12 SENIOR HIGH SCHOOL

BUSINESS FINANCE
Quarter 3 – Module 8
Mathematical Concepts and Tools for
Finance, Investment Problems and
Risk Return-Trade Off

NegOr_Q3_Business Finance12_Module 8_v2

Business Finance – Grade 12
Alternative Delivery Mode
Quarter 3 – Module 8: Mathematical Concepts and Tools for Finance, Investment
Problems and Risk Return-Trade Off
Second Edition, 2021

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NegOr_Q3_Business Finance12_Module 8_v2

Introductory Message
This Self-Learning Module (SLM) is prepared so that you, our dear learners, can
continue your studies and learn while at home. Activities, questions, directions,
exercises, and discussions are carefully stated for you to understand each
lesson.
Each SLM is composed of different parts. Each part shall guide you step-by-step
as you discover and understand the lesson prepared for you.
Pre-tests are provided to measure your prior knowledge on lessons in each SLM.
This will tell you if you need to proceed on completing this module or if you need
to ask your facilitator or your teacher’s assistance for better understanding of
the lesson. At the end of each module, you need to answer the post-test to self-
check your learning. Answer keys are provided for each activity and test. We
trust that you will be honest in using these.
In addition to the material in the main text, Notes to the Teacher are also
provided to our facilitators and parents for strategies and reminders on how
they can best help you on your home-based learning.
Please use this module with care. Do not put unnecessary marks on any part of
this SLM. Use a separate sheet of paper in answering the exercises and tests.
And read the instructions carefully before performing each task.
If you have any questions in using this SLM or any difficulty in answering the
tasks in this module, do not hesitate to consult your teacher or facilitator.
Thank you.

NegOr_Q3_Business Finance12_Module 8_v2 i NegOr_Q3_Business Finance12_Module 8_v2

 I

This module was designed to provide you with fun and meaningful opportunities for
guided and independent learning at our own pace and time. You will be enabled to process the
contents of the learning resource while being an active learner.

The module is intended for you to apply mathematical concepts and tools in computing
for finance and investment problems and explain the risk-return trade-off.

1 NegOr_Q3_Business Finance12_Module 8_v2

 I

Pre-assessment:
Multiple Choice
Direction: Choose the correct answer for each item. Write the letter of your answer in
your notebook.
1. Which of the following does NOT fall within the scope of financial planning?
A) Work History C) Cash Reserves and Equivalents
B) Equity Assets D) Tangible Assets
2. As you move through the scope of financial planning from Cash Reserves and Equivalents
to Income Assets to Equity Assets to Tangible Assets, what happens?
A) Risk increase, return decreases C) Risk and return both decrease
B) Risk and return both increase D) None of these
3. The purpose of Income Assets is to provide a way for investors to obtain?
A) Market Exposure B) Large Returns C) Income D) Investments
4. Which of the following is an example of an Income Asset?
A) Rental Property
B) Variable Annuity
C) Corporate, Municipal, State & Federal Bonds
D) Cash Reserves
5. The purpose of Equity Assets is to provide a way for investors to achieve?
A) Capital Appreciation C) Tax Deductions
B) Government Guarantees D) Market Exposure
6. The return may be thought of as
A) The growth in the value of an investment
B) The risk associated with an investment
C) Obtained only if the company pays dividends; without dividends, return is 0
D) The process of returning the stock to the corporation that issued it
7. Dividends _____ the rate of return?
A) Decrease C) Have no effect on
B) Increase D) Increase the risk off
8. Think carefully about this one. Some investors will accept high-risk investments and some
investors prefer low-risk investments. What term best describes that situation?
A) Risk aversion C) Risk tolerance
B) Risk return tradeoff D) Rate of return
9. Which type of risk does diversification help to manage?
A) Specific B) Market C) Both a and b D) Neither a nor b
10. Investors profit from investments in stock by
A) Receiving dividends B) Price growth
C) Both a and b D) Neither a nor b

2 NegOr_Q3_Business Finance12_Module 8_v2

 ’s In

Task 1

Direction: Answer the following questions below and write your answer in your activity
notebook.

