BASIC LONG-TERM

FINANCIAL CONCEPTS
Business Finance 01
OBJECTIVES
• Calculate future value and present value of money
• Compute for the effective annual interest rate
• Compute loan amortization using mathematical concepts and the present
value tables
• Apply mathematical concepts and tools in computing for finance and
investment problems
• Explain the risk-return trade-off
TIME VALUE OF MONEY
One day, the Master was going on a trip and decided to entrust his wealth to three
of his most trusted servants. He entrusted ₱500,000 to each servant. 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 ₱500,000
given to him. He was very pleased that he was quoted a long-term investment for 5
years at 8% per annum compounded annually and decided to invest the money in
that institution.
The second servant saw what the first servant did and 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.
•

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 Returned 734,664.04 700,000.00 500,000.00
SIMPLE INTEREST
• Simple Interest – the charging interest rate r based on a principal P over T
number of period.
Interest = P x r x T

In the story above,

Principal = ₱500,000
Rate = 8%
Time = 5 years
Thus,
Interest = 500,000 x .08 x 5 = ₱200,000
 COMPOUND INTEREST
•
COMPOUND INTEREST
•
COMPOUNDING FREQUENCY
•
•
EFFECTIVE ANNUAL RATE
•
•
•
FUTURE VALUE AND PRESENT VALUE
• Future Value - the amount to which an investment will grow after earning
interest.
In our previous examples, it is the principal plus total interest earned over a
stated period. So, the future value of an investment of ₱500,000.00 yielding
an interest of 8% for a 5-year period compounded annually is ₱734,664.04.
• Present Value - the amount you must invest today if you want to have a
certain amount of cash flow in the future.
TIME VALUE OF MONEY
• Time value is the concept that a peso today is not necessarily worth the
same as a peso tomorrow. The main principal is that money received today
can be invested to earn income sooner than money received in the future.

• The time value of money analysis helps managers and investors compare
cash flows today versus cash flow in the future. It answers questions such as
what amount in the future is equal to PHP500,000.00 today or what amount
today is equivalent to PHP734,664.04 in the future.

• The future value is computed using compounding while the present value is
computed using discounting. In practice, when making investment
decisions, investors usually adopt the present value approach.
Basic Patterns of Cash Flow
• Single Amount (Lump Sum) - a single cash outflow is made, and the total
receipts will be at a single future date.
• Annuity - periodic stream of equal cash flow at equal time intervals
(annually, monthly, etc.). For example, payment for a certain item shall be
for 12 equal monthly installments of PHP1,000.
• Mixed Stream - unequal periodic cash flows that reflect no pattern. For
example, payments made by a customer are in 3 unequal installments.
FUTURE VALUE OF A LUMP SUM
•
PRESENT VALUE OF A LUMP SUM
•
NUMBER OF PERIODS AND INTEREST
•
FUTURE VALUE AND PRESENT VALUE
OF MIXED STREAMS OF CASH FLOWS
FUTURE VALUE AND PRESENT VALUE
OF MIXED STREAMS OF CASH FLOWS
PRESENT VALUE AND FUTURE VALUE
OF ANNUITY PAYMENTS
• An annuity is a stream of equal periodic cash flows over a specified period.
First, you must distinguish between ordinary annuity and annuity due.
• Ordinary annuity payments are made at the end of each period (usually
annually), while for annuity due, the cash flow occurs at the beginning of
each period.

