Fin 2 PDF
Fin 2 PDF
Course Description:
Course Requirements:
Table of Contents
Module 1. Financial System 1
Introduction 1
Learning Outcomes 2
Lesson 1. The Basic Functions of Financial System 2
Lesson 2. Financial Intermediary 3
Lesson 3. Money Market 6
Lesson 4. Capital Market 8
Lesson 5. Types of Capital Market 9
Lesson 6. Other Examples of Financial Markets 10
Assessment task 1 11
Summary 12
References 12
MODULE 1
FINANCIAL MARKETS
Introduction
Financial Markets, from the name itself, are a type of marketplace that provides an
avenue for sale and purchase of assets such as bonds, stocks, foreign exchange, and
derivative. Often, they are also called capital markets, but they mean one and the same
thing. Simply put, businesses and investments can go to financial markets to raise money to
grow their business and to make more money, respectively.
To state it more clearly, let us imagine a bank wherein individual maintains a savings
account. The bank can use their money and the money of other depositors to loan to other
individuals and organizations and charge an interest fee. The depositors themselves also
earn and see their money grow through the interest that is paid to it. Therefore, the serves
as a financial market that benefit both the depositors and the debtors (corporate finance
institute.com, n.d.)..
This module exposes the students to the functions of financial system. It will also touch
difference between financial market and intermediary and give emphasis on the different
types of capital market (corporate finance institute.com, n.d.).
Learning Outcomes
At the end of the chapter, students should be able to:
Having a well-functioning financial system in place that directs funds to their most
productive uses is a crucial prerequisite for economic development. The financial system
consists of all financial intermediaries and financial markets, and their relations with respect
to the flow of funds to and from households, governments, business firms, and foreigners,
as well as the financial infrastructure.
The main task of the financial system is to channel funds from sectors that have a
surplus to sectors that have a shortage of funds. In doing so, the financial sector performs
two main functions: (1) reducing information and transaction costs, and (2) facilitating the
trading, diversification, and management of risk.
1. Promote savings. Through the various markets in the financial system, the
savings of different surplus spending units turn into investments because these
market offers a potential rate of return for a relatively low risk.
2. Enable payment. The financial system has the best and most expedient
mechanisms in facilitating payments when purchasing goods and services, e.g.
the checking accounts that commercial banks as well as other types authorized
banks offer.
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3. Protect against risks. Through the sale of life, property, and accident insurance
policies by Insurance companies, the financial market has become necessary to
entrepreneurs, consumers and the government. Insurance companies offer
protection from practically all kinds of risk.
5. Provide liquidity. The numerous financial instruments used to store the wealth
possessed the different economic units can readily be converted into cash with
little or no risk of loss. The financial system provides this service to savers who
hold financial instruments and are in need of cash.
6. Provide credit facilities. Aside from expediting the conversion of savings into
investments and providing liquidity, markets are also making credit facilities
available to consumers and investors whether for spending or for any other
purpose.
An individual who would want to invest his/her savings to earn additional income will
surely go to a bank to open a savings or a time deposit account. The deposit he/she makes,
in turn are used by the bank to lend to borrowers. Here, the bank is not obliged to tell the
depositor where his/her money is going. The only obligation of the bank is to safekeep the
money and pay the stipulated interest. The function of the bank, in short is to act like a
middleman. It obtains money from providers (investors) and lends it to the users
(borrowers).
Where would a firm or government agency go if they want to raise money to finance a
business for example? Should it approach individuals or firms with surplus money and ask
them to lend funds in exchange for interest? Most individuals or firms do not approach the
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financial markets directly, rather they use middleman or financial intermediaries. An
investment bank is also a financial intermediary. It does not accept deposits but provides
funds to individuals or companies that need them. When firms and government agencies
want to raise money by issuing bonds or commercial papers, they can go the investment
bank.
Financial intermediary is the organization which acts as a link between the investor and
the borrower, to meet the financial objectives of both the parties. These can be seen as
business entities which accept deposits from the depositors or investors (lenders) by
allowing them low interest on their sum. Further, these organizations, lend this amount to
the individuals and firms (borrowers) at a comparatively high rate of interest to make their
margin.