1. What is the importance of interest and the time value of money?

’s New

Task 2

Karl had been pleading from his father for over a month to increase his pocket money.
Finally, his father decided to use this as an opportunity to teach him an important investing
lesson. He called Karl and told him that he was ready to consider his plea. He gave him 2
options to choose from:

• Option A: I will increase your pocket money by 20% if you obtain an average grade of
90% and above in your upcoming exams. However, if your average grade falls below
90%, your pocket money will be reduced by 15%.

• Option B: Your pocket money will be increased by 5% effective immediately and will
not depend on how you score in your exams.

(https://finpeg.com/blog/risk-return-tradeoff/)
Question:

1. If you are Karl, which option would you choose? Why?

3 NegOr_Q3_Business Finance12_Module 8_v2

 is It

Long-term investments need significant capital outlay thus careful analysis should be
done. A corporation needs tools that may be employed in evaluating which investments to
prefer, and which to forego. This introduces us to our topic on Capital Budgeting.

Capital Budgeting is a way of evaluating and selecting long-term investments that are
in line with the firm’s goal of maximizing owners’ wealth.

Difference between long-terms investment from operating expenses:

Long-term investment results in benefits to accrue to the company more than one year while
operating expenses benefits the company only within the operating period.

Examples of Capital Expenditure:

Expand or enter into a new business venture,
Replace or renew fixed assets,
Construct new premises,
Opening a branch,
Acquisition of machinery and equipment

Steps in Capital Budgeting

1. Investment Proposal. Proposals for cost come from different levels within a
business organization. These are submitted to the finance team for thorough analysis.

2. Review and Analysis. Financial personnel perform formal review and analysis to
assess the benefits and cost of the investment proposals. These personnel make use of
several financial tools which they see fit in evaluating the project.

3. Decision Making. Companies usually delegate capital expenditure decisions based

on value limits. The analysis is presented to the proper approving officers who will in
turn make the decision on whether to push through with the project or not.

4. Implementation. Release of funds and commencement of the project occurs after

approval. Large expenditures are usually released in phases.

5. Monitoring. Results are monitored and actual cost and benefits are compared with
people who were expected. Action is required if deviations from the plan are significant
in amount.

4 NegOr_Q3_Business Finance12_Module 8_v2

Basic terminologies related to Capital Budgeting.

Independent Projects vs. Mutually Exclusive Projects

Independent Projects are those whose cash flows are independent of one another. The
acceptance of one project does not eliminate the others from further consideration. Mutually
exclusive projects, on the other hand, are projects which serve the same function and therefore
compete with one another. The acceptance of one eliminates all other proposals that serve a
similar function from further consideration.

Unlimited Funds vs. Capital Rationing

The amount and availability of funds affects the company’s decisions in capital outlays.
If the company has unlimited funds, then all projects which pass the risk-return criteria will be
accepted and implemented. Otherwise, firms will operate under capital rationing and will
accept only projects which provide the best opportunity to increase shareholder wealth.

Accept-Reject vs. Ranking Approaches

Accept-Reject approach is usually done for mutually exclusive projects where one
project is favored over the others. The approach accepts projects which pass a certain criterion.
Ranking is done when there are several projects passing the criteria and the company is only
able to fund so much. The highest-ranking projects will be selected for implementation.

Different Techniques in Capital Budgeting

Before proceeding with discussion of techniques, let us first introduce the concept of
relevant cash flows.

Relevant cash flows include the initial investment, cash inflows from income from the
project, and the expected terminal value of the project, if any. These are the cash flows
considered in analyzing whether an investment adds value to the firm. Cash flows should be
net of tax. However, to simplify our discussion, we shall not include tax in our consideration.

