LESSON 2:
SOURCES AND
Long-term financing
- refers to borrowing of money for a
term of more than one year by the ways
of issuing equity shares, or acquiring
debt financing, long term loans and
many other ways.
- are used for the strategic plans of a
business-like expansions and other
capital expenditures.
-Businesses also need long-term funds
to finance their requirements of fixed
assets, or assets whose useful life
extends beyond one year from the date
of acquisition.
Fixed Assets
-examples are assets or non-current
assets are land, building, processing
plant, machinery, motor vehicle, and
equipment.
CAPITAL STRUCTURE
When a business is in need of long-term
funds to finance its fixed assets, its
capital structure is primarily affected.
The equation of the capital structure
shown in the preceding subsection
indicates the long-term funds may be
sourced from the following:
a) Solely from long-term creditors
b) Solely from the owner or
stockholders
c) Both from long-term creditors and
owners
This relationship is illustrated in the
schematic diagram
The Capital Structure and the Source
of Funds
Long-term Capital
Unlevered/
liabilities
D
Capital e
Structure bt-Free capital structure
- company that does not
finance its operation using long-term debt
has this
-indicates that the owners provide almost all
financial requirements of the business, both
the working capital needs and fixed assets
requirement.
-mostly provided by the owners or
stockholders
-the return is usually lower since there are more
owner or stockholder who share in the
income. In this case, the financial risk (e.g.,
bankruptcy risk, interest risk) is expectedly
low.
Leverage capital structure
-the long-term creditors provide most of the
funding requirement, the return to
stockholders is usually high.
-However, the financial risk (e.g., default risk,
interest risk, or bankruptcy risk) in this case
is also expected to be high.
The basic question at this point is:
What is the capital structure that is
financially and operationally favorable to the
business?
The resounding answer is:
The capital structure that balances the factor
of return and risk, and at the same time
maximizes the price of the stock, is the most
financially and operationally favorable
capital structure to the business.
FACTORS INFLUENCING CAPITAL
STRUCTURE DECISION
1. Business risk- refers to the amount of
risk that is inherent in the operation of the
business. It is a kind of risk that cannot be
removed or detached from any business
operation. Once a firm starts to operate, the
business risk co-exists with the operation.
Business risk, therefore, is present whether
the business is financially leveraged or debt-
free.
2. Firm’s tax position- the firm may source
the funds for fixed asset requirements from
long-term liabilities like bonds or long-term
bank borrowings. These particular sources of
funds require payment of interest to the
providers. In taxation, interest payment of
debts is deductible from gross margin. This
treatment ultimately results in a lower
income, thereby bringing the business to a
lower tax rate bracket with lower income
tax. However, when the business continues
to use debts and make interest as tax shield,
the interest payment will no longer provide
additional benefit to the business at it will
eat up the operating income.
3. Financial Flexibility- Financial flexibility
refers to the ability of the business to raise
long-term funds when needed. When
economy is not doing well or when the
supply or flow of money is tightly controlled
by the government through the central bank,
businesses that do not have a favorable debt-
to-equity ratio may find difficulty in looking
for long term funds.
4. Managerial inclination- Managers have
different perspective on what capital
structure to maintain. Those who are
considered aggressive or risk-takers prefer to
use long-term debt to finance the long-term
needs or financial structure of the business.
Doing to tends to produce a high rate of
return coupled with high financial risk.
SOURCES OF LONG-TERM FUNDS
The source of funds is considered long-term
when the repayment period is more than one
year notwithstanding the normal operating
cycle of the business.
Examples of these are the following:
A. ISSUING EQUITY SHARES
Equity is the foremost requirement for a
company to make it afloat every time. Equity
shares are found in a corporation
representing ownership funds of a company.
Private funds from individuals or different
entities are exchanged for a part of
ownership of the company. Shareholders are
given dividends as the income or exchange
for investing in the company. This can be
done through trading in the stock exchange
or privately selling shares in accordance to
the state’s policies.
I. Preference Shares
Preference shares or preferred shares is a
share of stock in which the holder enjoys
higher preferences or rights over the holder
of an ordinary share. The holder of a
preference shares has preferences in terms of
the following:
A. Dividends
B. Assets
Dividends - refers to the amount of income
distributed to the shareholders of the
corporation. It is the board of directors that
declares the distribution of dividends
Dissolution - means the cessation of
business operations.
