By: MELANIE M.

ADAN, MBA
 PRAYER BEFORE CLASS

Dear Lord and Father of all, thank you for today.

Thank you for ways in which you
provide for us all.
For your protection and love, we thank you.
Help us to focus our hearts and minds now
on what we are about to learn.
Inspire us by your eternal light,
as we discover more about the world around us.
We ask all this in the mighty name of Jesus. AMEN.

Hail to the Cross. Our only Hope.

 TOPICS:
WEEK 9 : LESSON 7
INVESTMENT DECISIONS
• Compounding and Discounting
• How to determine whether investments are
profitable using the Net Present Value
Analysis
• Important Points about Shut Down
Decisions and Break-even Prices
 COMPOUNDING
All investment decisions involve a trade-off between current sacrifice
and future gain. Before investing, you need to know whether the future
benefits are more than the current costs.

Discounting is a tool that allows you to figure this out. The easiest way
to understand discounting is to first consider its opposite,
compounding.

(Future Value, k period in the future) = (Present Value) x (1 + r ) k

General Formula in Compounding:

FVn = PV (1+r)n
 COMPOUNDING
General Formula in Compounding:

FVn = PV (1+r)n
Where: FV = Future Value in n period
PV = Present Value or the money invested today
n = Number of period
r = Interest rate

Example:
You deposited Php 10,000 in a savings account. The account pays 3% annual interest. The account earned Php
300 in interest after the first year. How much will be the future value of the account after two years?
FVn = PV (1+r)n
= 10,000 (1+0.03)2
= 10,000 (1.0609)
= 10,609
 PRESENT VALUE vs. FUTURE VALUE
Today Year 1 Year 2

P10,000.00 P10,609.00

Present Value Future Value

 FUTURE VALUE OF MONEY
Compute how much your savings will earn by multiplying the principal
and the interest rate. Then add this interest amount. This new amount
will also earn interest, which will again be added to the new principal
which will again earn interest the following year. This is the reason why
future value is also known as compounding.
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.
 THE RULE OF 72 in COMPOUNDING
In the following table, we use the previously given formula to compute the time that it takes an
investment to double in value, when left to grow, as in a savings account. We see that higher interest
rates cause money to double in a shorter period of time.

In fact, we see that the interest rate multiplied by the time it takes to double equals about 72 (last
column). This is the so-called RULE OF 72.

Current Value Interest Rate Years Future Value Rate x Time

$ 100 2.00 % 36.0 $ 204 72
$ 100 4.00 % 18.0 $ 203 72
$ 100 6.00 % 12.0 $ 201 72
$ 100 7.20 % 10.0 $ 200 72
$ 100 10.00 % 7.2 $ 199 72
$ 100 12.00 % 6.0 $ 197 72
$ 100 15.00 % 5.0 $ 201 75
 DISCOUNTING
Discounting is the inverse of compounding and is defined by the
formula:

(Present Value) = (Future Value, k period in the future) / (1 + r ) k

General Formula in Discounting:

PV = FVn / (1+r)n

Where: PV = Present Value

FV = Future value in n period
n = Number of period
r = Interest rate
 PRESENT VALUE OF MONEY
Present Value is today’s worth of money.

An investor puts his money in stocks, bonds or other investment with

an objective of earning income. The investment plus the earned
income is the future value of money. Present value is determining
today’s worth of this future value (investment + earned income). It is
also known as discounting.
To illustrate:
Example:
The present value of $100.00 in 10 years if the interest rate if 7% is $50.83,
computed as follows:

PV = FVn / (1+r)n
= $100 / (1+0.07)10
= 100 / (1.9671….)
= $50.83
 Why do we need to compute for present value?
Various investment options have different required capital and expected
rate of return. Most of the time, you have the information about an
investment’s future value. However, it does not always mean that an
investment with a greater future absolute value is a better investment.
You also have to consider the initial capital required.
If you know the present value of an investment as well as the present
value of the other investments, you can compare for their respective value
today. 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. Therefore, you consider the investment with a lower present
value but with a higher possible return.
 Present Value of a Stream & Net Present Value Analysis
FORMULA:

Given the present value of the income stream that arises from a
project, one can easily compute the net present value of the project.
The Net Present Value (NPV) of a project is simply the present value
(PV) of the income stream generated by the project minus the
current cost (C0) of the project with the following formula:
NPV = PV - C0
 Present Value of a Stream & Net Present Value Analysis
TAKE NOTE!

• If the NPV of the project is positive, then the project is profitable

because the present value of the earnings from the project exceeds
the current cost of the project.

• On the manager, the manager should reject a project that has a

negative NPV since the cost of such project exceeds the present
value of the income stream that project generates.
 Present Value of a Stream & Net Present Value Analysis
DEMONSTRATION PROBLEM:
Ralph is a manager of Amcott Company. His task was to generate $7 million per year in sales for 3
years by sinking $20 million to Magicword. Assuming there were no other costs associated with
the project, the projected net present value using 7% rate of return to Amcott of purchasing
Magicword are as follows:

NPV = PV - C0
= 7,000,000 + 7,000,000 + 7,000,000 - $ 20,000,000
(1+0.07)1 (1+0.07)2 (1+0.07)3
= ( 6,542,056.07 + 6,114,071.10 + 5,714,085.14 ) - 20,000,000
= 18,370,212.31 - 20,000,000
= - 1,629,787.69
 SHUTDOWN DECISIONS AND BREAK-EVEN PRICES
Important Points:
COST TAXONOMY
• To study shut-down decisions, we work with
break-even prices rather than quantities.
• If you shut down, you lose your revenue, but
you get back your avoidable cost.
• If revenue is less than avoidable cost, or
equivalently, if price is less than average
avoidable cost, then the decision is to shut
down.
• The break-even price is the average avoidable
cost per unit.
• The only hard part in applying break-even
analysis is deciding which costs are avoidable.
For that, we use the Cost Taxonomy as follows:
Credits:

Froeb, L. M., McCann B. T., Ward, M. R., Shor, M. (2019). Managerial Economics. Fifth Edition. Cengage Learning Asia Pte Ltd.