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Basic Long-term Financial Concepts

If you have enough resources especially money, what would you do

with them? You may be thinking to put them into work. Therefore
you must be aware of relationship of risk and return involved in such
activity. In this part, we will also show that the value of your money
today would not be the same as its value in the future, vice versa.

After going over this lesson you should be able to

 Know the basic concept of risk and return

 Understand the time value of money
 Solve problems about the time value of money

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Basic Concepts of Risk and Return

Risk is the variability of returns from those that are expected. This
refers to a situation in which possible future events can have
reasonable probabilities assigned while uncertainty refers to
situations in which there is no viable method of assigning
probabilities to future random events.

Return is the income received on an investment plus any change in

market price. Thus there are two components in return—the basic
component or the periodic cash flows from the investment, either
in the form of interest or dividends; and the change in the price of
the asset, commonly called as the capital gain or loss.

The risk-return tradeoff is the principle that potential return rises

with an increase in risk. This concept means that low levels of
uncertainty or risk are associated with low potential returns while
high levels of uncertainty or risk are associated with high potential
returns. Thus invested money can render higher profits only if the
investor is willing to accept the possibility of losses.

Time Value of Money

The time value of money is the idea that money available at the
present time is worth more than the same amount in the future
due to its potential earning capacity. This impacts business finance
and results from the concept of interest. Interest is a fee paid for
using another party’s money. It is a payable amount on the part of
the borrower or lendee and a receivable amount on the part of the
creditor or lender.

Time value of money deals with future value and present value.
Future value is the value of a current asset at a specified date in
the future based on an assumed rate of growth over time. On the
other hand, present value is the current worth of a future sum of
money or stream of cash flows given a specified rate of return.

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Simple Interest

This is the interest paid (earned) on the original amount, or principal,

borrowed (lent).

Formula

Is=Prt

where
Is simple interest
P principal
r interest rate
t number of years the amount is deposited or borrowed for

Example

You made a bank deposit worth Php10,000. With 5% annual interest,

how much is the total interest after 2 years?

Given
P = 10,000
r = 0.05
t=2

SI= (10,000)(0.05)(2)
SI=1,000

Future Value of a Single Sum

Formula

F = P(1 + rt)

where
F future value
P principal or present value
r interest rate
t number of years the amount is deposited or borrowed for

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Example

You made a bank deposit worth Php10,000 which will earn 5% annual
interest. What is the value of this money after 2 years?

Given

P = 10,000
r = 0.05
t=2

FV = 10,000[1+(0.05)(2)]
FV = 11,000

Present Value of a Single Sum

P principal or present value

F future value
r interest rate
t number of years the amount is deposited or borrowed for

Example

You need to have Php11,00 after two years. Assuming that you will
only deposit once with a 5% annual interest, how much will you
deposit today?

Given

F = 11,000
r = 0.05
t=2

P = 10,000

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Compound Interest

This is the interest paid (earned) on any previous interest, as well as on

the principal borrowed (lent).

Formula

Ic = -1)

Ic compound interest
P principal
r interest rate
n number of times the interest is compounded per year
t number of years the amount is deposited or borrowed for

Example

You made a bank deposit worth Php10,000. With 5% interest

compounded annually, how much is the total interest after 2 years?

Given
P = Php10,000
r = 0.05
t=2
n=1
t=2

Ic =
Ic = Php1,025

Future Value of a Single Sum

Formula

where
F future value
P principal or present value
r interest rate
n number of times the interest is compounded per year

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t number of years the amount is deposited or borrowed for

Example

You made a bank deposit worth Php10,000. With 5% interest

compounded annually, how much will be the value of your money
after 2 years?

Given

P = 10,000
r = 0.05
n=1
t=2

F=
F = 11,025

Present Value of a Single Sum

P principal or present value

F future value
r interest rate
n number of times the interest is compounded per year
t number of years the amount is deposited or borrowed for

Example

You need to have Php11,025 after two years. Assuming that you will
only deposit once, with a 5% interest compounded annually, how
much will you deposit today?

Given

F = 11,025
r = 0.05
n=1
t=2

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P = 10,000

Annuity

Lately, you have learned about financial transactions relating to

compound interest which is mainly concerned with lump sum
investments at the beginning of the period or payments at the end of
the term. But most of the time, business transactions involve series of
equal receipts or payments made at equal intervals

In this part, we will tackle the ordinary annuity and annuity due.
Ordinary annuity means that periodic payments are made at the end of
each payment interval while nnuity due means that periodic payments
are made at the beginning of each payment interval.

Future Value of an Ordinary Annuity

final amount at the end of the term

R periodic payment
r interest rate per period
n number of periods

What is the amount of annuity of Php1,500 payable at the end of every

year for 4 years if interest rate is 10%?

Given
R 1,500
r 0.10
n 4

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Present Value of an Ordinary Annuity

present value of the ordinary annuity

R periodic payment
r interest rate per period
n number of periods

Example

What is the present value of annuity of Php1,500 payable at the end of

every year for 4 years, if interest rate is 10%?

Future Value of Annuity Due

final amount at the end of the term

R periodic payment
r interest rate per period
n number of periods

What is the amount of annuity due of Php1,500 payable at the

beginning of every year for 4 years if interest rate is 10%?

Given
R 1,500

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r 0.10
n 4

Present Value of an Annuity Due

present value of annuity due

R periodic payment
r interest rate per period
n number of periods

Example

What is the present value of annuity due of Php1,500 payable at the

beginning of every year for 4 years, if interest rate is 10%?

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Glossary
Fixed Capital - funds are required to purchase fixed assets

Working Capital - funds used for its day-to-day operations

References
C. Paramasivan and T. Subramanian. (2005). “Financial
Management”, New Age International Ltd., Publishers.
Investopedia.com

J. Van Horne and J. Wachowics(2008). “Fundamentals of Financial

Management”, Pearson Education Limited.

KEATMX (2005), “Managerial Economics”, TVM.

S.G. Eakins (2002). “Finance: Investments, Institutions, and

Management”, Addison-Wesley Higher Education Group

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Additional Resources

Videos

Khan Academy (2011). Risk and Reward

https://www.youtube.com/watch?v=mv5zucjq60k&feature=youtu.be

Investopedia (2015), Time Value of Money,

http://www.investopedia.com/terms/t/timevalueofmoney.asp

Zion’s TV (2013), Time Value of Money,

https://www.youtube.com/watch?v=0etEItEINZw

Online Readings

SwLearning (2016). Risk and Return, http://goo.gl/7ylwfU

Ordinary Annuity and Annuity Due (2016). Finance Formulas.

http://www.financeformulas.net/Future_Value_of_Annuity.html
http://www.financeformulas.net/Present_Value_of_Annuity.html
http://www.financeformulas.net/Future-Value-of-Annuity-Due.html
http://www.financeformulas.net/Present_Value_of_Annuity_Due.html

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