the amount of interest accumulated in the prior

Business Finance periods.

Quarter 3 – Module 6, 7 & 8 The process of determining future value when
Week 6, 7 & 8 compound interest is applied is called compounding.

After going through this module, you are expected to:

1. Calculate future value and present value of

Example 2:
money (ABM_BF12-IIIg-h-18)
Suppose Torres Company leaves its P10,000 on
2. Compute loan amortization using
deposit for two years in the bank paying 10 percent
mathematical concepts and the present value
annual interest. At the end of the first year, the initial
tables
deposit becomes P11,000. During the second year,
(ABM_BF12-IIIg-h-20)
the firm will earn 10 percent on this P11,000, or an
3. Apply mathematical concepts and tools in
additional P1,100 in interest. The firm is earning
computing for finance and investment
interest on the changing balance. Hence, at the end of
problems
the second year, the firm will have P12,100 in its
(ABM_BF12-IIIg-h-21)
account.
4. Explain the risk-return trade-off
(ABM_BF12-IIIg-h-22)
Balance at the beginning of year 2 P 11,000.00
Add: Interest for year 2 at 10% 1,100.00
TIME VALUE OF MONEY Future value at the end of year 2 P 12,100.00

Interest is defined as the cost of using money over FUTURE VALUE ANNUAL COMPOUNDING
time. Interest represents the time value of money.
n
FV n=PV (1+i)
Interest is the excess of resources (usually cash)
received or paid over the amount of resources loaned
Where: FV – Future value
or borrowed is called Principal. The cost of the
PV - is equal to the initial principal
excess resources to the borrower for the use of the
amount
money is called interest expense. The benefit of the
i - compounded at the interest
excess resource to the lender of the money is called
rate
interest revenue.
n - the period
Time value of money involves two major concepts:
Example 3:
future value and present value. Both concepts
The future value of P1,000 compounded at a 10%
consider three factors (1) principal, (2) interest rate,
annual interest rate at the end of one year, two year
and (3) time period.
and five year are computed as follows:
Business transactions subject to interest state whether
Substituting PV = P1,000 and i = 0.10 for different
simple or compound interest is to be calculated.
values of n produces the following results.
Simple interest is the product o the principal amount
multiplied by the period’s interest rate (a one-year
Year Calculation Future
rate is standard).
Value
SIMPLE INTEREST 1 FV1 = (P1,000) (1+0.10)1
=P1,100.00
Example 1.
Torres Company deposits P10,000 in a bank at 10 2 FV2 = (P1,000) (1+0.10)2
percent interest a year. One year later the P10,000 = (P1,000) (1.21) =
will grow to P11,000; P10,000 is the principal and P1,210.00
P1,000 is interest. The amount of interest is
determined by multiplying the interest rate of 10% 5 FV5 = (P1,000) (1+0.10)5
(.10 in decimal notation) by the principal of P10,000 = (P1,000) (1.61051) =
(0.10 x P10,000 = P1,000). Thus, the value of a peso P1,610.51
today can increase in the future because of interest.
FUTURE VALUE WITH INTRAPERIODS
Principal( beginning balance) P 10,000.00
COMPOUNDING
Interest for year 1 to 10 percent
(0.10 x P10,000 = P1,000.00) 1,000.00 Compounding that occurs more than once a year
Future value at the end of year 1 P 11,000.00 called intraperiod compounding. The calendar period
over which compounding occurs is called the
COMPOUND INTEREST compounding periods. Compounding may occur,
annually, semiannually, quarterly, or monthly. When
Compound interest is the interest on both the using intraperiod compounding the future value
principal and

pg. 1
formula must be modified to reflect the number of = (1.05)2 – 1
times per year compounding occurs, denoted by m. = 1.1025 – 1
= 0.1025 or 10.25 %
i mn
FV n=PV {1+ }
m
Initial Compounding Future Effective Annual
Example 4: Investment Period Value Interest Rate
Rather than placing P1,000 in Balanga Bank that
pays 10% interest annually, the financial manager P 1,000 Annually P 1,100.00 10.00%
decides to put the money in Abucay Bank that pays 1,000 Semiannually 1,102.50 10.25%
10% interest compounding semi-annually. Between 1,000 Quarterly 1,103.81 10.38%
the two banks, there would be a difference in the 1,000 Monthly 1,104.71 10.47%
future value of your investment after one year. 1,000 Daily 1,105.16 10.52%
Figure 1. Comparison of results of different
compounding periods for P1,000 invested
at 10% interest rate for one year.