For example, Mr. Alfonse is deciding on which of the 2 mutually exclusive projects
he should accept. Project A requires an initial outlay of PHP72,000 and is expected to receive
PHP17,000 annually for the next 5 years. Project B, on the other hand, requires an investment
of PHP80,000 but will earn PHP21,000 annually for the next 5 years. In this example, we can
see that the relevant cash flows are the upfront investment and the annual income from
investment.

5 NegOr_Q3_Business Finance12_Module 8_v2

Payback Method

This is the simplest method used in capital budgeting. It measures the amount of time,
usually in years, to recover the initial investment. To illustrate this method, let us use our
previous examples for relevant cash flows.

For Project A, the initial cash flow is PHP72,000. In 4 years, Mr. Alfonse would have
generated a total cash flow of PHP68,000. To get the actual time period, let us divide the
remaining amount (P4,000) and divide it by the cash flow for 5th year (P17,000). We get .24,
so the total payback period for Project A is 4 + .24 = 4.24 years. Conversely, if the cash flows
are equal, you may derive the answer by dividing the initial cash flow by the annuity,
72,000/17,000 = 4.24 years. Using this method for Project B, we get the payback period of
80,000/21,000 = 3.81 years.

Let us also illustrate the computation of payback period for uneven cash flows.

Initial Investment = 15,000

Year 1 = 7,000
Year 2 = 4,000
Year 3 = 6,000
Year 4 = 3,000
For years 1 and 2, we have already recovered 11,000 of our investment. We need 4,000
more to reach 15,000 thus for the third year, we have 4,000/6,000 = 0.67. The payback period
is 2.67 years. Notice that the cash flow for year 4 is already ignored.

Managers usually set an acceptable payback period for projects. In making accept-reject
decisions, projects which meet the set acceptable payback period shall be accepted and those
which do not, are discarded. It is a popular method used especially for small projects due to its
simplicity and consideration for the timing of cash flows. The criticism of this method,
however, is that it does not consider the time value of money. Also, it fails to consider the cash
flows after the payback period. For instance, in our previous example, we can see that Project
B is better compared to Project A due to the quick recovery of the investment. If Project A has
a cash flow of PHP50,000 at year 5, we can easily deduce that Project A is more profitable.
However, the payback method only recognizes the gains during the payback period.

Internal Rate of Return (IRR)

• The IRR is one of the most widely used techniques in capital budgeting. It is defined as
the discount rate that equates the NPV of an investment to zero. If this method is used
for capital budgeting analysis, the project’s IRR is compared to the company’s cost of
capital. If the IRR is greater than the cost of capital, the project should be accepted
otherwise, it should be rejected. Manual computation of the IRR involves trial and error.
However, this IRR computation is a lot easier using computation applications like MS
Excel.

6 NegOr_Q3_Business Finance12_Module 8_v2

 For example, you are planning to build a branch for your business at PHP350,000 and
expect to receive PHP400,000 in 1 year. First, compute for the rate of return
(profit/investment).

Rate of return = 50,000/350,000 = 14.3%

We compute for the rate of return because the NPV of a project with cost of capital
equal to the rate of return is equal to zero.

To illustrate:

NPV = 400,000/ (1+0.143) – 350,000 = 0

The IRR can easily be computed using MS Excel using the IRR function.

The NPV and IRR are interrelated techniques. An IRR greater than the cost of capital
equates to a positive NPV and vice versa. On a purely theoretical view, NPV is the better
measure since it measures the actual cash value a project creates for shareholders. However,
IRR is also a widely used tool since financial managers usually like to think in terms of ratios
and percentages.