Liquidation -, involves the process of
selling the non-cash assets, settling
liabilities, and finally, disturbing the
remaining cash to shareholders.
II. Ordinary Share
Ordinary share or common share is a share
of stock which does not enjoy any right or
preference in the dividend and assets of the
corporation. If a corporation is authorized to
issue only one type of share, the corporation
will automatically issue ordinary or common
shares.
Retained earnings
- account is also another sources of funds to
finance the acquisition of fixed assets or
long-term investment projects.
 - refers to the internally generated funds by
the business operation.
- are the accumulated profits, losses, and
adjustments of a corporation.
- Only a corporation entity maintains
retained earnings in the books of accounts.
two types of retained earnings:
 free retained earnings - which are available
for dividend declaration
 restricted or appropriated retained
earnings - which involves a portion of
retained earnings that has been set for a
specific purpose. The foremost objective of
this is to limit the amount available for
dividend declaration.
B. ACQUIRING BONDS
Borrower
- can be the government, a local body or a
corporation.
Bonds
- are debt instruments involving two parties
the borrower and the lender.
- They provide fixed interest payments at
periodic intervals and are redeemable at a
predetermined date in future.
- are normally issued against collateral and
are therefore a highly secured form of long-
term finance.
- prove to be a very cost-effective source of
funds in a bullish market.
- value of each bond certificate is indicated on
the face of the bond indenture.
- Usually, the minimum denomination P1,000.
The bond may be issued at more than or less
than its face value. If the bond is issued at
more than its face value, the difference
between the issue price and the face value is
called bond premium. On the other hand, if the
bond is issued below its face value, the
different between the issue price and face
value is called bond discount.
The cost of long-term debt borrowing or the
cost of the bond as the sources of long-term
funds are the amount of cost the company
incurs every year before taxes and is computed
as
follows:
COST OF DEBT = INTEREST EXPENSE (1 – TAX
RATE)
INTEREST EXPENSE= LOAN AMOUNT x
INTEREST RATE
Example:
IZZY company thinks of acquiring a fixed
asset that will improve the production capacity
of the business. To finance the acquisition,
IZZY plans to issue 8%, P1,000 face value
bonds amounting to P40,000,000.
The company has issued its old bonds at face
value, and expects to sell the new issuance
based on the P 1,000 face value. IZZY is
subject to a 30% income tax rate.
REQUIRED: Compute the cost of debt
issuance.
SOLUTION:
INTEREST EXPENSE= LOAN AMOUNT x
INTEREST RATE
= P 40,000,000 X 8%
= P 3, 200, 000
COST OF DEBT = INTEREST EXPENSE
(1-TAX RATE)
= P 3, 200, 000 (1-.30)
= P 3, 200, 000(.70)
= P 2, 240, 000
C. TERM LOAN
- are borrowings made from banks and
financial institutions. Such term loans may be
for the medium to long term with repayment
period ranging from 1 to 30 years. Such long-
term finance is generally procured to fund
specific projects (expansion, diversification,
capital expenditure etc.) and is, therefore, also
known as project finance.
- can be sourced by both small as well as
established businesses. Also, the interest rates
are relatively low and are negotiated
depending upon the duration of the loan,
nature of security furnished, the risk involved
etc.
-Term loans can be sanctioned immediately
within a matter of days depending upon the
financial health of the firm. Heavy collaterals
are required to be furnished to obtain a term
loan. Even then, the amount of loan disbursed
remains a fraction of the asset value.

Activity # 1 (Written Work 1)

Column A Column B
1. Loans with repayment terms of 10-30 years a. Retained earnings
2. Difference between issue price and face value b. Ordinary Shares
3. Its value is indicated in its indenture. c. Dissolution
4. Accumulated profits d. Bond premium
5. Earnings available for dividends e. Term loan
6. Stocks without preference and rights f. Bond Certificate
7. Cessation of the business operations g. Free retained earnings
8. Found in a company representing ownership h. long term
9. Less than 1 year repayment term i. Business risk
10. Cannot be detached or removed from business. j. Equity shares

LESSON 3: TIME
FUTURE VALUE: SINGLE AMOUNT
- The time value of money plays a very
significant role in making long-term
investment decisions.
- The basic tenet in finance relative to time
value is: The peso today is worth - more
than a peso in the future.
- Why is this so? The peso you have today
can be invested to earn interest, giving
you a larger future amount in return. The
concept time value of money is always
involved whenever investment decisions
are made. Time value analysis serves as
the prelude to all investment discussion.