A financial intermediary brings together the users and the providers of funds without having
them meet face to face. For this reason, they are also known to engage in an indirect form
of funds channeling. Actually, people and firms can go directly to the providers and users of
funds. By doing so, the use of financial intermediary is eliminated, resulting in a higher
return. However, if this is the case, why do some people and businesses still tap the
services of financial intermediaries (Prachi, 2019)?
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4. Financial intermediaries reconcile the conflicting interests of the users and
lenders of funds. Normally, lenders prefer to lend their money on a short-term
basis while borrowers prefer to have the money on a long-term basis to
provide liquidity. With the presence of financial intermediary, regardless of the
conflicting interests between the providers and users of funds, the demands
and preferences of the two can be made compatible, e.g. the loan can be
provided on a long-term basis but the lenders can withdraw their money
anytime that it is needed.
Banks: The central and commercial banks are the most well-known financial intermediaries
simplifying the lending and borrowing process, along with providing various other services to
its customers on a large scale.
Credit Unions: These are the cooperative financial units which facilitate lending and
borrowing of funds to provide financial assistance to its members.
Stock Exchanges: The stock exchange facilitate the trading of securities and stocks, and in
every trading activity, it charges the brokerage from each party which is its profit.
Mutual Fund Companies: The mutual fund organizations club the amount collected from
various investors. These investors have identical investment objectives and risk-taking
ability. The funds are then collectively invested in the securities, bonds, and other
investment options, to ensure a capital gain in the long run.
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Insurance Companies: These companies provide insurance policies to the individuals and
business entities to secure them against accident, death, risk, uncertainties and default. For
this purpose, they accept deposits in the form of premium, which is pooled into profitable
investments to gain returns. The insured person can claim the money in case of any mishap
as per the agreement.
Financial Advisers or Brokers: The investment brokers also collect the funds from various
investors to invest it in the securities, bonds, equities, etc. The financial advisers even
provide guidance and expert opinions to the investors.
Investment Bankers: These banks specialize in services like initial public offerings (IPO),
other equity offerings, proving for mergers and acquisitions, institutional client’s broker
services, underwriting debts, etc. As a result of constant mediation, between the investor or
public and the companies issuing securities.
A financial market is a mechanism in which buyers and sellers trade financial assets such
as stocks, bonds, currencies and derivatives. Unlike financial intermediaries, it is not a
source of funds but a link to provide a forum in which suppliers of funds and buyers of
loans/investment can transact business directly (Khan, et al 2006). Financial markets are
generally characterized as having formal regulations; transparent pricing; basic regulations
on trading, costs and fees; and market forces which determine the prices of the securities
that are being traded. Here, the providers of funds know where their money is being
invested or lent to. There are two types of financial markets, the money market and the
capital market (Khan, et al 2006)..
Money Market
The money market is a market intended for short-term placements. A placement takes at
most one year to mature. Money market exist because individuals or firms look for
temporary investments where their idle funds can be placed to earn income. To some
extent, companies look for short-term financing to support their seasonal needs. Because of
money markets, the temporary needs of the providers and users of funds meet (Khan, et al
2006).
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Money market instruments
There are various money market instruments traded in the money market (Khan, et
al 2006).
1. Certificate of deposit is a time deposit in which the depositor has to wait for a
certain number of days before the stated fixed interest is earned. The interest
given depends on the range of the amount deposited and the number of days
stipulated.
The higher the amount deposited, the higher the interest received.
4. Treasury bills are an obligation incurred by the national government. The interest
is usually higher than the savings or time deposit. T-bills are issued through a
competitive bidding process at a discount from par, which means that rather than
paying fixed interest payments, the return expected by the investor is capital
appreciation. T-bills are regarded as a risk-free investment because the
government guarantees their payment.
5. Bankers acceptance is a bank draft in which a bank is required to pay the holder
a specified amount on a specified date. It has a maturity of 90 days from date of
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issue, which can be extended to 180 days. People who invest in bank draft
expects a capital appreciation. At the time of purchase, these drafts are sold at a
discount and their value increases as it approaches the maturity date.
If the money market is intended for short-term financial instruments, the capital market is
intended for long-term financial instruments. Included in the capital market are issuances of
securities and long-term obligations by businesses and government agencies. Some of the
financial instruments have no maturity date (as in the case of common and preferred stocks)
while others have a maturity date that lasts for more than one year (as in the case of bonds).
