Business Finance

Basic Long-Term Financial

Concepts

Grade:12
2nd Semester
Quarter III
 CONTENT Basic Long-term Financial Concepts
The learners demonstrate an understanding of
CONTENT the basic concepts of risk and return, and the
STANDARDS time value of money
The learners are able to:
1.Distinguish simple and compound interest;
2.Solve exercises and problems in computing
for time value of money with the aid of present
PERFORMANCE and future value tables;
STANDARDS 3.Prepare loan amortization tables;
4. Compute for the net present value of a
project with a conventional cash-flow pattern
5. Describe the risk-return trade-off
 CONTENT Basic Long-term Financial Concepts
The learners:
18.Calculate the future value and
present value of money
19.Compute for the effective annual
interest rate
20.Compute loan amortization using
Learning
Competencies
mathematical concepts and the
present value tables
21.Apply mathematical concepts and
tools in computing for finance and
investment problems
22.Explain the risk-return trade-off
 Basic Long-term Financial Concepts

Topics:
• Simple and Compound interest
• Effective Annual Rate
• Present value vs. Future value
• Loan and bond defined
• Loan agreement contents
• Effective method of amortization
• Amortization of bond issued at a discount
Story…
One day, the Master was going on a trip and decided
to entrust his wealth to three of his most trusted servants.
The wealth shall be given to each servant based on the
Master’s assessment of their talents. To his first servant, he
entrusted PHP500,000. To his second servant, believing that
he can make wise choices as well, he also gave an amount
of PHP500,000. Finally, he called on his third servant and
gave him PHP500,000. The Master then went on his journey
and told the servants he will not be back for a long time.
Since the first servant was a very smart person, he decided
to invest the PHP500,000 given to him. He was very pleased
that he was quoted a long-term investment for 5 years at 8
percent per annum compounded annually, and decided to
invest the money in that institution.
 The second servant saw what the first servant did and
also decided to invest the money. However, when given the
choice by the investment firm, he did not understand simple and
compound interest. In the end, he accepted the quote at 8% per
annum simple interest. The third servant saw them and thought
that they were being too much of a risk-taker and decided just to
keep the money locked in a vault in his home.
The Master returned after 5 years. He then called on the
servants and asked them what has become of the wealth he had
entrusted them. The first servant presented his PHP500,000 plus
the interest he earned worth PHP500,000 x (1.08)5 – 500,000 =
234,664.04 . The second servant presented his PHP500,000
along with the interest earned at 500,000 x .08 x 5 = 200,000
Lastly the third servant returned his PHP500,000.
Summary of their earnings
Servant 1 Servant 2 Servant 3

Principal 500,000.00 500,000.00 500,000.00

Interest 234,664.04 200,000.00 0.00

Total 734,664.04 700,000.00 500,000.00

Returned
 LC 18 to
Simple vs. Compound interest 22

Simple Compound
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃 ×𝑟 ×𝑇 𝑟 !×#
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃× 1 + −𝑃
𝑚

In the story above, In the story above,

Principal = P500,000 Principal = P500,000
Rate = 8% Rate = 8%
Time = 5 years Time = 5 years
Compounding frequency = annually
Thus,
Thus,
Interest = 500,000 x .08 x 5 = P200,000 Interest = 500,000 x (1 + (0.08/1))(5x1) –
500,000 = PHP234,664.04
Exercise…
• In the example above, compute the interest
earned over a 5 year term given the Principal
amount of P500,000 at the rate of 8% with the
following compounding periods:
• Semi-annually
• Quarterly
• Monthly
• Daily
 Answer to exercises
• Semi-annually:PHP240,122.14
• Quarterly: PHP242,973.7
• Monthly: PHP244,922.85
• Semi-monthly: PHP245,416.34
• Daily (365 days): PHP245879.66
 LC 18 to
Effective Annual Rate (EAR) 22

Mr. Lopez wishes to find the effective annual rate for his
loan in BOD bank with a 5% nominal annual rate when
interest is compounded (1) annually; (2) semi-annually;
and (3) quarterly
 Present Value vs. Future Value
Investment of PHP500,000 yielding an interest of 8% for a 5-year
period compounded annually

Therefore;
Ø Future value is the amount to which an investment will grow after
earning interest
Ø In contrast, the present value is the amount you have to invest today
if you want to have a certain amount of cash flow in the future
Ø The future value is computed using compounding while the present
value is computed using discounting.
 Loan/Bond
• A loan is money lent at an interest rate for a
certain period of time. Loans are normally
secured from different financial institutions,
the most common of which, are banks.
• A bond is also a form of loan, but can be
traded through Philippine Dealing and
Exchange (PDEX) System.
 Loan Agreement Contents
• Amount of principal
• Maturity date and provision for repayment
• Term of the loan (lump sum, monthly, etc.)
• Grace period, if applicable
• Interest rates
• Loan/bond covenants (i.e. required ratios to be
maintained)
• Penalties for default
• Collateral documents, if applicable
• Let’s say that you are willing to invest a sum of
money that will yield PHP100,000 at the end
of year 1, what amount should you invest
today? If the investment earns 10%, then the
amount to be invested or the present value
should be equal to__________________
• Let’s say that you are willing to invest a sum of
money that will yield PHP100,000 at the end
of year 1, what amount should you invest
today? If the investment earns 10%, then the
amount to be invested or the present value
should be equal to____PHP90,909.09
 Answer:

PHP100,000 x (1/(1.101)) = PHP90,909.09

Present Value of interest payments LC 18
to 22
(annuities)
Assume that an investor will receive P10,000 annually for 3 years
and the interest rate is 10%.