a. Future Value of an Ordinary Annuity

b. Present Value of an Ordinary Annuity
c. Future Value of an Annuity Due
d. Present Value of an Annuity Due
FUTURE VALUE OF AN ORDINARY
ANNUITY
PRESENT VALUE OF ORDINARY ANNUITY
EXERCISE
Mr. Sotto won ₱10 million in the lottery. He was very excited to collect his winnings and had several
plans for his ₱10 million. He would buy his dream house, car, and a lot more. However, he was very
disappointed when the officers from PCSO said that he will not get his ₱10 million pesos upfront.
He, however, has the following options:
• Get 8.1 million upfront
• Receive 1 million every year for 10 years
• Receive 1.8 million every year for 5 years
The current government bonds have a yield of 5% per annum. Which is the best option?
Answer Key
Option 1 = PV is 8.1 million
Option 2 = PV = 1 million x PV factor (7.72173) = 7.721 million
Option 3 = PV = 1.8 million x PV factor (4.329) = 7.793 million
Option 1 is the best option.
FUTURE VALUE OF ANNUITY DUE
•
PRESENT VALUE OF ANNUITY DUE
•
EXERCISE
1. If you wish to accumulate ₱140,000 in 13 years, how much must you deposit
today in an account that pays an annual interest rate of 14%? Present Value in
Lump Sum
2. What will ₱ 247,000 grow to be in 9 years if it is invested today in an account
with an annual interest rate of 11%? Future Value in Lump Sum
3. Joe deposits ₱500 at the beginning of each quarter end for 7 years, in an
account paying 12 % compounded quarterly, how much will he have on deposit
after 7 years? Future Value in an Annuity Due
4. Napoleon deposits ₱1,200 at the end of each quarter for 10 years, in an
account paying 8 % compounded quarterly, how much will he have on deposit
after 10 years? Future Value in an Ordinary Annuity
5. Consider an APR of 12% with monthly compounding. What is the EAR (effective
annual rate)?
BOND OR LOAN
• A loan is money lent at an interest rate for a certain period. Loans are
normally secured from different financial institutions, the most common of
which, are banks.
• A bond is a fixed-income instrument that represents a loan made by an
investor to a borrower (typically corporate or governmental). A bond could
be thought of as an I.O.U. between the lender and borrower that includes
the details of the loan and its payments.
• Owning a bond is essentially like possessing a stream of future cash
payments. Those cash payments are usually made in the form of periodic
interest payments and the return of principal when the bond matures.
LOAN AMORTIZATION SCHEDULE
Contents of a Loan Agreement
• 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 (ex. required ratios to be maintained)
• Penalties for default
• Collateral documents, if applicable
Example: Loan Agreement & Loan Amortization Schedule
TIME VALUE OF MONEY IN LOAN /
BOND PRICING
TIME VALUE OF MONEY IN LOAN /
BOND PRICING
•
 TIME VALUE OF MONEY IN LOAN /
BOND PRICING
•

By using the formula

provided earlier, we get
that the present value of
annuity factor for 3 periods
using 10% interest is
2.4869.
Multiplying this factor by
₱10,000 provides a present
value of interest payments
of ₱24,868.6.
TIME VALUE OF MONEY IN LOAN /
BOND PRICING
• From the table (or by using the formula provided in the earlier module), we get that
the present value of annuity factor for 3 periods using 10% interest is 2.4869.
Multiplying this factor by ₱10,000 provides a present value of interest payments of
₱24,868.6.

• Take note of the frequency of compounding. It matters for both the interest
payments and face value discounting.
TIME VALUE OF MONEY IN LOAN /
BOND PRICING
•
TIME VALUE OF MONEY IN LOAN /
BOND PRICING
• Therefore, the price of the bond is:

₱100,000 face value at 10% for 3

75,131.48
years
₱ 10,000 interest for 3 years 24,868.52

Price of the Bond 100,000.00

• Take note that interest payments may be made semi-annually, or even monthly. In this case,
we need to adjust the interest rates and time periods accordingly.
BONDS ISSUED AT A DISCOUNT
• The face value of each bond, also referred to as the par value or
redemption value, is set by the issuer and typically printed on the bond
itself. It represents the amount the issuer promises to pay once the bond
reaches maturity.
• A bond will trade at a discount when it offers a coupon rate that is lower
than prevailing interest rates. The coupon rate is the interest rate paid on a
bond by its issuer for the term of the security. Since investors want a higher
yield, they will pay less for a bond with a coupon rate lower than the
prevailing rates—the upfront discount makes up for the lower coupon rate.
• When bonds are issued below the face or par value, they are said to be
issued at a discount.
BONDS ISSUED AT A DISCOUNT
 BOND ISSUED AT A PREMIUM
• A premium bond has a coupon rate higher than the prevailing interest rate for that bond
maturity and credit quality.
Let us recall our previous example but use 8% effective rate instead of 12%. It will result in
the following bond price:

