First long exam: August 5 | Monday | 4-7 pm Bring the following: Calculator, Financial Table, Blue Book, and

Pen (Flashlight) Coverage: Introduction: Finance and Financial Management | Objective of Finance | Financial Environment Value: Cash Flow | Time Value of Money | Risk, Return and Valuation Available lecture: June: 21 (cut) | 28 July: 3 | 5 | 10 | 12 | 17 July 19 and 24: Exercise 17 Items from 10th Edition (Chapter 4) #4 6 | 7 | 8 | 12 | 13 | 22 | 26 | 29 | 30 | 36 | 39 | 41 | 42 | 45 | 50 | 52 | 57 July 3 Time-Vale of Money Concept: Funds, like any other assets, have opportunity costs. If you get funds earlier, you can use them for some productive activities/purposes. B.D.: TVM is based on the belief that a dollar today is worth more than a dollar that will be received at some future date. Present Value Technique (PVT) Process of knowing the value of future cash today Discounting If you are going to receive cash in the future, what is its value today? B.D.: Present value is the current peso value of a future amount the amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount. Present value depends largely on the investment opportunities and the point in time at which the amount is to be received.

Future Value Technique (FVT) Opposite of PVT Compounding B.D.: Future value is the value of a present amount at a future date, found by applying compound interest over a specified period of time.

Interest Rate of Money or Opportunity Cost i is the Interest Rate or the Cost of Capital or the Opportunity Cost of Capital or Required Rate of Return. Lets say that opportunity cost = 10%. This means that the next best alternative is to invest it in an asset that can earn 10% annually. Difference between simple and compound interest: Simple interest You charge interest only on the original principal

Compound interest B.D.: An interest that is earned on a given deposit and has become part of the principal at the end of a specified period You charge interest on the interest earned on the past years

Example: PMT = P100,000 i = 10% Simple interest Year 0 1 2 3 100,000(.10) = 110,000 100,000(.10) = 120,000 100,000(.10) = 130,000 Year 0 1 2 3 Compound interest 100,000(.10) = 110,000 110,000(.10) = 121,000 121,000(.10) = 133,000

What is the future value of P100,000 at i = 10% 3 years from now? P133,000 ( Examples: 2. Interest = 8% a. Find PV: Given: P40,000 at years 3, 5, 8, 20 )

b. Year 3 5 8 20 c. Interest rate 6% 9% 12% 15%

Find FV: Given: P30,000 at years 3, 5, 8, 20 PV ( ) 44,079.84 55,527.91 139,828.71 FV ) ) 59,776.88 74,278.90 91,717.6 FV

27,223.33 21,610.76 8,581.93 Find PV and FV at interest rate = 6%, 9%, 12%, 15% at year 8 PV ( (

16,155.33 13,076.07 As time increases, the future value of money increases. As interest rate increases, the future value of money increases. Positive relationship: FV - time & interest rate Negative relationship: PV - time & interest rate

Factors affecting value of cash flow: 1. 2. Shortcut: From: To: ( ) Time Interest rate

Other tools: Microsoft excel | Financial calculator | Financial table Limitations of financial table Financial Table Table D-1: FVIF (pp. 71 76) Table D-2: FVIFA (pp. 77 80) Table D-3: PVIF (pp. 81 85) Table D-4: PVIFA (pp. 86 90) Annuity Stream of EQUAL PERIODIC CASH FLOWS, over a specified time period Cash flows can be inflows of returns earned on investments Can be outflows of funds invested to earn future returns Two types o Ordinary annuity: cash flow occurs at the end of each period o Annuity due: cash flow occurs at the beginning of each period Up to 50 years only Only 3 decimal places are reflected other information is lost

Examples: 1. i = 13%

500,000

Find PV a. b. Year 0 ( Year 1 ( Find FV a. b. Year 6 ( ) ( FV of 346,500 (this is in period 6) at Year 0 ( ) ( ) ) ) ( ) ) ( )

2 Factors for annuity 1. 2. PVIFA (PV interest for annuity) FVIFA (FV interest for annuity)

( ) ( ) NOTE: KAPAG PRESENT VALUE, YUNG CASH BALANCE AY MAPAPAPUNTA SA PERIOD PRIOR TO THE BEGINNING OF CASH FLOW

20K

20K

20K

20K

100K

100K

100K

100K

100K

100K

-1

If you use use

( (

) )

), the cash flow is beyond Year 0 (Year -1). You should

Another solution: ( ) NOTE: KAPAG FUTURE VALUE, YUNG CASH BALANCE AY MAPAPAPUNTA SA LAST PERIOD NG CASH FLOW.

100K

Cash Balance 100K 100K 100K 100K

-1

Find future value at year 6: ( Annuity due:

Difference between annuity due and ordinary annuity Future value: Value of annuity due > Value of ordinary annuity Because the cash flow of the annuity due occurs at the beginning of the period rather than at the end

Present value: Value of annuity due > Value of ordinary annuity Because the cash flow of the annuity due occurs at the beginning of the period rather than at the end PERPETUITY Stream of EQUAL PERIODIC CASH FLOWS WITH INFINITE LIFE ANNUITY WITH AN INFINITE LIFE Examples: o Scholarship grants, university grants, noble prize

Computation

10K

10K

10K

10K

10K

10K

For constant interest rate For increasing interest rate Problems will arise if g>i. If perpetuity starts at year 5 and you want to measure its present value today: (i=10%)

10K

Other examples

MIXED STREAM

50K

300K

300K

300K

200K

200K

200K

1. 2. 3.

