CHAPTER 5:

BASIC LONG-
TERM
FINANCIAL
CONCEPT
Time Value of Money
The two basic problems in financial management are
(1)INVESTMENT and (2) FINANCING.

INVESTMENT
in addressing this problem:
• they put their funds in real assets such as purchasing equipment
and machinery with the purpose of generating revenues.
• Adding a new wing to their office building or factory.
• Investing in the shares of another company.
• Lending money to others
Time Value of Money
The two basic problems in financial management are
(1) INVESTMENT and (2) FINANCING.

FINANCING
in addressing this problem:
• It requires businesses to seek out funding sources such as equity
infusion by investors or borrowing from financial institutions such as
banks.
• Individuals prefer to receive peso now instead of later because (a) it can
invest the peso now and earn a return from this investment and (b) a
peso expected to be receive in the future is riskier and less certain.
• We either determine their future value at a common future date or
compute for their present value today.
The Concept of Interest
The most basic finance-related formula is the computation of
interest. It is computed as follows:
(Equation 5.1) I=P x R x T
where:
I = Interest
P = Principal
R = Interest Rate
T = Time Period

Interest is earned or incurred for the use of the principal amount

over the relevant time period.
The Concept of Interest
Ex.
An individual borrowed Php 1,000 from a local bank at an interest
rate of 9% over one-year period.

PRINCIPAL = Php 1,000 The interest on the loan is computed as:

INTEREST RATE = 9%
Php 1,000 x 9% x 1 year = Php 90
TIME PERIOD = 1 year

Thus, the interest on the loan is Php 90. This Php 90 is the cost of
using Php 1,000 borrowed for one year.
 Simple Interest
If the interest earned or incurred is always based on the original
price, then simple interest is assumed.
Ex. You invested Php 10,000 for 3 years at 9% and the proceeds
from the investment will all be collected at the end of 3 years. Using
a simple interest assumption, interest will be computed as follows:
Year Principal Rate Time Interest Cumulative Total
Interest
1 Php 10,000 9% 1 Php 900 Php 900 Php 10,900
2 Php 10,000 9% 1 Php 900 Php 1,800 Php 11,800
3 Php 10,000 9% 1 Php 900 Php 2,700 Php 12,700

Interest, in this example, is always calculated based on the original

principal of Php 10,000. Under this assumption, the interest for
every year is the same, in this case, Php 900 annually. The total
interest for the three-year period is Php 2,700 (Php 900 x 3 years)
Compound Interest
It is simply earning interest on interest. This means that the
basis for the computation of the applicable interest for a certain
period is not only the original principal but also any interest earned
in the previous period assuming all cash flows would be paid or
received in lump sum upon maturity.