- The present applications of time value
analysis include, among others,
determination of the value of retirement,
computations of the value of stocks and
 bond, and preparation of amortization
schedule of long-term bank borrowings.
In time value of money analysis, compound
interest, and not simple interest, is applied.
• Simple interest
- means that the amount of interest is
computed only once during the term of
year, or more than one year.
The simple interest is computed using the
formula:
I=PxRxT
Where:
I - Interest
P - Principal
R - Rate
T - Time
• Compound interest
- indicates that the interest of one
compounding period is added to the
principal of the prior period to form the
new principal as basis for computing the
interest of succeeding periods.
Illustration: Nicanor has invested
₱300,000 at 6% simple interest for a
period of three years.
Required: Compute simple interest.
Answer: Since the term of the interest is
simple, the amount of interest is
computed only once.
I =PxRxT
= ₱300,000 x .06 x 3
= ₱54,000
For example, if the term is 120 days, the
interest will be ₱6,000 computed as
follows:
I=PxRxT
= ₱300,000 x .06 x 120/360
= ₱6,000
FUTURE VALUE
- known as compound amount, is the
accumulated value of the principal or
present value (PV) and all interest
amount invested today at a specific
compounded interest rate.
Illustration: Jenny has invested ₱10,000
on January 1, 2018 at 10% interest
compounded annually for five years.
Required: Compute the future value at the
end of five years.
Answer: The future value refers to the
amount at the end of the fifth year as an
interest of 8% is earned based on the
compounded amount at the beginning of
every year.
This is illustrated in the timeline as
follows:
-Future value indicates a compounding
interest. As mentioned, compounding simply
means that the interest at the end of one
compounding period is added to the principal
as basis of computing the interest for the next
period.
-As step-by-step process to determine the
future value of ₱10,000 compounded annually
for five years is as follows:
Compounded using the step-by-step approach,
the future amount of ₱10,000 invested at 10%
compounded annually through 5 years is
₱16,105. It can be observed that the value of
the investment increases along with the period
because of interest. Investment is only made
once at the beginning of the period.
FUTURE VALUE USING THE
FORMULA
To facilitate an easier computation of future
value, the following formula has been
developed:
Where:
FV - Future Value
PV - Present Value
i - Periodic interest rate -Total number of
compounding periods
Before going further, the following terms are
defined:
• Nominal rate (I) is the rate of investment or
borrowings. It is quoted as an annual interest
rate,
unless otherwise specified. In the Illustration,
the nominal rate is 10%.
• Compounding period refers to the period of
conversion made during the year. It can be
annual, semi-annual, quarterly, or monthly. In
the Illustration, the compounding period is
annual.
• Frequency of conversion is the number of
times the interest is added to the principal
during the year. If the compounding period is
annual, the frequency of conversion is 1; if
semi-annual, the frequency is 2; if quarterly, it
is 4; and if monthly, it is 12. In illustration, the
frequency of conversion is 1 since the term is
annually compounded.
• Total compounding period (n) refers to the
number of times an interest is computed
during the term of investment. It is computed
by multiplying the frequency of conversion
and the term of investment. In Illustration
12.2, the total compounding period is 5 (1 × 5
years). In case the compounding period is
quarterly, the total compounding period for a
term of 5 years will be 20 (4 × 5 years).
• Periodic interest rate (i) refers to the
interest rate per compounding period. It is
computed by dividing the nominal rate by the
compounding period. In the Illustration, the
periodic interest rate is 10% (10% ÷ 1 ). In
case the compounding period is quarterly, the
periodic interest rate for a nominal rate of 10%
is 2.5 (10% ÷ 4).
Applying the formula to Illustration, the future
value is computed as follows:
Future Value = PV (1 + i ) n
= ₱10,000 ( 1 + .10) 5
= ₱ 10,000 (1.61051)
= ₱ 16,105*
*Rounded-off the nearest peso
FUTURE VALUE USING THE TABLE
The future value can also be determined using
the table of future value in Annex A. the factor
value in Annex A uses the future value
formula of (1+1)n. The first column represents
the different period (n) followed by several
columns for different interest rates.
ILLUSTRATION
Yvone invested ₱200,000 at 8% interest
compounded quarterly for a period of 5 years.
Required: Using the table of future value,
compute the amount of the investment at the
end of the fifth year.
