Chapter 5 Basic Long Term Financial Concepts

5.
Basic Long-term
Financial Concepts
Mr. Christopher B. Cauan

Business Finance
Learning Objectives ------------------------------------------ .
. .
. This chapter aims to achieve the following: .
.
discuss relevant long-term financial concepts to help .
. the student brainstorm creative ideas on small business .
. and finance, and .
. .
. Introduce and discuss the finance concepts of future .
. value, present value, effective annual rate, loan
.
. amortization, investments, risk and return, plus other
.
relevant concepts in finance.
. .
. .
. .
---------------------------------------------------------------------------

Business Finance
Time Value of Money and Opportunity Cost
The concept of time value of money states that a peso today, all
things equal, has a greater value than a peso in the future
because of the opportunity to invest that peso today and earn
interest.
Choosing one option means letting go of the other option.
This concepts holds true when spending your money because it is

a limited resource. You cannot spend money and save money at
the same time.
Therefore, opportunity cost is anything given up after choosing
an option. In finance, it is the possible income from one option
or investment opportunity given up.

Business Finance
Good Money Management is a decision to invest either in money
market, fixed-income securities, stocks, bonds, real state, or in
small business venture.
How do you determine the amount of interest that you will earn?
You deposited ₱ 10,000 in a savings account.

The bank pays an interest of 3% annually.
How much interest will the account earn in one year?
Formula:
Principal x annual interest rate x time = Interest earned for one
year
₱10,000 x 0.03 x 1= ₱300
Account earned for one year
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5.1 Future Value
and
Present Value

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What is Future Value?
The future value of money is the amount your original funds will
be worth in the future, based on earning an interest rate over a
time period.
Principal x interest = interest amount

interest amount + Principal = new amount
new amount x interest = interest amount
Future Value is also known as compounding which makes

money increase over time, given a certain interest rate.

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Formula:
FVn = PV(1+i) n
where: FV = future value in n period

PV = present value or the money invested today
i = interest rate
n = number of periods

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Example
You deposit ₱10,000 in a savings account.
The account pays 3% annual interest.
How much will the account earn after two years?
Solution:
Year 1: (₱10,000 x 0.03) = ₱300.00
Year 2: (₱10,000 + ₱300) x 0.03 = ₱309.00
Using the formula, FVn = PV(1+i) n

FVn = ₱10,000 (1 + 0.03) 2 = ₱10,609.00
* the future value of your original money at the end of the
second year is ₱10,609.00

Business Finance
Year Principal Interest New amount
1 10,000.00 300.00 10,300.00
2 10,300.00 309.00 10,609.00
3 10,609.00 318.27 10,927.27
4 10,927.27 327.82 11,255.09
5 11,255.09 337.65 11,592.74
6 11,592.74 347.78 11,940.52
7 11,940.52 358.22 12,298.74
8 12,298.74 368.96 12,667.70
9 12,667.70 380.03 13,047.73
10 13,047.73 391.43 13,439.16
Rate: 3%

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What is Present Value
Present Value is today’s worth of future money.
Present Value is determining today’s worth of this future value
(investment + earned income) which is also called as
discounting.
Today Year 1 Year 2
₱ 10,000.00 ₱ 10,609.00
Present Value Future Value
Formula:
PV = FV n (1+i) n
where: PV = present value ; FV = Future value in n period
n = number of period ; i = interest rate
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Why do we need to compute for Present Value?
Present Value will tell you the initial amount of money required
to achieve your target return at a given interest rate at a certain
number of periods.
Comparison of the present value of one investment to another

investment.
Computing the return of investment based on interest rate will

help an investor decide which investment to choose from.

Business Finance
Factors that determine the present value of an investment
include:
1. The rate that the market gives.