Ex.
Using the previous example where you invested Php 10,000 for
3 years at 9% and the proceeds from the investment will all be
collected at the end of 3 years, we illustrate the computation of
compound interest. Using a compound interest assumption,
interest will be computed as follows:
Compound Interest
Year Principal + Rate Time Interest Cumulative Total
Cumulative Interest
Interest
1 Php 10,000 9% 1 Php 900 Php 900 Php 10,900
2 Php 10,900 9% 1 Php 981 Php 1,881 Php 11,881
3 Php 11,881 9% 1 Php 1,069.29 Php Php
2,950.29 12,950.29
Interest, in this example, is increasing per period because the
principal is also increasing by the amount of interest earned in the
previous year. Under this assumption, the interest for every year is no
longer the same but is higher as it nears maturity. The total interest
for the three-year period is Php 2,950.29. This is the sum of the
increasing interest for the three-year period
(Php 900 + Php 981 + Php 1,069.29).
Future Value of Money
In the previous example, the value of the investment at the end of
year 1 is equal to Php 10,900 computed as follows:
Value at the End of Year 1 = Php 10,000 + (Php 10,000 x 9% x 1 year)
Php 10,900 = Php 10,000 x (1 + 9%)
We, therefore, say that given an interest rate of 9%, the future
value of Php 10,000 after one year is Php 10,900.
Similarly, the future value of the Php 10,000 at the end of year 2
will be equal to the value at the end year 1 plus the compound
interest earned in year 2 as shown below:
Value at the End of Year 2 = Php 10,900 + (Php 19,000 x 9% x 1 year)
Php 11,881 = Php 10,900 x (1 + 9%)
The future value then at the end of year 3 is determined as follows:
Value at the End of Year 3 = Php 11,881 + (Php 11,881 x 9% x 1 year)
Php 12,950.29 = Php 11,881 x (1 + 9%)
Future Value of Money
The future value of Php 10,000 invested for 3 years at a rate of  
9% is equal to Php 12,950.29.
Therefore, we use the general formula below to determine the
future value:
(Equation 5.2) Future value = Initial Value x
where:
R = Interest Rate
T = Time Period
To get the future value, we multiply the initial value by which is
referred to as the future value interest factor (FVIF).
Using our example, the FVIF given 3 years and a rate of 9% is
equal to 1.2950. This is the intersection of time period =3 and
interest rate = 9% in the FVIF table.
Future Value of Money
This is equal to = 1.2950 (rounded off to 4 decimal places.)  
To get the future value of our example,
Php 12,950.29 = Php 10,000 x 1.2950
Present Value of Money
Formula for the present value of money:  
Present value =
(Equation 5.3) Present value x
To get the present value, we multiply the future lump-sum amount
by
1 / which is referred to as the present value interest factor (PVIF).
The PVIF is also called the discount factor and the whole process of
determining the present value is referred to as discounting. The
interest rate used to get the present value is denoted as the discount
rate.
Present Value of Money
Ex.
Your father told you that he will entrust you with the funds for
your graduate program education. He gave you two options: (1)
receive the money now in the amount of Php 200,000 or (2) receive
Php 500,000 ten years form now. The available investment
opportunities to you provide a 10% rate of return. Which option
would you prefer?
To address this dilemma, you either determine the future value of
the Php 200,000 and compare it with the expected cash flow of Php
500,000 ten years from now, or compute the present value of the
Php 500,000 and compare it to the Php 200,000 which you can
receive today.
Present Value of Money
Choosing the second method will require you to get the present value 
of the Php 500,000 as shown below:
Present Value =
=
Present Value = Php 192 771.64
Php 192 771.64 < Php 200,000

Since the Php 200,000 is greater than Php 192 771.64 (the present
value of the Php 500,000), you will choose to receive the Php 200,000
today instead of waiting for it in ten years’ time. Getting it now will give
you the opportunity to grow the investment at the rate of 10% and the
related future value is
expected to be greater than the Php 500,000. To validate this,
we compute for the future value of the Php 200,000:
Present Value of Money
Future Value = Present Value x  
= Php 200,000 x
Future Value = Php 518,748.50
Php 518,748.50 > Php 500,000

Using our example, the PVIF given 10 years and a rate of 10% is
equal to 0.3855. This is the intersection of time period = 10 and
interest rate = 10% in the PVIF table.
This is equal to = 0.3855 (rounded off to four decimal places.)
To get the present value of our example:
Php 192,750 = Php 500,000 x 0.3855
Php 192,750 = Php 192,771.64
 Multiple Cash Flows
To a certain extent, all our examples contemplate a single lump-
sum cash flow at the end of the term. If multiple cash flows occur at
different times, the more difficult it becomes to compare these cash
flows streams. Getting their present values becomes more imperative
in order to make an appropriate decision. Simply get the present
values of the individual cash flows and add them together. Since the
present values refer to the same date (today), these are value-
addictive.
Ex. (PAGE 101)
Step 1:
Draw a timeline:
Time = 0 1 2 3

25,000 25,000 25,000

Multiple Cash Flows
Step 2 and 3:  
Compute the individual present values and get the sum:
Total Present Value = + +
Total Present Value = + +
Total Present Value = Php 25,000 x 0.9524 + Php 25,000 x 0.9070 + Php 25,000 x
0.8638
Total Present Value = Php 23,810 + Php 22,675 + Php 21,595
Total Present Value = Php 68,080

Php 68,080 is cheaper than the Php 70,000 cash price which means
you should pay through instalment instead. Simply adding the the
three Php 25,000 payments may lead you to think that the Php 70,000
is
cheaper but the more relevant figure should be the present
Annuities
(Equation 5.4) Present value of an Annuity = C x  

Where:
C = Equal Cash Flow Sream
R = Interest Rate
T = Time Period

(Equation 5.5) Present Value of a Perpetuity =

Loan Amortization
Effective Annual Interest Rate
(Equation 5.6) Effective Annual Rate = (1 + R/M  

Where:
R = Annual Interset Rate
M = Frequency of Compounding
Basic Application of the Time Value of
Money on Investment Problems