Report in Business Finance

Learning Competencies

1. Calculate Future value of money

2. Calculate Present value of money
3. Compute for the effective annual interest rate
4. Make a short assessment regarding Future and Present Value of money
5. Compute Loan Amortization using mathematical concepts
6. Compute loan amortization using the present value tables
7. Apply mathematical concepts and tools in computing for finance problems
8. Apply mathematical concepts and tools in computing for investment problems
9. Explain the Risk-return trade-off
10. Short assessment regarding the Basic Long-term Financial Concepts
 Future Value of Money
(Equation 5.2)

Value at the end of year 1 = P10,000 + (P10,000 x 9% x 1 year)

P10,900 = P10,000 x (1 + 9%)

We, therefore, say that given an interest rate of 9% the future value of P10,000
after 1 year is P10,900

Similarly, the future value of the P10,000 at the end of year 2 will be equal to the
value at the end of year 1 plus the compound interest earned in year 2 as shown below:

Value at the end of year 2 = P10,900 + (P10,900 x 9% x 1 year)

P11,881 = P10,900 x (1 + 9%)

P11,881 = P10,000 x (1 + 9%) x (1 + 9%)

P11,881 = P10,000 x (1 + 9%)

The Future value then at the end of year 3 is determined as follows:

Value at the end of year 3 = P11,881 + (P11,881 x 9% x 1year)

P12,950.29 = P11,881 x (1 + 9%)

P12,950.29 = P10,000 x (1 + 9%) x (1 + 9%)

P12,950.29 = P10,000 x (1 + 9%) x (1 + 9%) x (1 + 9%)

P12,950.29 = P10,000 x (1 + 9%)

The future value of 10,000 invested for 3 years at a rate of 9% is equal to

12,950.29.

Therefore, we use the general formula below to determine the future value:

Future Value = Initial Value x (1 + R) ^T

Where:

R= Interest Rate

T= Time Period
 To get the future value, we multiply the initial value by (1 + R) ^T which is
referred to as the future value interest factor (FVIF).

A future value table can be developed using the above formula. Simply find the
intersection of the relevant time period (T) presentedinthe rows of the table and the
relevant interest rate (R) presented in the columns of the table.

Using our example, the FVIF given 3 years and a rate of 9% is equal to 1.2950.
This is the intersection of time period =3 and interest rate =9% in the FVIF table.

This is equal to (1 + 9%) = 1.2950 (rounded off to 4 decimal places).

To get the future value of our example:

P12,950.29 = P10,000 x (1 + R) ^T

P12,950.29 = P10,000 x (1 + 9%)

P12,950.29 = P10,000 x 1.2950

Future Value Interest Factor (FVIF) = (1 + R) ^T
 Present Value of Money
To make cash flows comparable, we either determine their future value at a common
future data or compute their present value today. Most decision makers choose to
get the present values since the decisions are made today.

To get the present value of a lump-sum amount, we go back to equation 5.2:

Future Value = Initial Value x (1 + R) ^T

The future value in the formula is the expected lump-sum amount while the initial
value is actually the present value. Rearranging equation 5.2 gives us the formula
for the present value of money:

Present Value = Future Value

(1 + R)^T

(Equation 5.3)

Present Value = Future Value x __1__

(1 + R)^T

To get the present value, we multiply the future lump- sum amount by 1 / (1 + R)^T
which is referred to as the present value interest factor (PVIF). The PVIF is also
called the discount factor and the whole process of determining the present value is
referred to as discounting. The nterest rate used to get the present value is denoted
as the discount rate.

For example, your father told you that he will entrust you with the funds for your
graduate program education. He gave you two options: (1) receive the money now in
the amount of P200,000 or (2) receive P500,000 ten years from now. The available
investment opportunities to you provide a 10% rate of return. Which option would
you prefer?

To address this dilemma, you either determine the future value of the P200,000 and
compare it with the expected cash flow of P500,000 ten years from now, or compute
the present value of the P500,000 and compare it to the P200,000 which youcan
receive today.

Choosing the second method will require you to get the present value of the
P500,000 as shown below:
 Present Value = Future Value

(1 + R) ^T

= __P500,000__

(1 + 10%) ^10

Present Value = P192, 771.64

P192,771.64 < P200,000

Since the P200,000 is greater than P192,771.64 (the present value of the
500,000), you will choose to receive the P200,000 today instead of waiting for it in ten
years time. Getting it now will give you the opportunity to grow the investment at a rate
of 10% and the related future value is expected to be greater than the P500,000. To
validate this, we compute for the future value of the P200,000:

Future Value = Present Value x (1 + R) ^T

= P200,000 x (1 + 10%) ^T

Future Value = P518, 748.50

P518,748.50 > P500,000

A present value table can also be developed using the present value interest
factors. Simply find the intersection of the relevant time period (T) presented in the rows
of the table and the relevant interest rate (R) presented in the columns of the table.

Using our example, the PVIF given 10 years and a rate of 10% is equal to
0.3855. This is the intersection of time period = 10 and interest rate = 10% in the PVIF
table.

This is equal to ____1____ = 0.3855 (rounded off to four decimal places).

(1 + 10%) ^10

To get the present value of our example:

P192,750 = P500,000 x 0.3855

P192,750 - P192,771.64

How do you decide if you are taking the point of view of the person disbursing
money? In this case you will choose the cheaper option or the one with the lower
present value.
 For example, your schools annual tuition fee is P100,000 per year If you pay at
the start of the school year. Another option is to pay for the tuition fee at the end but as
a higher amount of P110,000

Let us say that the prevailing interest rate is equal to 12%. To make tha cash
flows comparable, we compute for the present value of the P110,000:

Present Value = P110,000

(1 + R) ^T

= P110,000

(1 + 12%)

Present Value = P98,214.29

The present value of P110,000 is equal to P98,214.29 which is cheaper the

paying P100,000 at the start of the school year. So, if you forego paying at the start, you
can invest the P100,000 for one year at a rate of 12%. This will grow to P112,000
(P100,000 x 1 + 12%) after a year which is more than enough to pay for the required
P110,000 payment at the end of the year.