Balanga Bank Abucay Bank

Annual Compounding Semi-annually

Compounding
FUTURE VALUE
FV1 = (P1,000) (1+0.10)1 FV1 = (P1,000) (1+
0.10 DETERMINATION OF FUTURE VALUE OF A
) (1) (2)
STREAM OF PAYMENTS
2 The concept of future value can be extended beyond
= (P1,000) (1.10) = (P1,000)
(1.1025) compounding a single payment to compounding a
= P1,100.00 =P1,102.50 series, or stream of payments.

Now compute for the difference P1,100 – P1,102.50

= P2.50 higher is Abucay Bank than Balanga Bank. FUTURE VALUE DETERMINATION
Thus, more interest is earned in semiannual INVOLVING STREAM OF UNEAQUAL
compounding that with annual compounding. PAYMENTS.

Higher interest earned resulted from increased Calculating the future value of an unequal stream of
frequency of compounding period makes the future payments involves finding the future value of each
value grow rapidly because interest is higher in payment at a specified future date and then summing
changing balance of the principal amount. these future values.

NOMINAL INTEREST RATE COMPARED n

FV n=∑ Pt ( 1+i )
n−t
WITH EFFECTIVE INTEREST RATE
t=0
Annual interest rate is simply the stated rate, such as
10%. While effective interest rate also called annual Example 6:
percentage rate or APR is the true interest rate and A company plans to deposit P2,000 today and P1,500
may differ from nominal rate depending on the one year from now at St. Catherine Rural Bank. No
frequency on compounding. future deposits or withdrawals are made, and the
bank pays 10% interest compounded annually. The
future value of the account at the end of four years is
{ }
m
i
APR= 1+ −1 computed as:
m
FV4 = (P2,000) (1.10)4 + (P1,500)
The equation above is used to find the effective (1.10)3
interest rate. In this equation, i is the nominal rate and = (P2,000) (1.464) + (P1,500)
m is the number of compounding period per year. (1.331)
= P2,928.00 + P1,996.50
Example 5: = P4,924.50
Universal Corporation deposits money in a bank that
pays a 10% nominal interest rate and compounds FUTURE VALUE DETERMINATION
interest semiannually. INVOLVING STREAM OF EQUAL
PAYMENTS
Substituting i = 0.10 and m = 2 will result to:
A stream of equal payments made at regular interval

{ }
0.10
2 is an annuity sometimes called fixed annuity. There
APR = 1+ −1 are two types of fixed annuities.
2

pg. 2
 1. Ordinary annuity is one in which the
payments or receipts occurs at the end of
each period. This type of annuity is also
called a regular or deferred annuity.
FVOA n= A (FVIFA i ,n )
FVOA = future value of ordinary annuity
A = the amount of the fixed annuity
payment
1
FVIFAi,n = future value interest factor of an
ordinary annuity for interest rate (i)n
Example 7:
Clear Corporation deposits P1,000 at the end of each
three consecutive years in a bank account paying
10% interest compounded annually. The value of the
account at the end of the third year is computed by,
first substituting A = P1,000, i m = 1.10 and n = 3.
FVOA = (P1,000)
(FVIFA10%, 3)
= (P1,000)
(3.310)
= P3,310.00
2. Annuity Due is one which payments or
receipts occur at the beginning of each
period.
FVAD n= A ( FVIFA i ,n ) ( 1+i )
Strawberry Enterprise expects to receive P1,100 one
year from now. What is the present value of this
amount if the discount rate is 10%?
Substitute i=10% or 0.10 and n=1, FV=P1,100
P 1,100
PV = 1
1.10
or
= P1,000
LOAN AMORTIZATION USING
MATHEMATICAL CONCEPTS
Loan amortization. The determination of the equal
periodic loan payments necessary to provide a lender
with a specified interest return and to repay the loan
principal over a specified period.
Loan amortization schedule. A schedule of equal
payments to repay a loan. It shows the allocation of
each loan payment to interest and principal.
To find the equal annual payment required to pay off,
or amortize, the loan, PVAn, over a certain number of
years at a specified interest rate
PVA n
PMT =