Answer: From the given data, the following
are determined:
Present value - ₱200,000
Nominal rate - 8%
Frequency of conversion - 4 (quarterly)
Periodic interest rate - 2% (8% ÷ 4)
Terms - 5 years
Total compounding periods - 20 (5 years × 4)
In Table 1, locate the column for 2%. Run
your fingers on the column until you reach the
period 20. The value where n and the interest
rate intersect represents the value of (1 + i)n .
In this case, the value in the intersection of n =
20 and I= 2% is 1.4859.
The future value of ₱200,000 after the end of
20 years is then computed as follows:
FV = ₱200,000 × 1.4859
 = ₱297,180
The table of future value is used in case the
computation is made without the help of
scientific or financial calculation. However,
the value of n in the table is only good for 100
periods.
When the value of n exceeds the periods
provided in the table, the future value factor
can be determined using the law of exponents,
For example, the term of investment is 25
years at 10% interest compounded quarterly.
In this case, the total compounding periods (n)
is 100 (25 years x 4), and the periodic interest
rate is 2.50% (10% ÷ 4).
The procedural process as illustrated above is
a step-by-step approach of a single amount. It
is a very tedious process. Simply imagine the
computations that will be made in case the
compounding period is 60. To facilitate a
simpler computation, the following formula is
used to determine the future value of annuity.
Where:
FV = Future value of annuity
A = Annuity investment
i = Periodic interest rate
n = Total compounding period
The formula to compute the future value of
₱5,000 invested every end of the year for four
years at 10% compounded interest appears as
follows:
the total compounding periods (n) is 100 (25
years x 4), and the periodic interest rate is
2.50% (10%
The procedural process as illustrated above is
a step-by-step approach of a single amount. It
is a very tedious process.
Simply imagine the computations that will be
made in case the compounding period is 60.
To facilitate a simpler computation, the
following formula is used to determine the
future value of annuity.
Where:
FV = Future value of annuity
A = Annuity investment
i = Periodic interest rate
n = Total compounding period
The formula to compute the future value of
₱5,000 invested every end of the year for four
years at 10% compounded interest appears as
follows:
The future amount derived using the formula
is equal to the amount computed using the
step-by-step approach.
FUTURE VALUE ANNUITY USING A
TABLE
The table of the future value of annuity is
provided in Annex C. The table of annuity is
commonly used when the computation is made
without the aid of scientific or financial
calculators.
Using the information in illustration 12.4, the
future value of annuity ₱5,000 invested at 10%
interest compounded annually for four years
can be determined using the value factor in
Annex C.
Locate the column for 10% interest. Run your
finger on the column until you reach the period
4. The value where n and the interest rate
intersect represents the future value factor of
the annuity.
In this case, the value in the intersection of n =
20 and i= 10% is 4.641. This value is
multiplied by the amount of investment of
₱5,000 to give the future value of the annuity
shown as follows:
Future value of annuity = ₱5,000 × 4.641
= ₱ 23,205
The result indicates that when ₱5,000 is
invested every end of the year for four years
with an interest of 10% compounded annually,
the investment will eventually amount to
₱23,205 at the end of four years.
PRESENT VALUE: SINGLE AMOUNT
The term present value simply refers to the
value of money at the present. Hence, the ₱100
in your pocket today has a present value of
₱100. However, the amount of ₱100 10 years
from now is not the same as ₱100 today. It
represents value is definitely lower.
This concept is illustrated in the timeline as
follows:
In determining the future value of a single
amount, compounding is applied. However,
when the present value of a certain amount is
computed, discounting is used.
Discounting refers to the process of
determining the present value of a single
amount or series of cash flows. It is the reverse
process of compounding. Both concept –
compounding and discounting – are important
in the discussion of investment.
PRESENT VALUE USING THE
FORMULA
The procedure to compute the present value of
an amount is to reverse the process of
computing future value. Hence, the formula to
determine the future value is in the inverse of
identifying the present value. The formula to
compute the present value appears as follows:
Where: PV = Present value
FV = Future value of annuity
i = Periodic interest rate
n = Total number compounding period
ILLUSTRATION
Princess’s goal is to have an investment of
₱500,000 after four years. The amount to be
invested will earn an interest of 12%
compounded quarterly.
Required: Determine the amount to be
invested by Princess at 12% interest
compounded quarterly.