2. The cash flows expected.
3. Number of periods these cash flows will continue.

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5.2 Nominal and Effectiv
Interest Rates

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Nominal interest rate or sometimes called annual interest rate
or quoted rate indicates the interest rate paid or earned in one
year without compounding. It is commonly known as simple
interest rate.
On the other hand, the effective annual rate is also known as

effective interest rate indicates the compound interest rate paid
or earned in one year. This is the true amount of interest you
pay or earn in one year.

Business Finance
Below illustrates the nominal and effective interest rates in action.
If you deposit ₱1,000 in a savings account, how much interest will you
earn for two years?
a. using 4% annual percentage rate
b. using 4% interest rate compounded monthly
A. Annual percentage rate

Principal x rate x period = interest earned
Year 1 : ₱1,000 x 0.04 x 1 year = ₱40.00
Year 2 : ₱1,000 x 0.04 x 1 year = ₱40.00
The total interest earned for two years is ₱80.00

Business Finance
B. Effective annual rate
Principal x annual interest rate

i. = Interest earned for the
1st month
12
₱1,000.00 x 0.04
= 3.33
12
(Principal + Previously Earned Interest) x Annual Interest rate

ii. Interest earned
= for a given
12
month
(₱1,000.00 + 3.33) x 0.04

= 3.34
12

Business Finance
Illustration for one year
MONTHLY CALCULATION
Month P +I Interest Interest earned
1 1,000.00 4.00% 3.33
2 1,003.33 4.00% 3.34
3 1,006.67 4.00% 3.36
4 1,010.03 4.00% 3.37
5 1,013.40 4.00% 3.38
6 1,016.78 4.00% 3.39
7 1,020.17 4.00% 3.40
8 1,023.57 4.00% 3.41
9 1,026.98 4.00% 3.42
10 1,030.40 4.00% 3.43
11 1,033.83 4.00% 3.45
12 1,037.28 4.00% 3.46

Business Finance
Calculate for the second year
MONTHLY CALCULATION
Month P +I Interest Interest earned
13 1,040.74 4.00% 3.47
14 1,044.21 4.00% 3.48
15 1,047.69 4.00% 3.49
16 1,051.18 4.00% 3.50
17 1,054.68 4.00% 3.52
18 1,058.20 4.00% 3.53
19 4.00%
1,061.73 3.54
20 1,065.27 4.00% 3.55
21 1,068.82 4.00% 3.56
22 1,072.38 4.00% 3.57
23 1,075.95 4.00% 3.59
24 1,079.54 4.00% 3.60

Business Finance
At the end of the two years, you will have ₱83.14 (₱1,000 +
83.14). You earned ₱83.14 in compounded interest for the two
years.
nm
i
FV = PV 1 +
m
where: FV = future value in n period

PV = present value or the money invested today
i = interest rate
m = number of compounding periods per year
n = number of years

Business Finance
Solution using the formula:
nm
i
FV = PV 1 +
m
0.04 2(12)
= ₱ 1,000 1 +
12
24
= ₱ 1,000 (1.003333333)
= ₱ 1,000 (1.083142959)
= ₱ 1,083.14 the future value of your
money at the end of the two
years

Business Finance
5.3 Loan
Amortization/
Installment Loan

Business Finance
Example:
Claudia Buenavista is a single working mom. She has been

employed by a retail mall for a little over a year and wants
to purchase an appliance through a bank loan available to
her.
How much should she budget for the loan amortization of
this purchase?
How will she know how much to pay?