Example 14:
1
PVIFA i ,n ( x 1−
i [ 1
(1+i )n
)
]
FVAD = future value of annuity due
As just stated, you want to determine the equal
Example 8: annual end-of-year payments necessary to amortize
Rather than of depositing at the end of each year for fully a P5,000, 10% loan over 4 years.
three consecutive years, the firm makes deposits at
the beginning of each year. Interest is compounded The present value interest factor for an annuity
annually at 10%. How much will the firm have in corresponding to 10% and 4 years (PVIFA10%,4yrs) is
account after three years? 3.170. Substituting PVA4_P6,000 and
PVIFA10%,4yrs_3.16987 into
Substitute A = P1,000, i=10%, and n=3.
Equation above and solving for PMT yield an annual
FVAD = (P1,000) (3.310) (1.10) loan payment of P1,577.35. Thus, to repay the
= (P1,000) (3.641) interest and principal on a P5,000, 10%, 4-year loan,
= P3,641.00 equal annual end-of-year payments of $1,577.35 are
necessary.
The future value for the annuity due (P3,641) is
greater than that for the ordinary annuity (P3,310)
because each deposit is made one year earlier and P5,000
PMT =

[ ]
consequently earns interest one year longer.
1 1
x 1−
PRESENT VALUE 0.10 ( 1+0.10 )4
DISCOUNTING
P 5,000
Future value determination compounds money PMT =
forward in time to determine its worth in the future. 3.170
Present value determination discounts money that PMT =
will be received in the future back in time to see it is P1,577.35
worth in the present.
Prepare Loan Amortization Schedule:
PV =
FV n
(1+i)
n
∨FV n
{ 1
(1+i)
n }
Example 9:

pg. 3
 LOAN AMORTIZATION SCHEDULE Probability. The chance that a given outcome will
(P5,000 principal amount, 10% intereset in 4-year repayment periods)
occur.
Payments
End of the Beginning Loan Interest Principal End of the
year of the year (0.10 x (2) (2) - (3) year
Probability distribution. A model that relates
principal principal probabilities to the associated outcomes.
(1) - (4)
(1) (2) (3) (4) (5)
1 5,000.00 1,577.35 500.00 1,077.35 3,922.65
Bar chart. The simplest type of probability
2 3,922.65 1,577.35 392.26 1,185.09 2,737.56 distribution; shows only a limited number of
3 2,737.56 1,577.35 273.76 1,303.60 1,433.97 outcomes and associated probabilities for a given
4 1,433.97 1,577.35 143.40 1,433.96 -
event.

RISK AND RETURN Continuous Probability Distribution. A probability

The financial manager, to maximize share price, must
learn to assess two key determinants: risk and return.
In providing financial decision presents certain risk
and return characteristics, and the unique
combination of these characteristics has an impact on
share price. Risk can be viewed as it is related either
to a single asset or to a portfolio—a collection, or
group, of assets. We will look at both, beginning with
the risk of a single asset. First, though, it is important
to introduce some fundamental ideas about risk,
return, and risk preferences.
Risk The chance of financial loss or,
more formally, the variability of
returns associated with a given
asset.
distribution showing all the possible outcomes and
associated probabilities for a given event.
Risk Measurement
1. Standard deviation (_k). The most common
statistical indicator of an asset’s risk; it
measures the dispersion around the expected
value.
Expected value of a return (k_). The most likely
return on a given asset.
Normal probability distribution. A symmetrical
probability distribution whose shape resembles a
“bell-shaped” curve.