The funds that comprise the firm’s capital structure are raised in the capital market (Keown,
2005).
• Issuers. These are either public or private corporations. Funds are raised by
means of public issues, rights issues or private placements.
• Financial instruments. These are the instruments purchased by the investors.
They may take the form of bonds, equities, warrants, etc.
• Financial intermediaries. These are the financial institutions which facilitate
the issuance of the securities. Examples include universal and investment
banks.
• The Investors. These are the individuals or firms with extra funds who are
willing to invest in the securities offered.
1. Bond Market is where the long-term debt instruments are issued by firms
and government agencies to raise money. It is also where participants can
buy and sell bonds. The participants are individuals, the government, or
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private firms who have extra money and are looking for a venue where they
can invest it to generate additional income in the form of interest and capital
gain on bonds.
3. Stock Market is where publicly listed stocks are bought and sold. If a firm
wants to raise money in the form of stocks, it normally goes to an investment
banker to facilitate the sale. This is in the form of an initial public offering
(IPO) where stocks are sold for the first time to the general public. However,
the stock market facilitates the subsequent selling of the stock. Participants in
the stock market range from small individual stock investors to large hedge
fund traders who can be based anywhere. Their orders usually end up in the
stock exchange with the stock broker who executes the order.
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Assessment Task 1
Summary c. Would you advise investors to buy more stocks given the said
• Financial market is a market place where buying and selling activities of stocks,
assets and other capital resources take place for the purpose of generating more
financial resources.
• An efficient and effective financial system redirects financial resources to the sectors
who most need it. The economic unit or sector with shortage will be filled in by the
units/ sectors with surplus.
• Primary market is a venue where firms and government agencies raise money by
issuing financial instruments like stocks or bonds for the first time.
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• Secondary Market also called the aftermarket. It is where the financial instruments
that are already issued are traded.
References
Block S.B., & Hirt, G.A. (2006) Foundations of Financial Management (9 th Edition).Blackwell
Publishing Limited, Florida.
Brealy, R.A, Myers, S.C., & Marcus, A.J. (2007) The Fundamentals of Corporate Finance
(5th Edition), Mc Graw Hills Company. USA.
Brigham, E.F., & Houston, J.F. (2011) Fundamentals of Financial Management , (9th
Edition)
Engler, G.N. (1978). Business Financial Management. Texas Business Publication Timbang,
Ferdinand L. Financial Management Part II
Gitman, L.J. & Zutter C.J. (2006). Principles of Managerial Finance. The Apprentice Hall
Series 3rd Edition. Retrieved from: https://baixardoc.com/documents/principles-ofmanagerial-
finance-13th-edition-by-l-j-gitman-c-j--5d1a6eb8af43a
Keown, A. J., Martin, D., Petty, W. & Scott, D. (2005) Financial Management: Principles and
Applications, 10th Edition. Virginia Polytechnic Institute and State University.
Retrieved from: https://theinvestorsbook.com/financial-intermediaries.html
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MODULE 2
Investment Market
Introduction
If you are not a seasoned investors, then the word investment must
be something intimidating because of the constantly changing financial market
situation. If you are not a risk taker, so you will take off investment. But you need to
invest for your future. Investment markets collect funds from institutional and retail
investors, and are entrusted with making investments in financial instruments
according to the strategies agreed upon with the investors.
Learning Outcomes
At the end of this module, the students are expected to :
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1. relate the similarities of investment markets and financial markets;
2. determine the roles of the investment banker in maintaining financial stability of
an economy;.
3. illustrate the step-by-step investment procedures; and
4. interpret the diagram showing the investment trading cycle.
The investment banker is a middleman engaged in raising long-term funds for businesses
and government agencies. He provides advice to the issuing corporation on the prices and
the securities to be issued. The usual functions of investment bankers are as
follows (Depersio, 2019):
1. Originate securities issues through negotiations between the officer of the
issuing firm and officers of the investment bank.
a. The initial discussions are concerned with determining the amount of
capital to be raised, the security to be issued and the particular terms and
conditions on the issue.
b. The investigation looks into the financial capability of the firm if the
issuances of the securities satisfy the investors. CPA’s are hired
scrutinize the books, audit and develop the required financial statements.
Lawyers are hired to investigate the legal aspects of the issue.
d. The registration ensures that all requirements on the new issues are
submitted to the SEC where all the material information about the security
is disclosed.