Will your decision be different if the interest rate is at 8%? The present value of
the P110,000 is:

Present Value = P110,000

(1 + R) ^T

= P`110,000

(1 + 8%)

Present Value = P101,859.90

P101,859.90 is more expensive than the P100,000 option at the start of the school year.
At an interest rate of 8%, you should choose to pay the P100,000 immediately instead.
If you insist on paying at the end, then your P100,000 will grow to P108,000 (P100,000
x 1 + 8%) which is not enough to cover for the required payment of P110,000 at the
end.
 Effective Annual Interest Rate
Interest rates are normally quoted as annual rates but the compounding frequency
may differ per transaction. This means that if the annual rate is 12% but
compounding is done more frequently, for example every quarter, then the effective
annual rate is higher than 12%. To determine the effective annual rate, the following
formula is used:

(Equation 5.6)

Effective Annual Rate = (1 + R/M) ^M 1

Where:

R = Annual Interest Rate

M = Frequency of Compounding

For example, credit card companies usually charge a monthly interest rate of
3.5% (exclusive of other charges). The annual effective rate is not simply determined
by multiplying 3.5% by 12 month since this transaction assumes monthly
compounding. To get the annual effective rate, we compute the following:

Effective Annual Rate = (1 + R/M)^M 1

EAR = [1 + (3.5% X 12.12)]^12 1

EAR = 51.11%

This means that if you purchase a P1,000 dress at the start of the year and did
not pay for it until after one year, then you should pay P1,511 already exclusive of
the other charges.

Loan Amortization
A classic example of a business transaction that pays out an equal cash flow stream
regularly is an amortizing loan. Most housing and car loans are amortizing loans that
require the borrower to pay that equal amount either annually, semi-annually,
quarterly, or most of the time, monthly.
 Amortization Table for P3-million Loan

Amortization Payments Interest Principal Principal

Dates Payment Balance
3,000,0000

December 31, 650,000 150,000 500,000 2,500,000

2015
June 30, 2016 625,000 125,000 500,000 2,000,000
December 31, 600,000 100,000 500,000 1,500,000
2016
June 30, 2017 575,000 75,000 500,000 1,000,000
December 31, 550,000 50,000 500,000 500,000
2017
June 30, 2018 525,000 25,000 500,000

Note that the interest rate of 10% is for one year. Therefore, for six months, the
interest rate is only 5%. Let us compute the interest expense from June 30 to
December 31, 2015.

Interest = P3,000,000 x 10% x (6/12)

Interest = P150,000

For the next six months ending June 30, 2016, the interest expense is only
P125,000 because the principal balance is already reduced to P2,500,000 as of
December 31, 2015.

Thus, part of the semi-annual payment is for the repayment of principal and
interest payments.

Equal Regular Payments (Principal and Interest combined)

Some loans require equal regarding payments. In this case, how is the regular
payment (C) determined?

Present Value of an Annuity = Cx (_1_- ___1___)

R R(1 + R)^r

C = Present Value of an Annuity

PVIFA
 For example, you plan to purchase a house worth P3,000,000. Assuming you
incur a 10-year loan that is repaid in equal annual instalments with an interest rate of
10%. What is tha annual mortgage payment?

C = Present Value of an Annuity

PVIFA

C = P3,000,000

PVIFA(10%, 10)

P488,236.57 = P3,000,000

6.144

The P3,000,000 borrowed is the present value of the loan that will require equal
annual payments of P488,236.57. The total payments will equal P4,882,365.70
(P488,236.57 x 10 years). P3,000,000 is for the principal borrowed and the difference of
P1,882,365.70 is the total interest over the 10-year period.

Apply mathematical concepts and tools in computing

for finance problems and Apply mathematical concepts
and tools in computing for investment problems
For example, a project requires an initial outlay of P100,000. The relevant inflows
associated with the project are P60,000 in year one and P50,000 in years two and
three. The appropriate discount rate for this project is 11%. To compute the net
present value:
Net Present Value = -P100,000 + _P60,000_ + __P50,000__ + __P50,000__

(1 + R)^T (1 + R)^T+1 (1 + R)^T+2

Net Present Value = -P100,000 + _P60,000_ + __P50,000__ + __P50,000__

(1 + 11%)^1 (1 + 11%)^2 (1 + 11%)^3

Net Present Value = -P100,000 + P 60,000 X PVIF(11%,1) + P50,000 x PVIF(11%, 2) +

P50,000 x PVIF(11%,3)

Net Present Value = -P100,000 + P54,054.05 + P40, 581.12 + P36,560.40

Net Present Value = P31, 195.57

Risk-return trade-off
The risk/return tradeoff could easily be called the ability-to-sleep-at-night-test.
While some people can handle the equivalent of financial skydiving without batting
an eye, others are terrified to climb the financial ladder without a secure harness.
Deciding what amount of risk you can take while remaining comfortable with your
investments is very important.

In the investing world, the dictionary definition of risk is the chance that an
investments actual return will be different than expected. Technically, this is
measured in statistics by standard deviation. Risk means you have the possibly of
losing some, or even all, of your original investment.

Low levels of uncertainty(low risk) are associated with low potential returns. High
levels of uncertainty(high risk) are associated with high potential returns. The
risk/return tradeoff is the balance between the desire for the lowest possible risk and
the highest possible return. This is demonstrated graphically in the chart below. A
higher standard deviation means a higher risk ang highest possible return.