Return The total gain or loss experienced 2. Coefficient of variation (CV). A measure of
on an investment over a given relative dispersion that is useful in
period of time; calculated by comparing the risks of assets with differing
dividing the asset’s cash expected returns.
distributions during the period, plus
change in value, by its beginning- RISK OF A PORTFOLIO
of-period investment value.
Portfolio A collection, or group, of
Risk Preference assets.
1. Risk-indifferent. The attitude toward risk in
which no change in return would be required Efficient portfolio A portfolio that
for an increase in risk. maximizes return for a
2. Risk-averse. The attitude toward risk in given level of risk or
which an increased return would be required minimizes risk for a given
for an increase in risk. level of return.
3. Risk-seeking. The attitude toward risk in
which a decreased return would be accepted 1. Correlation. A statistical measure of the
for an increase in risk. relationship between any two series of numbers
representing data of any kind.
RISK OF A SINGLE ASSET
The concept of risk can be developed by first Positively correlated Describes two series that
considering a single asset held in isolation. We can move in the same direction.
look at expected-return behaviors to assess risk, and
statistics Negatively correlated Describes two series that
can be used to measure it. move in opposite directions.

Correlation coefficient A measure of the degree

Risk Assessment of correlation between two series.

1. Sensitivity analysis. An approach for Perfectly positively correlated Describes two

assessing risk that uses several possible- positively
return estimates to obtain a sense of the correlated series
variability among outcomes. that have a
correlation
2. Range. A measure of an asset’s risk, which coefficient of_1.
is found by subtracting the pessimistic
(worst) outcome from the optimistic (best)
outcome.

pg. 4
Perfectly negatively correlated Describes two Alternative Single amount
negatively A P28,500 at end of 3 years
correlated series B P54,000 at end of 9 years
that have a C P160,000 at end of 20
correlation years
coefficient of _1.

Uncorrelated Describes two a. Find the value today of each alternative.

series that lack b. Are all the alternatives acceptable, i.e., worth
any interaction $20,000 today?
and therefore c. Which alternative, if any, will you take?
have a
correlation
coefficient close B. Present value—Mixed streams Consider
to zero. the mixed streams of cash flows shown in
the following table.
2.Diversification. The concept of correlation is Cash Flow stream
essential to developing an efficient portfolio. To Years A B
reduce overall risk, it is best to combine, or add to the 1 50,000.00 10,000.00
portfolio, assets that have a negative (or a low 2 40,000.00 20,000.00
positive) correlation
3 30,000.00 30,000.00
4 20,000.00 40,000.00
References: 5 10,000.00 50,000.00
Totals 150,000.00 150,000.00
Principles of Managerial Finance
Lawrence J. Gitman, 10th Edition a. Find the present value of each stream using a 15%
discount rate.
Financial Management Principles and Application b. Compare the calculated present values and discuss
Volume 1 them in light of the fact that the undiscounted cash
Ma. Elenita Balatbat Cabrera flows total $150,000 in each case.

LEARNING ACTIVITY SHEET IN BUSINESS

FINANCE GRADE 12
2nd Semester, 3rd Quarter, Week 6
Activity 1

Provide what is required. Answer in 2 decimal

point. Provide your solution.

1. What is the present value of

a. P10,000 in 5years at 8%
b. P15,000 in 10 years at 12%
c. P5,000 in 8 years at 10%
LEARNING ACTIVITY SHEET IN BUSINESS
2. If you invest P15,000 today, how much will FINANCE GRADE 12
you have 2nd Semester, 3rd Quarter, Week 8
a. In 5 years at 10% Activity 3
b. In 10 years at 8%
c. In 25 years at 12% Answer the following. Discuss in minimum in 5
sentences. 10 point each item.

LEARNING ACTIVITY SHEET IN BUSINESS 1. What is risk in the context of financial

FINANCE GRADE 12
2nd Semester, 3rd Quarter, Week 7
Activity 2
A. Present value comparisons of single
amounts
In exchange for a P20,000 payment today, a
well-known company will allow you to
choose one of the alternatives shown in the
following table. Your opportunity cost is
11%.
decision making?
2. Define return and describe how to find the
rate of return on an investment.
3. Compare the following risk preferences: (a)
risk-averse, (b) risk-indifferent, and (c) risk-
seeking. Which is most common among
financial managers?
4. Explain how the range is used in sensitivity
analysis.
5. What is an efficient portfolio? How can the
return
and standard deviation of a portfolio be
determined?

pg. 5
pg. 6