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3. Manage the distribution of the securities to the ultimate investors. Members of
the underwriting syndicate form a selling group consisting of dealers who will
contact the ultimate investors.
The process of investment involves careful study and analysis of the various classes of
assets and the risk-return ratio attached to it (PSE, Inc. 2019).
2. Open an account and fill out a customer information form and submit
identification papers for verification. The stockbroker will then assign a trader
or agent to assist the investor in either buying or selling any listed security.
3. Give the order to the trader, and then ask for the confirmation receipt. The
buy or sell orders are relayed to the stockbroker’s dealer for confirmation. In
an automated system as in that of PSE, the order is keyed in through a
trading terminal and automatically matched.
4. Pay before the settlement date. The delivery or payment should be made
before the settlement date of T+3 (trading day + 3 days). For traditional
stockbrokers, the settlement of transactions is usually done after 3 working
days from the transaction date.
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5. The investor shall receive from his/her broker either the proceeds of the sale
of his/her stocks (after 3 business days) or proofs of ownership of the stocks
he/she bought (confirmation receipt and invoice)
All equity transaction, whether buying or selling, have a settlement period of T+3. This
means that a seller should deliver the stock certificate, if any, to his/her broker and the buyer
must have paid the cost of the transaction to his/her broker within 3 working days after the
trade is done.
Historically, the settlement is done manually (i.e., 27-day cycle). With scripless trading,
wherein the settlement is done via the book entry system (through the Philippine Central
Depositary or PCD), transactions are settled on the third day after the trade date. Under this
system, the investor has the option to hold on to his/her certificate (uplift) or deposit (lodge)
this certificate in the PCD through his/her broker-participant account.
Figure 1 shows how investment trading cycle operate. This is actually based from the
data from the Philippine Stock Exchange, Inc., ( 2019 )
PSE
Broker Broker
Broker Broker
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Figure 1. Trading
Board Lot System Equity trading is done using the board lot or round lot system. The
board lot determines the minimum number of shares an investor can buy or sell at a specific
price range. Therefore, the minimum amount of initial investment varies and depends on the
market price of the stock as well as its corresponding board lot. The prices of stocks move
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2000.0000 to 4998.0000 2.0000 5
Buying Transaction
Mr. X wishes to buy a stock whose market price is about Php 10.00. Based on the board lot
table, the number of shares he can buy at a regular transaction should be in multiple of 100
shares. In this case, if Mr. X wants to buy 100 shares (which is a multiple of 100 shares), his
required cash outflows are as follows:
* The brokers commission varies depending on the value of the transaction, with a maximum
allowable commission rate of 1.5% (See Table 1)
Note: If a buying client chooses to receive and maintain a physical certificate in his/her
name, an upliftment/withdrawal fee of Php 50.00 per certificate issuance request and
transfer fee of Php 100.00 +12% VAT are charged. In the illustration above, the combined
upliftment/withdrawal fee and transfer fee to be paid by the buying client amount to Php
162.00 (Php 50.00 + Php 112.00).
Selling Transaction
Ms. Y wishes to sell a stock that is trading at Php 10.00. Based on the board lot table, the
number of shares she can sell at a regular transaction should be in multiples of 100 shares.
In this case, If Ms. Y wants to sell 1,000 shares (which is a multiple of 100 shares), her cash
inflow is as follows:
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Market price/share 10.00
Number of shares to be bought x 1,000
10,000.00
Brokers commission*(0.25% +12% VAT) - 28.00
Stock transaction tax **(value x 0.5%) - 50.00
SEC Fee (value x .005%) - 0.50
PSE Transaction fee (value x.005%) - 0.50
SCCP Fee (transaction value x 0.01%) - 1.00
Net cash receivable 9,920.00
*The brokers commission varies depending on the value of the transactions with a maximum
allowable commission rate of 1.5% (See Table 2).
Note: If a selling client has certificates, he/she needs to convert them into book-entry form in
the PCD system. A cancellation fee of Php 20.00 +12% VAT and a transfer fee of Php
100.00 + 12% VAT are charged. In the illustration above, the combined cancellation and
transfer fees to be paid by the selling client amount to Php 134.40 (Php 22.40 + 112.00)
Brokerage Commission
A stockbroker is compensated for his/her services in the execution of orders on the
Exchange through commission charges which are paid to him/her by both the buyer and the
seller.