Put everything to year 0 at i=12% ( Put to year 3 ( Put to year 5 ( ) ( ) ) ( ) ) ( )( )

Other cases 1 period is not always 1 year it can be daily, weekly, monthly, etc. Example 1. 2. Determine value of 100 in year 2. However, this cash flow will be compounded once every year. ( ) What if compounding frequency is quarterly? Compounding/Discounting frequency m 2 4 12 52 Interest rate (i/m) Periods (m x n) Formula ( ( ( ( ) ) ) )

Compounding period Semiannual Quarterly Monthly Weekly 3. NOTE:

Continuous compounding

AS COMPOUNDING FREQUENCY INCREASES, THE FUTURE VALUE INCREASES (dahil mas madalas/mabilis umikot ang pera) AS DISCOUNTING FREQUENCY INCREASES, THE PRESENT VALUE DECREASES

Special Applications of Time Value Application Deposits needed to accumulate a future sum Loan amortization Interest rate/growth rate Finding an unknown no. of periods Loan amortization This refers to the computation of equal periodic loan payments. These payments provide a lender with a specified interest return and repay the loan principal over a specified period. Loan amortization schedule: schedule of equal payments to repay a loan. It shows the allocation of each loan payment to interest and principal. From (single amount, annuity, etc.) To (single amount, annuity, etc.)

Example: Given: i = 10% | PVA = 1,000,000 | n = 4 years | annual amortization Loan amortization schedule for P1 M loan
Principal amount at beginning of period Equal payment Payment Principal = equal - interest Interest (beg. X interest rate) Principal amount at end of period (beg. principal)

61.1229: Due to rounding of figures If i = 8%, the equal annual amortization will decrease because you are paying lower interest on the loan. If you bargain for a longer amortization number/period, (ex. 8 years), the equal annual amortization will decrease but totat interest will increase because youll be paying interest for a longer period of time. Other case: Equal monthly amortization

Interest rate/growth rate Single amount Annuity Note: If you lower the amount to 150,000 every year or have a lower principal, the INTEREST WILL INCREASE to compensate the decrease in the principal. Mixed stream Problem: different interest factors

Unknown number of periods Single amount refer to financial table: Period = 7

Note: If you lower the interest, the period will increase since payment is slower (it may take a longer year). If you increase PMT, the period will decrease since youll be able to pay the amount in a shorter year. Valuation Looking at the worth of a certain asset What dictates worth of an asset? look at future benefits derived from an asset Valuation is the process of knowing the present value of future benefits . Interest rate Required rate of return Hurdle rate Opportunity cost Required rate of return Components of investment: = real rate of return or the return when market is in equilibrium (no inflation and differences in opinion of consumers regarding the value of commodity; minimum interest = inflationary premium (expected inflation in the future) = risk premium (measure of risk) If investment is risky, RP is high. If investment is less risky, RP is low. If there is no risk, RP is 0. Risk-free rate It is the interest rate when a given investment has no risks. = risk-free rate; no risk where i is the nominal interest rate (interest rate that includes inflation) o Real interest rate no inflation Examples of risk-free investments o Government issued securities since the government can always pay its obligation If interest rate is high, risk is also high. o Present value is low since risk is high. o RISKY ASSETS HAVE LOWER VALUE. If interest rate is low, risk is also low. o Present value is high. o LESS RISKY ASSETS HAVE HIGHER VALUE. If you assign a higher risk premium on an asset, its present value will decrease. But people have different assessment of risks. Normally, we have different estimates of interest/risks. If there are differences in estimates of risk premium, then there will be differences in cost of capital and valuation or estimation of worth of certain asset. Valuation depends on estimate of required rate of return. o Loan Investment Budgeting General term

Different terms for interest:

Financial asset: 1. Bond It is a debt instrument with long-term maturity. You earn from it from the coupon rate and face value. Example: You have a bond with a face value (or par value - yung amount na makukuha upon maturity or katapusan) of P10,000. Maturity is 10 years. So a face value of P10,000 means that at the end of 10 years, you will receive P10,000. Coupon rate is 12%. Every year, the holder of bond will receive 12% of face value or P1,200. It is usually given semi-annually (600-600) but in the example, it is assumed to be given annually. Total benefit: 10,000 + 12% or 1,200 every year. CUT 1:03:12

Bond valuation Yield to maturity interest rate or required rate of return ( If YTM = 8%. PV = 12,682 This is the maximum amount. ) ( )

If YTM = 12%, PV will decrease to P10,000. If YTM = 16%, PV will decrease to P8,069.6 If YTM = Coupon rate, the value of bond is equal to the face value. If YTM < Coupon rate, the value of bond is greater than the face value. If YTM > Coupon rate, the value of bond is less than the face value. How to determine the proper YTM? Based on image of company or their ability to issue bonds or their life span o If a company has a bad track record, there is a higher risk and a lower bond. o If a company has a good track record, there is a lower risk and a higher bond. For ordinary citizens, how will they be able to determine YTM? o Refer to organization or bond rating agencies o Look at how bonds are being priced Primary market First time to sell bonds Secondary market Pagkabili ng bonds, ibebenta mo ulit Through this, you can know the selling price of bonds o Is it possible to know YTM through secondary market? YES. How? Trial-and-error

Government sell to eligible security dealers

Financial institutions (banks, insurance, etc.)

sell to

Ordinary individuals