Business Finance
Illustration:
Installment loan amount: ₱10,000
Installment term: 12 months
Monthly add-on rate: 1.50%
Monthly effective interest rate: 2.643%
Monthly factor rate: 0.0983333
Installment Loan Payment
Loan amount: ₱10,000 (1.50% x 12) + 1 = 1.18
Installment term: 12 months 1.18/12 = 9.83%
Monthly Rate: 1.50%
Monthly Effective: 2.643%
Monthly factor rate: 0.0983333
Business Finance
The monthly factor rate is used to determine the amount of
payment for the loan on a monthly basis (principal + interest).
Every month, the amount below is paid.
₱10,000.00 x 0.0983333 = ₱983.33 (a)
The amount of interest paid on the loan is determined by using

the monthly effective interest rate. Of the total amount paid
monthly above, the monthly interest is computed as follows:
₱10,000.00 x 0.02643 = ₱264.30 (b)

Business Finance
The amount of the principal is determined by subtracting the
interest payment (b) from the principal payment (a). This bank
product will vary from the bank to bank credit standing.
₱983.33 - ₱264.30 = ₱719.03
The amount above is used to compute the new outstanding

principal which becomes smaller, each monthly, until the entire
loan is fully paid.
These helps you make full use of credit opportunities available to
you.
A necessary purchase can in time be fully paid with discipline
and perseverance.

Business Finance
TOTAL PRINCIPAL INTERES OUTSTANDIN
PAYMENT T 43
G
02 6
x 0.
2 643 10,000.00
.0
x0
1 983.33 719.03 264.30 9,280.97
2 983.33 738.03 245.30 8,542.94
3 983.33 757.54 225.79 7,785.40
4 983.33 777.56 205.77 7,007.84
5 983.33 798.11 185.22 6,209.73
6 983.33 819.21 164.12 5,390.52
7 983.33 840.86 142.47 4,549.66
8 983.33 863.08 120.25 3,686.58
9 983.33 885.89 97.44 2,800.70
10 983.33 909.31 74.02 1,891.39
11 983.33 933.34 49.99 958.05
12 983.33 958.05 25.32 0.00
Business Finance
5.4 Applying Business
Concepts in Financial
and Investment
Problems

Business Finance
One of the most effective ways to understand the basic
concepts of finance is through personal finance.
How does one source his funding?

create a budget
monitor the budget
and control his costs
….. to ultimately maximize his revenues and reduce his
expenses.

Business Finance
Plan Your Budget Now
The Teenager’s Personal Budget

Budget for the Month ₱4,000
Daily Allowance ₱200
Daily cost for lunch ₱75 ₱1,500
Others ₱900
Savings monthly ₱1,600
Savings yearly ₱19,200
Savings, 3 years ₱57,600
If invested in the stock market, how much will ₱50,000

grow?
Business Finance
Assuming that in a period of 10 years, the stock market will
grow 3.5 times, from an index of 2,000 to an index of 7,000,
your ₱50,000 investment could potentially reach ₱175,000
in the same time frame.
Personal Investments
The Various Investments Portfolio Types: Which one are

you?
 What is the age of the investor?
20s – 30s he can afford to take more risks with his
investments, going for more percentage allotted to stock
investment returns tend to be higher, however longer term.

Business Finance
30s – 40s married, with perhaps two kids, he will now
have to temper his risk taking as he now will have monthly
requirements given that he is keeping house with a family. He
will need to allot more to fixed income securities that give
regular cash flows to cover monthly expenses – food, tuition
and fees, rent, water, and electricity. However, still keep some
of his stock investments, albeit with a lower exposure.
40s – 60s he becomes more conservative with his

investments and becomes more risk averse means less stock
investments exposure (10%), with the rest of his investments in
money market instruments, fixed income securities, bonds –
both for corporate and government.

Business Finance
60s he may want to keep his entire investments in fixed
income and shorter to medium-term duration. This is because
at this stage of his life, he may need more monthly income
requirements, usually food, medicine, water, and electricity.
 Other considerations include:

 Gender: Is the investor male or female?
 Civil Status: Is the investor single or married?
 Does he have children, dependents?
 Where does his income come from?
 What is his objective for investing?
 to afford luxury vacations
 to be able to send his children to school
 to start saving up for retirement
Business Finance
Money market, fixed-income securities and bonds
An investment portfolio that consists of money market
instruments, fixed-income securities, and bonds are for
investors that are conservative.
Conservative investors are usually older, more mature, and
have dependents or a family to take care of.
He would likely be looking for a fixed amount of income to

generate regularly because he has regular monthly bills to
pay for – rent, car, groceries, medicines, transportation
costs, electricity, and children’s education.