₱100,000 face value at

79,031.45
4% for 6 periods
₱ 5,000 interest for 6
26,210.68
periods
Price of the Bond 105,242.13
ZERO-COUPON BOND
• For a zero-coupon bond, since there are no intermediate coupons/cash
flows, only the second part is applicable. Therefore, the price of a
zero-coupon bond can be calculated as:
EFFECTIVE INTEREST AMORTIZATION
• The effective interest method distinguishes two types of interest rate, the
nominal rate or the stated rate and effective 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.
• Using this method, the amortization of bond discount or premium results in
periodic interest expense equal to a constant percentage of the carrying
amount of the bonds.
EFFECTIVE INTEREST METHOD
1. 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.
2. Calculate the bond interest paid (or accrued) by multiplying the
face value of the bonds by the contractual interest rate.
3. Calculate the amortization amount by determining the difference of
(1) and (2).
AMORTIZATION OF BONDS ISSUED AT
A DISCOUNT
• Let us use the previous example of a bond 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 OF BONDS ISSUED AT
PREMIUM
• Period: 6 semi-annual periods (3 years)
Effective interest: 8%
Stated rate: 10%
Face Value: 100,000
Issue Price: 105,242.14
CAPITAL BUDGETING
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.
• The planning process in which financial managers estimate the financial
impact and economic viability of a proposed project
CAPITAL BUDGETING
Capital budgeting serves three important purposes for companies:
1. Accountability – Companies that invest in projects without adequate research
can quickly get into trouble. Capital budgeting provides a way for the company
to quantify the risk and returns associated with a project, thus increasing
accountability.
2. Measurability – Capital budgeting provide a way to quantitatively measure the
effectiveness and long-term viability of projects. This enables companies to
objectively determine how attractive a project is.
3. Resource Allocation – Companies have limited capital and must often choose
between mutually exclusive alternatives. Since capital budgeting summarizes a
project’s attractiveness with a number, this allows companies to compare
projects and implement the project which would best increase value and
accomplish goals.
CAPITAL BUDGETING
Regardless of purpose, all capital projects share the following characteristics:
1. Large Initial Outflow – There is typically a large outflow of resources at the
beginning of the projects. The investments are usually made to acquire long-term
assets, or otherwise prepare the company to undertake the project (e.g., cost to
hire and train new employees).
2. Gradual Inflows – The company expects to realize benefits from the project,
either in the form of additional income or reduced costs. These benefits are not
as large as the initial outflow and happen over a period of time.
3. Irreversibility – Projects usually involve the acquisition of fixed assets, such as
purchasing a new machine or constructing a new building. If the company
suddenly decides to cancel the project, it will not be easy to dispose of the
machine or building without a large loss. Because of this, implemented projects
are very hard to reverse.
4. Risk – Because of the time lag between the initial investment and its recovery, all
capital projects are subject to risk. The level of risk depends on the industry, the
nature of the project, the timing, the amount of cash flows, and the length of time
involved.
 TYPES OF CAPITAL PROJECTS
• Cost reduction – These projects do not generate revenues; they increase the efficiency or
effectiveness of a company’s processes. These projects add value by reducing company’s
cost, which increase income. For example, PLDT could invest in more energy-efficient
transmission equipment to save on power costs.
• Business Expansion – These projects increase the scope of a company’s operations either
by expanding an existing line of business or expanding into a new line of business. For
example, PLDT can expand into digital services by acquiring companies that offer
services such as cloud computing, cybersecurity, and e-commerce solutions. It can also
expand its existing broadband services by deploying fiber-optic cables to more locations
in the country.
• Equipment replacement – These projects involve deciding whether to retire or replace
existing equipment or to keep existing assets in place. These decisions are complex and
often involve taxes. For example, PLDT is currently upgrading its telecommunications
network to 5G, and must decide which areas will be upgrade with 5G-compatible
TYPES OF CAPITAL PROJECTS
• Equipment selection - These types of projects involve the company
choosing between two mutually exclusive alternatives. For example, PLDT
can choose from wide range of 56 equipment suppliers like Nokia, Ericsson,
Qualcomm, Samsung, and Huawei. Each supplier provides equipment with
differing costs, capabilities, useful lives, and of course, different prices.
• Lease or buy - The decision of whether to lease or to invest in an asset can
be analyzed using capital budgeting techniques. For example, if PLDT
decides to expand its mobile network coverage, it can choose between
putting up its own cell towers or leasing space from cell tower providers.
The costs for the alternatives are different, and there are distinct
advantages and disadvantages to each side.
 STEPS IN CAPITAL BUDGETING
1. First, the company must identify what potential value-adding projects or investments it can pursue.
These projects must be consistent with the company's business goals. For example, a retailer looking
to expand its operations must identify potential sites to open new stores.
2. Second, the company gathers information about each potential alternative. This includes identifying
the project's costs and other resources required in terms of financial and operational commitments,
quantifying the benefits associated with the project, and adjusting the benefits for the risks involved.
3. Third, the company must establish criteria that it will use to accept or reject projects. This could
include a maximum period in which the project must break even (e.g., five years), or a minimum
return of investment (e.g., 15%).
4. Fourth, the company should use capital budgeting techniques to evaluate the projects. The type of
decision to be made depends on the inter-relationship of the projects under consideration, and
whether the company is rationing capital or not.
5. Fifth, the selected project is implemented by management, and the project's actual performance is
compared to the budget. This lets the company know how effective its processes were, and helps it
improve in the future.
 BASIC TERMINOLOGIES RELATED TO
CAPITAL BUDGETING
• Independent vs. Mutually Exclusive Investments