Answer: the problem is simply asking for the
present value or discounted value of ₱500,000
which has been invested at 12% compounded
quarterly for four years.
In this case, the future value is ₱500,000. The
nominal interest rate is 12% compounded
quarterly; hence, the periodic interest is 3%
(12% ÷ 4). Since the term is four years and the
frequency of conversion is quarterly, then the
total compounding period is 16.
PV = FV (1 + i) -n
= ₱500,000 × (1.03) -16
= ₱500,000 × .6232
= ₱311,600
Based on the computation, Princess needs to
invest ₱311,600 at 12% interest compounded
quarterly in order to have an investment of
₱500,000 at the end of four years.
The timeline appears as follows:
PRESENT VALUE USING A TABLE
The present value of an amount can also be
computed using the table of present value
shown in Annex B.
Again, the table of present value serves as the
alternative approach whenever the
computation is not aided by scientific or
financial computation.
ILLUSTRATION
HYZEL plans to accumulate ₱800,000 at the
end of eight years in which the money earns an
interest of 9% compounded quarterly.
Required: Determine the amount to be
invested by Hyzel at an 9% compounded
quarterly using the table of present value.
Answer: Since the frequency of conversion is
quarterly, the periodic interest rate is 2.25%
(9% ÷ 4), and the total compounding periods is
32 (8 years × 4).
Locate the column of 2.25% interest rate. Run
your finger on the column until you reach the
period 32. The value where n = 32, and the
interest rate of 2.25% intersect represents the
present value factor (0.4907). This present
value factor is then multiplied to the future
value of ₱800,000 to determine the
present value of investment computed as
follows:
PV = FV (1 + i) -n
= ₱800,000 × (0.4907)
= ₱392,560
It indicates that Hyzel should invest ₱392,560
today at an interest of 9% compounded
quarterly in order to have an accumulated
amount of ₱800,000 at the end of eight years.
PRESENT VALUE: ANNUITY
The present value of annuity refers to the
present value of all individual investment or
deposits made. Each individual investment is
discounted and all the discounted amounts are
added to represent the present value of the
annuity.
This concept is illustrated in the timeline
assuming that the annuity is ₱10,000 at 10%
interest compounded annually for four years.
Using by step-by-step approach, the present
value of ₱10,000 annuity for four years
compounded at 10% annually appears as
follows:
Period 1 ₱10,000 × (1.10)-1 or ₱10,000 ×
0.9091 ₱ 9,091
2 10,000 × (1.10)-2 or 10,000 ×
0.8264 8,264
3 10,000 × (1.10)-3 or 10,000 ×
0.7513 7,513
4 10,000 × (1.10)-4 or 10,000 ×
0.6830 6,830
Present value of ₱10,000 annuity ₱ 31,698
This indicates that the ₱10,000 annuity or
annual investment made every end of the year
for four years at the interest rate of 10%
compounded annually, or total investment of
₱40,000 for four years has a value today
(present) of ₱31,698. The total investments of
₱40,000, however, does not represent the
future value of ₱31,698.
Since present value is a reverse of future value,
the present value of ₱31,698 can be interpreted
from the concept of future value annuity. In
this case, an amount of ₱31,698 invested today
at the rate 0f 10% compounded annually can
provide an annuity of ₱10,000 every end of the
year for four year.
PRESENT VALUE OF ANNUITY USING
THE FORMULA
Where: PV = Present value annuity
A = Annuity
i = Periodic interest rate
n = Total compounding period
ILLUSTARTION
IZZY plans to invest ₱3,000 at the end of
every quarter for 8 years at the interest rate of
10% compounded quarterly.
Required: Determine the present value of the
quarterly annuity of ₱3,000 for eight years.
Answer: The periodic interest rate is 2.5%
(10% ÷ 4), and the total compounding period
is 32 (8 years × 4). Since Izzy will make an
investment of ₱ 3,000 every end of the quarter,
the total investment of Izzy for 32 quarters will
be ₱96,000 (₱3,000 × 32).
Applying for formula, the present value of
₱3,000 quarterly annuity for eight years at the
interest rate of 10% compounded quarterly is
computed as follows:
The present value of ₱3,000 annuity at the end
of every quarter for 32 quarters at the interest
rate of 10% compounded quarterly is ₱65,544,
tough the total investment amount to ₱96,000
(3,000 × 32 quarters).