Business Finance
Stocks
Stocks investors are more aggressive investors. They are

younger and do not have dependents yet. Their investment
horizon or timetable for expecting investment returns is
longer and, hence, stock investors have the luxury of time to
wait for stock markets to recover in case they have gone
down temporarily.
Unlike the conservative investor, stock market investors do

not necessarily need a monthly income.

Business Finance
A combination of fixed-income and stocks
Investors who will design a more balanced investment
portfolio will have another set of investment profit and
investment risk appetite.
He will most likely be middle aged, with a small family
depending on him, hence, his need for a regular and fixed
income stream.
Being young however, he can afford to be partially
aggressive, time on his side, and hence capable of investing
in the stock market and riding the waves that go up and
down.

Business Finance
Real estate
Investors who like real estate may be categorized under
“old school” or traditional. Wealthy families hold on to
more tangible assets like real estate, and in the Philippines
many still consider real estate as reliable and stable.
These are the several advantages and disadvantages to

investing in real estate.
Advantages
1. Hedge against inflation. Real estate investments can be used

to hedge against inflation.

Business Finance
This means that when the prices of goods and commodities
move up, the purchasing power of the consumer goes down,
or he can afford less now than before.
Having real estate investments, the value overtime will

increase and his real estate proceeds.
Selling them can cover expenses that he has consumed over
time.
2. Rent income. Real estate investments may provide you with
regular rent income, or cash flows.
This can be leased or rented. The property can either to put

up as commercial business, to rent it out, or to use it
warehouse his business inventory.
Business Finance
3. They are real and tangible properties, assets owned by the
investor or by the business. Assets that can be sold to pay
off the debts of the investor or the debts of the business.
Disadvantages
1. Real estate investments are illiquid investments. They

cannot easily be converted into cash.
It may take months or years to sell a property, and hence,
their conversion to cash or cash flows may limit the investor.
While these assets are not yet liquidated, the owner’s debts
are increasing due to interest rates.
Business Finance
2. Although they offer some protection against inflation, real
estate investments may also experience a decline in value.
When inflation goes down, the price of everything else goes

down, the value of real estate investments may also go down
and, therefore, selling the property for less than the acquired
amount.
This can be very dangerous to the real estate investor

because of being too dependent on the real estate’s value to
increase and cover his debts.

Business Finance
3. Lack of diversification. Because real estate investments are
expensive, investor can only invest in one or two properties.
This means that the investor loses his opportunity to invest

in other types of investments or securities that offer better
features like liquidity.
4. Management and operating expense issues come with real
estate investments. This pertains to looking for reliable
tenants, incurring operating expenses in maintaining the
property like replacing worn our carpeting or keeping the
garden in order, or fixing the bathroom tiles.
Other investment outlets do not carry this burden.

Business Finance
The Entrepreneur
A business has real assets such as inventories, plant, and
equipment.
A business also incurs debts and obligations for operations;
uses financial instruments to finance its expansion; and uses
marketable securities to increase its revenues and finance its
operations.
The financial statements are the report card of the business.
The statements of a business include:
 The income statement that shows the earnings of business. It
reports the revenues and costs and expenses of a business
during a period of time.
 The balance sheet that shows the assets and liabilities of the
business and its owner’s equity.
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Setting up a business is the most risky choice of investing.
It means:
 Knowing why you are in business and what you are in
business for;
 Setting goals and targets and achieving them on time;
 Knowing the right people to hire and knowing how to

motivate them to achieve your targets as a business ;
 Delivering the goods and services of your customers;
 Keeping costs down; and

 Keeping the company profitable and sustainable.