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

The 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 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.
RELEVANT CASH FLOWS
Project Outflows Project Inflows
Beginning of Project Beginning of Project
- Initial investment cost’ - Proceeds from sale of replaced asset
- Working capital commitments
- Disposal costs of replaced asset Throughout the Project
- Incremental project cash revenues
Throughout the Project - Cost reductions related to project
- Incremental project cash expenses - Depreciation tax shield of purchased asset
- Project-related repairs and maintenance
- Opportunity costs of the project End of the Project
- Salvage value of purchased asset
End of the Project - Release of working capital upon project
- Cleanup and restoration costs completion

Capital budgeting techniques are broadly divided into two types-techniques that do not discount, and
therefore do not consider the time value of money, and techniques that do discount.
DIFFERENT TECHNIQUES IN CAPITAL
BUDGETING
• 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 - 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. The
NPV can be computed by comparing the present value of cash inflows
against the present value of cash outflows. Cash flows are discounted using
the firm’s cost of capital (cost of acquiring funding needs) to get the present
values.
• Internal Rate of Return - 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
PAYBACK METHOD
• A commonly used technique that do not discount cash flows
• This technique does not consider the time value of money, and since it
consider ₱100 today to have the same value as ₱ 100 five years from now,
they do not take long-term risk into account.
• The payback period measures how long it takes for a capital project to
breakeven or "pay back" the initial investment. It is a quick and simple way
to measure the risks associated with a project.
• The unit of time depends on the periodicity of the cash flows used in the
analysis.
• The payback period of annual cash flows are measured in years, while the
payback period of monthly cashflows are measured in months.
PAYBACK METHOD
•
PAYBACK METHOD
PAYBACK METHOD
Decision Criteria
• If the projects under comparison are independent, all projects that meet the
company's criteria of what is an acceptable payback period should be
accepted. For example, a company might consider three years as the
maximum tolerable payback period for a four-year project. This means that all
such projects that breakeven after four years are rejected, while those that pay
back in three years or less are implemented.
• If the projects are mutually exclusive, the project with the lowest payback
period should be considered. This is still subject to the firm's maximum
acceptable payback period (e.g., at most three years for a four-year project).
• If the projects are mutually inclusive, then the projects should be accepted
together if they collectively meet the firm's maximum payback period.
PAYBACK METHOD
Telcom is evaluating two projects with the same initial cost and project life,
but with different cash flows. Project X starts with higher cash flows, which are
gradually reduced, while Project Y has the opposite situation. The company
rejects projects with payback periods longer than 70% of the project's life.
Annual after-tax cash flows are illustrated as follows:

Cashflows Year 0 Year 1 Year 2 Year 3 Year 4

Project X -1250.00 600.00 500.00 400.00 300.00
Project Y -1250.00 300.00 400.00 500.00 750.00
PAYBACK METHOD
•

Cashflows Year 0 Year 1 Year 2 Year 3 Year 4

Project X -1250.00 -650.00 -150.00 250.00
Project Y -1250.00 -950.00 -550.00 -50.00 700.00
PAYBACK METHOD
•
 PAYBACK METHOD
Evaluation
• If Projects X and Y are independent, only Project X should be accepted because it has a payback period that
falls below the maximum acceptable payback period of 2.8 years (70% of the project life of four years).
• If Projects X and Y are mutually exclusive, Project X should be accepted because it is the project with the
lowest payback period that fulfills the firm's criteria.
• If Projects X and Y are mutually inclusive, both projects should be accepted because the projects collectively
have a payback period of 2.778 years, which just falls below the maximum acceptable level. The calculation is
summarized below:
Cashflows Year 0 Year 1 Year 2 Year 3 Year 4
Combined -2500.00 900.00 900.00 900.00 1050.00
Cash Flows
Cumulative -2500.00 -1600.00 -700.00 200.00 1250.00
Cash Flows
NET PRESENT VALUE
•
NET PRESENT VALUE
•
NET PRESENT VALUE
NET PRESENT VALUE
Decision Criteria
Projects with an NPV higher than zero add value to the firm, and those with
negative NPVs destroy value. As such, the following decision criteria would
apply:
• Independent: All projects with positive NPV should be accepted.
• Mutually exclusive: The project with the highest NPV should be accepted.
• Mutually inclusive: Accept the projects if their total NPV is positive.
NET PRESENT VALUE
• Let us calculate the NPV of Telcom's proposed investments, continuing
from the previous example. Telcom uses a discount rate of 10%, and the
project's after-tax cash flows are repeated below:
Cashflows Year 0 Year 1 Year 2 Year 3 Year 4
Project X -1250.00 600.00 500.00 400.00 300.00
Project Y -1250.00 300.00 400.00 500.00 750.00
NET PRESENT VALUE
•
INTERNAL RATE OF RETURN
•
INTERNAL RATE OF RETURN
Decision Criteria
Projects evaluated using IRR are compared against a hurdle rate, which is
usually the company's weighted average cost of capital. A hurdle rate is the
minimum rate of return a project or investment must achieve before a
manager or investor deems it acceptable, considering the need for profit,
risks, and costs. As such, the following decision criteria would apply:
• Independent: All projects with IRs higher than the hurdle rate should be
accepted.
• Mutually exclusive: The project with the highest IRR that is above the hurdle
rate should be accepted.
• Mutually inclusive: Accept the projects only if the IRR of their combined
cash flows is higher than the hurdle rate.
CALCULATING THE IRR
• The internal rate of return is easy to calculate with a financial calculator or a
spreadsheet. However, it is challenging in the board exam since only simple
four-function calculators are allowed. If the exam calls for IRR to be
calculated, this is one of the two strategies:
TESTING THE TEST
If the IRR is given as an answer in a multiple-choice question, calculate the
NPV using one of the choices as the discount rate. If NPV is positive,
recalculate using another choice with a higher discount rate, and use a lower
discount rate if NPV is negative. The correct choice will result in an NPV of
zero.
For example, the IRR of the following series of cash flows: -1,470.83, 250.00,
500.00, 750.00, 1,000.00 is closest to:
a. 15% b. 18% c. 20% d. 22%
CALCULATING THE IRR
• First, select a random choice to test. If we pick 18% as the IRR, the NPV is:

• Because NPV is not zero, 18% is not the answer. Since NPV is positive, 15%
cannot be the answer either. We can pick between 20% and 22% for our
next guess. Since NPV is quite close to zero, use 20% as the discount rate,
and recalculate for NPV:

• Since NPV is at zero, we can confidently choose answer C (20%) as the IRR.
Note that NPV does not necessarily have to be at zero, It can be very close
to zero, and within single digits (either positive or negative.
Reference
• Business Finance Teaching Guide for Senior High School (2016)
• Financial Management by Jovelyn Yu & Stevenson Yu (2024)