Risk and Return Trade-off

Definition:
1. Higher risk is associated with greater probability of higher return and lower risk with a
greater probability of smaller return.
(https://economictimes.indiatimes.com/definition/risk-return-trade-off)
2. The risk-return trade-off is the concept that the level of return to be earned from an
investment should increase as the level of risk increases.
(https://www.accountingtools.com/articles/2017/5/13/risk-return-trade-off)

Understanding the Risk-Return Trade-Off and How it Can Help You Invest Wisely

Going back to Karl’s plead to his father on revising his pocket money. While it took
some time for Karl to figure out which option was suitable for him, he did learn an important
investing lesson that day – there is always a risk-return trade-off in investments. The higher
the expected returns (note the word expected) form an investment option, the higher are the
risks associated with it (more like Option A in this case). While investment options with
lower risks will also have lower expected returns.

This situation is also true for making financial decisions. Taking a higher risk gives you
the opportunity to earn higher returns. Low risk investments like treasury notes, also called
risk-free instruments, earn a low- and steady-income flow. In making investment decisions,
financial managers ensure that the proposed business will earn more than the risk-free rate
since they need to compensate for the risk the investment will entail. This introduces us to the

7 NegOr_Q3_Business Finance12_Module 8_v2

Required Rate of Return. It is the minimum expected yield investors require to select a
particular investment.

But what is Risk?

Investments generally entail different types of risk driven by various factors.

However, all of it boils down to one simple definition of risk – the chance that the actual
return on your investment will vary from the expected return.

Example: You purchase mutual fund units worth P10,000 today and plan to withdraw your
money in 3 years. Historically, mutual fund units have yielded 12% annual return. Hence,
you expect your investment to grow approx. P 14,050 in 3 years. Your risk here is the chance
that your units will be worth less than P 14,050 (downside risk) in 3 years from today or the
possibility that your units will be worth more (Yes! Even this is called a risk – upside risk).

To put this in perspective, let us consider two investment options – shares of a

Company (Option A) & a bank fixed deposit (Option B).

Option A Option B

Type of investment Shares Bank FD

Expected return (%) 15% 7%

Return range with 95% chance 9% - 21% 6% - 8%

As you can see, while A has higher expected return, there is also a higher degree of
uncertainty over actual returns (your actual returns could vary between 9% and 21% with a
95% chance). In B, you are more or less assured of an earning close to the expected return
(7%).

Going back to our original point, investment A is riskier investment option. Hence,
offers a relatively higher expected return (to compensate for the associated risk), while
investment B is less risky investment option. Hence, offers a relatively lower expected return.
The same is true for all kinds of investments.

This understanding of risk-return trade-off is very important in making correct

investment decisions. It helps you pick the right investment option bearing in mind how much
risk are you willing to take. It also helps weed out fraudulent investment proposals. If someone
comes to you and says that he has a proposal that will earn you a guaranteed 20% return (no
risks), you should simply walk off! Nothing in life comes for free!

8 NegOr_Q3_Business Finance12_Module 8_v2

 ’s More

Task 3

In your activity notebook, explain how the risk and return trade-off can be applied in real life
situation.
_______________________________________________________
_______________________________________________________
________________________________________.

I Have Learned

Complete the following statements. Write your statements in your activity notebook.

1. As an ABM student, I have learned that capital budgeting, internal rate of return and risk
return trade-off are __________________________________________________.

2. As an ABM student, I have realized that _______________________________.

3. Using the knowledge I have learned in this lesson, I will apply

__________________________________________________________________.

I Can Do

Task 4

Direction: Answer the given exercise below. Write your answers in your activity notebook.

Year Project Pizza

0 (100,000)
1 50,000
2 50,000
1. Given the cash flows above and a discount rate of 5%, compute the payback period and NPV
of Project Pizza.
2. If PHP50,000 is earned on the 3rd year of the project, what is the new NPV of the project?
What is the payback period?