VALUE OF ANNUITY USING PRESENT
A TABLE
In case the computation of the present value of
annuity does not use scientific or financial
calculators, the process can be performed with
the aid of present value of annuity factors
shown
ILLUSTRATION
Rolly invest ₱5,000 every end of the six years.
The money is compounded semi-annually at a
nominal rate of 8%.
Required: Determine the present value of the
annuity of using the factor value in Annex D.
Answer: In this case, the frequency of
conversion is semi-annual; hence, the total
compounding periods are 12 years (6 years ×
2) while the periodic interest rate is 4% (8% ÷
2).
Using the value factor in the table, locate the
column of 4% interest rate. This time, run your
finger on the column until you reach the period
(n) 12. The value in the intersection of n = 12
and I = 4% = 9.3851. The quarterly annuity of
₱5,000 is then multiplied by the value in order
to determine the present value of annuity of
₱5,000for six years at 8% compounded semi-
annually.
The computation appears as follows:
PV = ₱5,000 (9.3851)
= ₱ 46,925.50
The mathematical formulas presented and
discussed here to determine the future and
present valuers of the annuity are applicable
only if the frequency of conversion coincides
with the compounding period. For example,
the frequency of conversion and the
compounding period are both quarterly.
However, in case the frequency of conversion
does not coincide with the compounding
period, the formulas given can no longer be
used. This latter type of equity is discussed in
a collegiate course under mathematics of
investment
Activity # 1 (Written Work 3)
I. Directions: Compute the interest. Round off
your final answer up to 2 decimal places.
1. ₱27,000 at 6.5% simple interest for 1 year.
2. ₱31,000 at 7.5% simple interest for 50 days.
3. ₱63,000 at 12.5% simple interest for 3 years
and 6 months.
4. ₱89,500 at 11.5% simple interest for 220
days.
5. 36,000 at 9.7% simple interest for 2 years.
II. Directions: Compute the future value of
the following single investments. Round off
your final answer
up to 2 decimal places.
1. ₱35,000 at 8.7% interest compounded
quarterly for 4 years.
2. ₱30,456 at 10.3% interest compounded
semi-annually for 11 years.
3. ₱50,502 at 14% interest compounded
monthly for 3 years.
 4. ₱60,050 at 9.5% interest compounded bi-
monthly for 4 years.
5. ₱104,000 at 6.89% interest compounded
annually for 3 years.
Activity # 2 (Performance Task 3)
Problem A:
Jenny’s father deposited P 36,000 at the end of
each year for 5 years in her savings account. If
her bank paid 4.67 % interest compounded
annually, find the future value. Round off your
final answer up to 2 decimal places.
Problem B:
RS Bank pays interest at the rate of 7.6%
annually compounded quarterly. How much
money will Aerol have in the bank at the end
of 4 years if he deposits P3,500 at the end of
each quarter? Round off your final answer up
to 2 decimal places.
or for other benefits to the investing company
such as those obtained
through trading relationships.
2. In economics, investment refers to tangible
or physical assets like buildings, pieces of
machineries, or equipment that contribute
income to the business or individual.
3. In finance, investment is the amount of
money invested in financial assets like bonds,
stocks, mutual funds, or insurance policies. It
also includes money deposited in the bank,
claims on trading accounts, and investment in
treasury bills.
Regardless of the many definitions of terms,
they all have a common ground, that is,
investment provides financial or economic
returns to the business. The factor of risk,
however, becomes an intrinsic element of
investment.

Problem C: TYPES OF INVESTMENT

Find the present value of annuity of P 4,500 at Investments are broadly classified into the
the end of each month for 6 years at 9.89% following:
compounded monthly. Round off your final 1. Financial instruments
answer up to 2 decimal places. 2. Non-financial instruments

Financial instrument is a contract that provides

financial assets to one party and, at the same
time, entails, financial liability or equity to
LESSON 4: INTRODUCTION TOanother. Investment classified as financial
INVESTMENT (CONCEPT OF instruments
following:
include, among others, the

CONCEPT OF INVESTMENT 1. Stock or equity instruments

The term investment as of this writing does not 2. Bonds or debt instruments
have a universal working definition. Its 3. Cash and cash equivalents
meaning varies across different disciples 4. Trade accounts
which are highly influenced by their own 5. Mutual funds
governing theories and principles. Thus, 6. Insurance funds
various fields view investment from different
perspectives. In contrast, investment, classified as non-
financial instruments include, among others,
1. In accounting, for example, investment the following:
refers to assets held by the business for 1. Real properties
accretion of wealth through distribution. 2. Inventories
Examples include interest, royalties, 3. Patents
dividends, and rentals for capital appreciation 4. Gold bullion

A brief discussion of the abovementioned
investments follows. Stocks and bonds,
however, are explained separately in the
succeeding sections.