From the table (or by using the formula), the present value of annuity factor for
3 periods using 10% interest is 2.4869. Multiplying this factor by PHP10,000
provides a present value of interest payments of PHP24,868.6.
 Present Value of a bond
Suppose that a bond with face value of PHP100,000 pays interest
of 10% annually and matures in 3 years. What is the price of the
bond?
PHP100,000 Face Value at 10% 75,131.40
for 3 years(PHP100,000 x
(1/(1.10)3)

PHP10,000 interest for 3 years 24,868.60

Price of the Bond 100,000.00
 Effective interest amortization
Two types of interest rate:
Ø nominal rate or the stated rate
Øeffective rate or the market rate

When the bond is sold at a discount, the

effective rate is higher than the nominal rate. On
the other hand, when the bond is sold at a
premium, the effective rate is lower than the
nominal rate.
Steps under Effective Interest Method
Amortization
• Calculate the bond interest expense by
multiplying the carrying amount of the bonds at
the beginning of the interest period by the
effective interest rate.
• Calculate the bond interest paid (or accrued) by
multiplying the face value of the bonds by the
contractual interest rate.
• Calculate the amortization amount by
determining the difference of (1) and (2).
•
 Amortization of bonds issued at a
discount
• Period: 6 semi-annual periods (3 years)
• Effective interest: 12%
• Stated rate: 10%
• Face Value: 100,000
• Issue Price: 95,082.68
 Amortization Schedule
Interest Amortization of
Interest to be Expense Discount
paid =carrying =Int exp. - Int
Period =100,000 x 5% amount x 6% paid Carrying Balance

95,082.68

1 5,000.00 5,704.96 704.96 95,787.64

2 5,000.00 5,747.26 747.26 96,534.90

3 5,000.00 5,792.09 792.09 97,326.99

4 5,000.00 5,839.62 839.62 98,166.61

5 5,000.00 5,890.00 890.00 99,056.61

6 5,000.00 5,943.40 943.40 100,000.00

 Amortization of bonds issued at a
discount

• Period: 6 semi-annual periods (3 years)

• Effective interest: 8%
• Stated rate: 10%
• Face Value: 100,000
• Issue Price: 105,242.14
 Amortization Schedule
Interest to be Interest Expense Amortization of
Perio paid =carrying amount x Premium Carrying
d =100,000 x 5% 4% =Int exp. - Int paid Balance

105,242.14

1 5,000.00 4,209.69 (790.31) 104,451.83

2 5,000.00 4,178.07 (821.93) 103,629.90

3 5,000.00 4,145.20 (854.80) 102,775.09

4 5,000.00 4,111.00 (889.00) 101,886.10

5 5,000.00 4,075.44 (924.56) 100,961.54

6 5,000.00 4,038.46 (961.54) 100,000.00

 Exercises
1. Ms. Rodriguez invested in a PHP2,000 bond with a coupon
rate and effective rate of 5%. How much is the issue price?
2. You have a one year PHP1,000 bond with a coupon rate of
5% and was offered at an effective rate of 6%. How much is the
issue price?
3. Mr. Garcia invested in a P1,000 bond for one year with a
coupon rate of 7% and was offered at an effective rate of 5%.
How much should he pay upfront? (Issue price)
• Answers:
• 1. Since the coupon and effective rate are the
same, the issue price stays at PHP2,000.
• 2. Issue price = (1,000 + 50 coupon)/1.06 =
990.56
• 3. Issue price = (1000 + 70 coupon)/1.05 =
1,019.05
 Practice Problem
1. On January 1, 2015, Mac Inc. issued 3,000,000 bonds with a
coupon rate of 8% maturing in 4 years. The interest is paid
annually, and the market interest rate at the date of issue was
11%. What is the issue price of the bond? Prepare the 4 year
amortization schedule for the bond.
2. On January 1, 2014, Sonic Co. issued 4,000,000 12% bonds
maturing in 5 years. The bonds pay interest semi-annually. The
market rate of interest as of the date of issuance is 10%. What
is the issue price of the bond? Prepare the 5 year amortization
schedule for the bond.
•
 Answer to no. 4
Issue price: PHP2,720,779.89
Principal 1,976,192.92
Interest 744,586.97
2,720,779.89

Interest to be Interest Expense Amortization of

Perio paid =carrying amount x Discount Carrying
d =3M x 8% 11% =Int exp. - Int paid Balance

2,720,779.89

1 240,000.00 299,285.79 59,285.79 2,780,065.68

2 240,000.00 305,807.22 65,807.22 2,845,872.90

3 240,000.00 313,046.02 73,046.02 2,918,918.92

4 240,000.00 321,081.08 81,081.08 3,000,000.00

 Answer to no. 5
Issue price: PHP4,308,869.40
Principal 2,455,653.01
Interest 1,853,216.39
4,308,869.40
 Interest to be paid Interest Expense Amortization of Discount
Period =4M x 6% =carrying amount x 5% =Int exp. - Int paid Carrying Balance

4,308,869.40

1 240,000.00 215,443.47 (24,556.53) 4,284,312.87

240,000.00
2 214,215.64 (25,784.36) 4,258,528.51
240,000.00
3 212,926.43 (27,073.57) 4,231,454.94
240,000.00
4 211,572.75 (28,427.25) 4,203,027.68
240,000.00
5 210,151.38 (29,848.62) 4,173,179.07
240,000.00
6 208,658.95 (31,341.05) 4,141,838.02
240,000.00
7 207,091.90 (32,908.10) 4,108,929.92
240,000.00
8 205,446.50 (34,553.50) 4,074,376.42
240,000.00
9 203,718.82 (36,281.18) 4,038,095.24
240,000.00
10 201,904.76 (38,095.24) 4,000,000.00
 Thank you!
End of Chapter 5