Business Finance
Learning Objectives
Introduce and discuss the finance concepts of future value,
present value, effective annual rate, loan amortization,
investments, risk and return, plus other relevant concepts in
finance.
Activity #4
Instructions:
Proceed to your respective group (business group).
With regards to your own business, brainstorm with your group
mates and discuss the possible risks your business is facing now
or in the future.
Give at least three risks and discuss it in class for 3 minutes per
group.

Business Finance
RUBRIC
Group Effort 5
Content 10
Presentation 5
Total 20 points

Business Finance
5.5 The Risk-Return
Tradeoff

Business Finance
Risk-return tradeoff explains that there is commensurate
return for every risk a business owner or investor takes.
The common business term “the greater the risk, the greater
the potential return,” or “no pain, no gain.”
An example of a situation for a risk-return tradeoff:

1. A business can enhance its profitability by carrying less cash
and marketable securities since these earn very low rates in
the market;
2. The funds, instead, are put into more risk, such as a higher
investment in inventories that can generate more sales for
the company;

Business Finance
3. If the company is able to sell more from this inventory, then
it is able to generate more return for the risk it entered to;
4. However, the tradeoff can be complex: inventory does not

generate sales due to economy slowdown and quality of
product; less stable cash to pay short-term loans for the
additional inventory; and
5. The higher the risk the business takes, the higher the
potential to earn, as well as the potential to lose leading to
delay of short-term debts payments.

Business Finance
Challenges that a business owner is facing today because of the
growing knowledge, technology and changing markets:
 International conflicts/events
 Extreme weather events
 Failure of national governance
 State collapse or crises
 Unemployment and underemployment
 Natural catastrophes
 Failure of climate change adaptation
 Water crises
 Data fraud or theft
 Cyber attacks, computer hackers

Business Finance
End
of
Chapter 5

Business Finance

Chapter 5 Basic Long Term Financial Concepts

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5.

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

Choosing one option means letting go of the other option.

This concepts holds true when spending your money because it is

Mr. Christopher B. Cauan

You deposited ₱ 10,000 in a savings account.

Mr. Christopher B. Cauan

Principal x interest = interest amount

Future Value is also known as compounding which makes

Mr. Christopher B. Cauan

where: FV = future value in n period

Mr. Christopher B. Cauan

Using the formula, FVn = PV(1+i) n

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

Today Year 1 Year 2

Comparison of the present value of one investment to another

Computing the return of investment based on interest rate will

Mr. Christopher B. Cauan

1. The rate that the market gives.

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

On the other hand, the effective annual rate is also known as

Mr. Christopher B. Cauan

A. Annual percentage rate

The total interest earned for two years is ₱80.00

Mr. Christopher B. Cauan

Principal x annual interest rate

(Principal + Previously Earned Interest) x Annual Interest rate

(₱1,000.00 + 3.33) x 0.04

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

where: FV = future value in n period

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

Claudia Buenavista is a single working mom. She has been

Mr. Christopher B. Cauan

₱10,000.00 x 0.0983333 = ₱983.33 (a)

The amount of interest paid on the loan is determined by using

₱10,000.00 x 0.02643 = ₱264.30 (b)

Mr. Christopher B. Cauan

₱983.33 - ₱264.30 = ₱719.03

The amount above is used to compute the new outstanding

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

How does one source his funding?

Mr. Christopher B. Cauan

The Teenager’s Personal Budget

If invested in the stock market, how much will ₱50,000

The Various Investments Portfolio Types: Which one are

Mr. Christopher B. Cauan

40s – 60s he becomes more conservative with his

Mr. Christopher B. Cauan

 Other considerations include:

He would likely be looking for a fixed amount of income to

Mr. Christopher B. Cauan

Stocks investors are more aggressive investors. They are

Unlike the conservative investor, stock market investors do

Mr. Christopher B. Cauan

Mr. Christopher B. Cauan

These are the several advantages and disadvantages to