Cash includes bills, coins, and money
deposited in the bank. Cash deposit may be
stored in savings or current account. A
sufficient amount of cash maintained by a
business provides liquidity premium to its
operating activities. However, holding cash in
the most instances does not lead to inflow of
economic or financial benefits to the business.
Cash by itself does not produce cash.
Cash equivalent include short-term and
highly liquid investments that are readily
convertible into cash. The primary advantage
of cash equivalents is that they usually present
insignificant risk of changes in value brought
about by changes in interest rates. Their
foremost disadvantage is that the return is
usually low because of minimal risk exposure.
Examples of cash equivalents are treasury bills
of the BSP, time deposits, or
money market instruments.
Trade accounts represent the right to collect a
sum of money in the near future. They include
accounts receivable and notes receivable
arising from sales of goods or services. Trade
accounts do not provide additional benefits in
the form of return on investment except for the
benefit of the full collection of the claims.
Collection of trade accounts contribute
significantly to the cash flow position of a
business.
Mutual fund refers to money pooled together
by people and kept and handled by a
professional manager. Maintaining mutual
funds is based on the finance theories of cost
efficiency, risk diversification, and
professional fund management. People who
have contributed or pooled their money
together, however, have various objectives and
priorities. Since it is the trust company that
manages the fund and decides where to put the
investment, the expectation of the investor is
not usually properly addressed.
Insurance fund refers to money collected and
pooled by insurance companies from the
premiums paid by the insured or policyholders
and used as protection or hedge against
uncertain risks. An insurance fund usually
provides a higher return on investment because
of the high risk involved.
Real properties are non-financial instruments
that represent hard or fixed assets usually
attached to soil. It includes, among others, the
following: land, building, or machinery if
installed as part of the building.
Inventories are product that are intended for
sale but remain unsold at the end of the period.
No economic or financial benefits are gained
unless inventories are sold and collection is
made.
Patents are intangible non-financial
instruments granted by the government. They
represent exclusive rights of a business to
manufacture the invented product for a
specific period of time. A patent product,
therefore, cannot be copied or produced by
another manufacturing company. The life of a
patent is 20 years and can be extended beyond
the legal life by a new patent.
Gold bullion is a precious commodity which
carries a high market value most especially
when the market is volatile. Companies
consider investing in gold when the values of
some products in the market depend on the
value of gold.
INVESTMENT IN BOND
Bond has been introduced on our previous
module as one of the sources of long-term
funds. It has been mentioned that a business
issues bonds to raise necessary funds through
borrowing from another party. In this section,
bonds are explained from the perspective of
the buyer of the bond, or the so-called
investor.
A bond is an unconditional promise to pay:
a. A specified sum of money at a
determinable future time; and
b. Its periodic interest is based on the
agreement.
Bonds can be classified as follows:
Term bonds that have single maturity date.
For example, on January 1, 2018, the business
is authorized to issue bonds amounting to
₱5,000,000 that will mature on December
31,2028. In this case, all bonds have a single
maturity date, which is December 31,2028.
Serial bonds are those that have series of
maturity dates. These bonds are payable on
installments. For example, the business is
authorized to issue on January 1,2018, 5-year,
₱2,000,000 bonds
with the following maturity dates:
December 31,2018 ₱400,000
December 31,2019 400,000
December 31,2020 400,000
December 31, 2021 400,000
December 31,2022 400,000
Callable bonds are bonds that can be called in
or redeemed by the issuing company prior to
the date of maturity. For instance, the maturity
date of the bond is December 31,2025, but the
issuing company may redeem the bonds before
this date. Oftentimes, the redemption price or
callable price is higher than the face value of
the bonds. For example, the face value of the
bond is ₱1,000, but it may be redeemed at
₱1,100.
Convertible bonds are those that offer
bondholder the right to convert or exchange
the bonds prior to their maturity date with
shares of stock. For instance, the ₱1,000 face
value bond may be converted into 10 shares of
common stock with a par value of ₱100.
