Principal
R = Rate
T = Time

S.I = P x R x T

Compound Interest

is a method to calculate the amount of interest charged on a sum at a given rate and for a given period of time. If
the interest earned or incurred is always based on the original principal, then simple interest is assumed
The usual assumption in most business transactions is to use compound interest. Compound interest is simply
earning interest on interest. This means that the basis for the computation of that applicable interest for a certain period is
not only the original principal but also any interest earned in the previous period assuming all cash flows would be paid or
received in lump sum of a maturity.
The formula for Compound interests where:
C= Compound Interest
P= Principal amount
I= Interest
T= Time

C = P x (1 + I) - P