For trade transactions covering equity and equity related products, the maximum
commission rate is 1.5% of the total transaction cost in addition to the 12& VAT. The
minimum commission depends on the amount of the transaction (PSE, Inc., 2019). (See
Table 2).
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If a buying client opts to have a stock certificate issued in his/her name, he/she must take
the request through his/her broker who will then issue the upliftment request through the
PDC system. Upon receipt, the PDTC will then submit the request to the transfer agent for
the issuance of the certificate. The PDTC will charge the broker an upliftment/withdrawal fee
of Php 50 per certificate issuance request. The transfer agent will charge his/her usual
issuance certificate on top of the PDTC’s upliftment/withdrawal fee (PSE, Inc., 2019).
Cancellation Fee
If a selling client has physical certificate, he/she must have the certificates converted into
book-entry form in the PDTC system by requesting (through his/her broker) for a direct
transfer with the transfer agent, which costs Php 100 (plus 12% VAT) per certificate for the
transfer of ownership of shares to the PDTC Nominee Corporation.
In addition to the DT fee, a client must pay a cancellation fee of Php 20.00 (plus 12% VAT)
to the transfer agent for the cancellation of the certificates to be lodged in the PDTC for the
lodgment of shares. This tax applicable only to listed equities (PSE, Inc., 2019).
Withholding Tax
Under the Internal Revenue Code of 1997, and except in cases where tax treaties are in
force, the dividends received from domestic corporations are subject to a withholding tax of
10%, if the recipient is a citizen or resident alien; 20% if the recipient is a non-resident
individual engaged in trade or business in the Philippines; 25% if the recipient is a
nonresident individual not engaged in trade or business in the Philippines; 30%if the
recipient is a non-resident foreign corporation. Dividends received by domestic and resident
foreign corporations are not subject to tax. The rate of income tax withheld on the dividends
paid to a non-resident foreign corporations may be reduced to 15% if the country in which
the nonresident foreign corporation is domiciled (a) imposes no taxes on foreign-source
dividends or (b) allows a credit against tax due from the foreign non-resident corporation for
taxes deemed to have been paid in the Philippines equivalent to 15% of such dividends
(PSE, Inc., 2019).
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Table 2. Transaction Fees (Philippines Stock Exchange, Inc.
2019) https://www.pse.com.ph/stockMarket/home.html
Type of Fee Rate
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Above 5 Billion up to 10 Billion 0.075% but not less than 5 M
Above 10 Billion 0.05% but not less than 7.5 M
Investment management fees are charged as a percentage of the total assets managed.
Example: An investment advisor who charges 1% means that for every $100,000 invested,
you will pay $1,000 per year in advisory fees.
2. Why do you think they were able to sustain their status of top
Summary
• Investment markets collect funds from institutional and retail investors, and are
entrusted with making investments in financial instruments according to the
strategies agreed upon with the investors.
• The process of investment involves careful study and analysis of the various classes
of assets and the risk-return ratio attached to it.
References
23
Block S.B., & Hirt, G.A. (2006) Foundations of Financial Management (9th Edition).Blackwell
Publishing Limited, Florida.
Brealy, R.A, Myers, S.C., & Marcus, A.J. (2007) The Fundamentals of Corporate Finance
(5th Edition), Mc Graw Hills Company. USA.
Brigham, E.F., & Houston, J.F. (2011) Fundamentals of Financial Management , (9th
Edition)
Engler, G.N. (1978). Business Financial Management. Business Publication, Inc., Dallas,
Texas.
Module 3
Time Value Of Money
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Introduction
In business finance managers rely on the concept of time value of money which states that
the amount of money today is different from what it will be in the future. Because of this
difference, a finance manager makes computations carefully before arriving at a decision.
For instance, an insurance company that pays Php 500,000 after 20 years to a policyholder
receives a premium payment of Php 12,500 per year. For 20 years, the premium payment
made by the policyholder will amount to a sum of Php 250,000 only. Why is the insurance
company willing to sacrifice the other Php 250,000? The answer to the question is simple
i.e. the insurance company believes that it can do much more using the Php 12,500 that it
actually receives every year. The firm believes that the expected return will exceed what is
willing to pay the policyholder (Timbang, 2016).