Nominal Rate and Effective Interest
Nominal rate refers to the interest rate that
appears on the face of the bonds. It is usually
expressed on an annual basis. When the
nominal rate is multiplied by the face value of
the bond, the result represents the interest
income on the investment.
The investor receives cash interest income
based on the nominal rate of the bond as a
percentage of the face value.
The average interest rate in the Philippines
from 1985 to 2015 is 9.52%, reaching a very
high rate of 56.60%, in December 1990 and a
very low rate of 3.50% in September 2012.
ILLUSTRATION
On January 1,2018, Jenny acquires ₱1,000,000
bonds at 10% interest payable semi-annually
on June 30 and December 31. The life of the
bonds is five years.
Required: Determine the amount of cash
inflow every interest payment date.
Answer: The annual cash inflow in the form
of interest from bonds for a period of five
years is ₱100,000 (₱1,000,000 x 10%), or a
semi-annual interest of ₱50,000 (₱1,000,000 x
5%).
Thus, every June 30 and December 31 starting
June 30,2018 and five years thereafter, Jenny
will receive ₱50,000 cash as interest income
from her bond investment.
However, the true semi-annual interest may or
may not be equal to ₱50,000. The
amount depends on whether the effective
interest rate is equal or not to the nominal rate.
In conclusion, to evaluate the true earnings
from the investment is bonds, one does not
have to rely solely on the amount of cash
received every interest payment date. The
effective interest rate of the bonds must also be
determined.
 effective interest rate, otherwise
known as yield to maturity or market rate of
interest, is the true or actual rate of interest
that investors earn from investing in bonds.
 Three factors influenced the effective
interest rate of the bonds, namely;
a. Real rate of returns
b. Inflation premium
c. Risk premium
 The real rate of return represents the interest
charged by the investor to the other party for
using the money without the considering of
eroding effect of the inflationary changes.
 inflation premium is the amount of interest
charged by the investor for the effect of
inflation while the money is used by another
party. The average inflation rate in the
Philippines from 2009 to 2014 is 3.8 percent.
 When the real rate of return is
combined with the inflation premium, the
result is the risk-free rate.
 risk premium represents the risk
associated with the investment. It is
comprised of business risk and financial risk,
among others.
 Business risk is directly related to
the inability of the business to maintain
stability and growth in its earnings as a result
of losing its competitive position in the
market.
 financial risk is directlyrelated to
the liquidity problem of the business, that is,
not being able to settle its obligation as they
mature.
The effective interest rate on bonds, therefore,
is computed as follows:
Real rate of return xxxxx
Add: Inflation premium xxxxx
Risk-free rate xxxxx
Add: Risk premium xxxxx
Effective interest rate xxxxx
In the Philippines, only in Banko Sentral ng
Pilipinas (BSP) sets the short-run nominal
policy rate that serves as benchmark for
market interest rates. The BSP cannot set the
real interest rate since it cannot set inflation
expectations. However, the action of BSP has
a tremendous effect on the real interest rate of
funds.
Risk and rate of return have a direct
relationship in investment. This means that
when the risk on
investment is high, the rate of return is high as
well. In a similar manner, when the risk on
investment is low, the rate of return is also
low.
ILLUSTRATION
The average real rate of return is determined at
2.80%. the inflation premium or expectation is
determined at 3.40%, and the risk premium
covering both business risk and financial risk
is set at 3%.
Required: Compute the risk-free rate and
effective rate of interest.
Answer: The risk-free rate is computed as
follows:
Real rate return 2.80%
Add: Inflation premium 3.40%
Risk-free rate 6.20%
The effective rate of interest is computed as
follows:
Risk-free rate 6.20%
Add: Risk premium 3.00%
Effective interest rate 9.20%
Activity # 1 (Performance Task 4)
A. The real rate of return of JENNY
Corporation has been averaging at 4.2% for
the past 7 years. The risk premium associated
with investment on JENNY’s bonds has been
determined at 3.0%. Statistics indicated the
inflation rate will reach 4.4%.
Required: Determine the following.
1. Risk-free rate of bond investment.
2. Bond effective interest rate.
B. The bonds of YVONE Corporation are
selling in the market at an effective interest
rate of 14%. Investors are risking their
investments on YVONE’s bonds at a rate of
5.2%. Statistics revealed that inflation rate is
expected to remain at 3.7%
Required: Determine the following:
1.Risk-free rate of bond investment.
2.Real rate of interest on bonds.