Business Finance

CHAPTER 5
Basic Long-term Financial
Concepts
The Future Value of Money
and the Present Value of
Money
 Learning Objective
• To calculate the future value and present value
of money
The Concept of Interest
What is the FORMULA for
computing INTEREST?

where:
I = Interest
Interest is earned or
P = Principal incurred for the use of
R = Interest Rate the principal amount
T = Time Period over the relevant time
period.
 The Concept of Interest
EXAMPLE: An individual borrowed ₱1,000 from a local
bank at an interest rate of 9% over a one-year period.
 In the example, the ₱1,000 amount borrowed is the principal
of the loan; 9% is the applicable interest rate; and the
relevant time period is one year.
 The interest on the loan is computed as:

I = ₱1,000 x 9% x 1 year
I = ₱90
 Thus, the interest on the loan is ₱90. This ₱90 is the cost
of using the ₱1,000 borrowed for one year.
 Self-Test Questions
1. What is the basic formula for the computation of
interest?
2. What is the cost for the use of money?
 Exercise 1
Direction: Identify the (a) principal, (b) interest rate, and (c) time
period in the examples below:
1. Your mother invested ₱18,000 in government securities that
yield 6% annually for two years.
2. Your father obtained a car loan for ₱800,000 with an annual
rate of 15% for 5 years.
3. Your sister placed her graduation gifts amounting to ₱25,000
in a special savings account that provides an interest of 2%
for 8 months.
4. Your brother borrowed from your neighbor ₱7,000 to buy a
new mobile phone. The neighbor charged 11% for the
borrowed amount payable after three years.
5. You deposited ₱5,000 from the savings of your daily
allowance in a time deposit account with your savings bank at
a rate of 1.5% per annum. This will mature in 6 months.
 Simple Interest
If the interest earned or
incurred is always based on
the original principal, then
simple interest is
assumed.

http://www.fundation.com/wp-content/uploads/2015/10/simple-interest-
loans.jpg
 Simple Interest
EXAMPLE: You invested ₱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:

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

original principal of ₱10,000. Under this assumption, the interest
for every year is the same, in this case, ₱900 annually. The total
interest for the three-year period is ₱2 700 (₱900 × 3 years).
 Self-Test Questions
1. On which principal amount simple interest is always
calculated?
2. Why does the interest applicable to every period
stay the same using a simple interest assumption?
 Exercise 2
Direction: Using the situations provided in Exercise 1, compute
the annual interest, total interest, and amount to be received or
paid at the end of the term for each scenario below using a
simple interest assumption:
1. Your mother invested ₱18,000 in government securities that
yield 6% annually for two years.
2. Your father obtained a car loan for ₱800,000 with an annual
rate of 15% for 5 years.
3. Your sister placed her graduation gifts amounting to ₱25,000
in a special savings account that provides an interest of 2%
for 8 months.
4. Your brother borrowed from your neighbor ₱7,000 to buy a
new mobile phone. The neighbor charged 11% for the
borrowed amount payable after three years.
5. You deposited ₱5,000 from the savings of your daily
allowance in a time deposit account with your savings bank
at a rate of 1.5% per annum. This will mature in 6 months.
 Compound Interest
Compound interest 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
http://www.fundation.com/wp-content/uploads/2015/10/simple-
previous period assuming all
interest-loans.jpg
cash flows would be paid or
received in lump sum upon
maturity.
 Compound Interest
EXAMPLE: Using the previous example where you invested
₱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:

₱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 ₱2,950.29. This is the sum of the increasing interest for the 3-
year period (₱900 + ₱981 + ₱1,069.29).
 Self-Test Questions
1. What is the difference between simple interest and
compound interest?
2. Why does interest applicable to the succeeding
period increase using a compound interest
assumption?
 Exercise 3
Direction: Using the situations provided in Exercise 1, compute
the annual interest, total interest, and amount to be received or
paid at the end of the term for each scenario using a compound
interest assumption:
1. Your mother invested ₱18,000 in government securities that
yield 6% annually for two years.
2. Your father obtained a car loan for ₱800,000 with an annual rate
of 15% for 5 years.
3. Your sister placed her graduation gifts amounting to ₱25,000 in
a special savings account that provides an interest of 2% for 8
months.
4. Your brother borrowed from your neighbor ₱7,000 to buy a new
mobile phone. The neighbor charged 11% for the borrowed
amount payable after three years.
5. You deposited ₱5,000 from the savings of your daily allowance
in a time deposit account with your savings bank at a rate of
1.5% per annum. This will mature in 6 months.
 Future Value of Money
What is the general FORMULA for
computing FUTURE VALUE?

where:
R = Interest Rate future value
T = Time Period interest factor
(FVIF)
 Future Value of Money
 Using the example from the previous lessons here, 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.
 This is equal to = 1.2950 (rounded off to 4 decimal
places).

Future Value Table

 Self-Test Questions
1. What is the general formula in getting the future
value interest factor (FVIF)?
2. How do you use the FVIF table based on a given
time period and interest rate?
 Exercise 4
Direction: Using the situations provided in Exercise 1, compute
for the future value at the end of the term for each scenario using
the future value of money formula or the FVIF table:
1. Your mother invested ₱18,000 in government securities that
yield 6% annually for two years.
2. Your father obtained a car loan for ₱800,000 with an annual rate
of 15% for 5 years.
3. Your sister placed her graduation gifts amounting to ₱25,000 in
a special savings account that provides an interest of 2% for 8
months.
4. Your brother borrowed from your neighbor ₱7,000 to buy a new
mobile phone. The neighbor charged 11% for the borrowed
amount payable after three years.
5. You deposited ₱5,000 from the savings of your daily allowance
in a time deposit account with your savings bank at a rate of
1.5% per annum. This will mature in 6 months.
 Present Value of Money
What is the FORMULA for getting the
PRESENT VALUE of a lump-sum amount?

Expected lump-sum Present value

amount
 Rearranging the equation above gives us the formula for
the present value of money:
 Present Value of Money
EXAMPLE: 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
₱200,000 or (2) receive ₱500,000 10 years from now. The
available investment opportunities to you provide a 10% rate
of return. Which option would you prefer?

• Determine the future value of the

To address ₱200,000 and compare it with the
this dilemma, expected cash flow of ₱500,000
you either… 10 years from now
OR
• Compute for the present value of
the ₱500,000 and compare it to
the ₱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 ₱500,000.

• Determine the future value of the

₱200,000 and compare it with the
expected cash flow of ₱500,000
ten years from now
OR
• Compute for the present value of
the ₱500,000 and compare it to
the ₱200,000 which you can
receive today.
 Present Value of Money
 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

 To get the present value of our example:

Present Value Table

 Self-Test Questions
1. What is the general formula in getting the present
value interest factor (PVIF)?
2. How do you use the PVIF table based on a given
time period and interest rate?
 Exercise 5
Direction: Compute for the present value of each scenario using
the present value of money formula or the PVIF table:
1. Your mother is expecting to get ₱18,000 in two years’ time
after investing in government securities that yield 6% annually.
2. Your father obtained a car loan payable in lump-sum in 5 years
at a total amount of ₱800,000 with an annual rate of 15%.
3. Your sister placed her graduation gifts in a special savings
account that provides an interest of 2% for 8 months. She
expects to get ₱25,000 after 8 months.
4. Your brother borrowed from your neighbor to buy a new
mobile phone. The neighbor charged 11% for the borrowed
amount payable after three years at a total amount of ₱7,000.
5. You deposited your savings from your daily allowance in a
time deposit account with your savings bank at a rate of 1.5%
per annum. This will mature in 6 months and you expect to get
₱5,000 at the end of the term.