9 NegOr_Q3_Business Finance12_Module 8_v2

I. TRUE or FALSE
Directions: Write TRUE if the statement defines risk-return trade off, otherwise write FALSE.
Write your answers in your notebook.
1. This states that the potential return rises with an increase in risk.
2. One of the essential components of each investment decision.
3. To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
4. Some will readily invest in low-return investments because there is a low risk of losing
the investment.
5. The risk-return trade-off is the concept that the level of return to be earned from an
investment should increase as the level of risk decreases.
II. PROBLEM

Directions: The data below shows projects A and B. Answer the questions in your notebook.
Show your solutions.
Year Project A Project B
0 (200,000) (200,000)
1 80,000 100,000
2 80,000 100,000
3 80,000 100,000
4 80,000

1. If the opportunity cost of capital is 11%, which of these projects is worth pursuing? Find the
NPV of both projects.

2. Suppose that you can only choose one of these projects. Which is more favorable to the firm
given that the discount rate remains at 11%? (Which has the higher NPV)

3. Which project would you choose if the opportunity cost of capital were 16%? (NPV/IRR)

4. What is the payback period for each project?

Answer the following questions in your notebook.

1. Whys is capital budgeting important in business?
2. Explain briefly what is “risk -return -trade off” in your own words.
3. What are the steps in capital budgeting?

10 NegOr_Q3_Business Finance12_Module 8_v2

NegOr_Q3_Business Finance12_Module 8_v2 11
PRETEST
WHAT’S IN
TASK 1
Answers may vary.
TASK 2
Answers may vary.
TASK 3
Answers may vary.
ASSESSMENT
I. TRUE OR FALSE
1. TRUE
2. TRUE
3. TRUE
4. TRUE
5. FALSE
 II. PROBLEM
ASSESSMENT

For Teachers Reference Only:

TASK 4
What I Can Do

12 NegOr_Q3_Business Finance12_Module 8_v2

Glossary

Capital Budgeting- It is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximizing owners’ wealth.
Long-term investment- results in benefits to accrue to the company in excess of one year.
Operating expenses- benefits the company only within the operating period.
Independent Projects - are those whose cash flows are independent of one another. The
acceptance of one project does not eliminate the others from further consideration.
Mutually Exclusive Investments - are projects which serve the same function and therefore
compete with one another. The acceptance of one eliminates all other proposals that serve a
similar function from further consideration.
Unlimited Funds – The amount and availability of funds affects the company’s decisions in
capital outlays. If the company has unlimited funds, then all projects which pass the risk-
return criteria will be accepted and implemented.
Capital Rationing – will accept only projects which provide the best opportunity to increase
shareholder wealth.
Accept-Reject approach - is usually done for mutually exclusive projects where one project
is favored over the others. The approach accepts projects which pass a certain criteria.
Ranking Approaches- is done when there are several projects passing the criteria and the
company is only able to fund so much. The highest-ranking projects will be selected for
implementation.

Payback Method – This is the simplest method used in capital budgeting. It measures the
amount of time, usually in years, to recover the initial investment.

Net Present Value (NPV) – This method is more sophisticated than the payback method since
it considers the time value of money and it considers all the cash flows during the life of the
project including the terminal value.

Internal Rate of Return (IRR) – The IRR is one of the most widely used techniques in capital
budgeting. It is defined as the discount rate that equates the NPV of an investment to zero.

13 NegOr_Q3_Business Finance12_Module 8_v2

References

Business Finance
Teaching Guide for Senior High School. Published by the Commission on Higher Education,
2016 Chairperson: Patricia B. Licuanan, Ph.D. (Page 268- 284)

Long Term Finance Definition and importance. © 2021 The World Bank Group Accessed:
January 11, 2022.https://tinyurl.com/5n7ra9mc

Pre-Assessment. ProProfs Quizzes. The financial Planning Process. Concept Of Risk And
Return Accessed: January 11, 2022
https://tinyurl.com/2p8jxbzb
https://tinyurl.com/yvvn48v4
https://tinyurl.com/4eyxhs8n
https://tinyurl.com/5h8fv6vv
https://tinyurl.com/2p8a5vf7
https://www.accountingtools.com/articles/2017/5/13/risk-return-trade-off

14 NegOr_Q3_Business Finance12_Module 8_v2