This module explains why the time value of money is a critical consideration in
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nancial and investment decisions. It helps individuals and firms determine how much money
must be placed today to accumulate a future sum given an interest rate for a given period.
Thus, the placement may be either in lump-sum or regular intervals, and at the beginning or
at the end of the period. Likewise, the time value of money helps determine how much
interest will earn if placed today at a certain rate for a certain period (Timbang, 2016).
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Students will also be exposed to the computation of the compounding interest of money
invested in the financial markets. It determines the future amount of money earned if an
investment is made at the present. It is also used to ascertain how much money should be
invested to acquire a target amount in the future, e.g. pension funds for retiring employees,
sinking funds for long-term obligations, etc. Discounting, the opposite of compounding is
used to evaluate future cash flows associated with capital budgeting projects and the
valuation of bonds and stocks (Timbang, 2016).
Learning Outcomes
At the end of this module, the students are expected to:
The time value of money (TVM) is the concept that money you have now is worth more
than the identical sum in the future due to its potential earning capacity. This core principle of
finance holds that provided money can earn interest, any amount of money is worth more
the sooner it is received. TVM is also sometimes referred to as present discounted value.
The time value of money draws from the idea that rational investors prefer to receive
money today rather than the same amount of money in the future because of money's
potential to grow in value over a given period of time. For example, money deposited into a
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savings account earns a certain interest rate and is therefore said to be compounding in
value (Chen, 2020).
A peso actually received today is worth more than a peso to be received tomorrow.
This valuation holds true because of interest money can earn after having been invested.
Compounding interest means that the interest not withdrawn also earns interest, i.e. the
interest itself also earns interest. Knowing how much interest is earned on the money placed
in the present helps individuals decide whether or not to look for other investment
opportunities(Timbang, 2016).
For better understanding of the concept of compounding, the following symbols are
defined:
FV = PV (1+i) ^n
In this case, if PV=1000, i=12% and n=4, the result is:
FV=1,000 (1.12) ^4
=1,573
Example:
Mario Orio place Php 1,000 in a savings account earning 7% interest compounded annually.
How much money will he accumulate after 5 years?
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FV=PV(1+i) ^n
FV= 1,000(1+.07) ^5
=1,403
Example:
Lackie Tyan invested a large sum of money in ZZZ Corporation. The company pays a Php 3
dividend per share. The dividends are expected to increase by 15% per year for the next 3
years. Lackie wants to project the dividends from years 1 to 3.
At year 1
FV=PV(1+i) ^n
=3(1+i) ^1
=3(1.15)
=3.45
At year 2
FV=3(1+i) ^2
=3(1.322)
=3.97
At year 3
FV=3(1.15) ^2
=3(1.521)
=4.56
Interest is often compounded more than once a year. Banks and other financial
institutions accepting placements compound interest quarterly, daily, or even continuously. If
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interest is compounded many times a year, the general formula for solving the future value
is:
FV = PV (1+1/m) ^t x m
The number of conversion periods for 1 year is denoted by m while the total number of
conversion periods for the whole investment term is denoted by n. Conversion periods are
usually expressed by any convenient length of time and usually taken as an exact division of
the year, e.g. monthly, quarterly, semi-annually and annually. When the conversion periods
are:
Annually m=1
Semi=Annually m=2
Quarterly m=4
Monthly m=12
The total number of conversion periods for the whole term n can be found from the relation:
n = time x number of conversion periods per year m
n =t x m
The Interest rate is usually expressed as an annual or yearly rate, and must be changed
to the interest rate per conversion period or periodic rate i and can be found from the
relation:
i = interest rate r
conversion period per year m
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quarterly 9% ÷ 4 i=2.25%
monthly 9% ÷ 12 i=0.75%
The formula reflects a more frequent compounding (t x m) at a smaller interest rate per
period (i/m). The future value increases as m increases. Thus, continuous compounding
results in the maximum possible future value at the end of n periods for a given rate of
interest.
Example
Assume that P=1,000, i=12% and n=4 years. Thus:
Annual compounding (m=1) FV=1,000(1.12)^4x1
=1,000(1.574)^4
=1,574
An annuity is defined as a series of equal payments (or receipts) made at fixed intervals for
a specified number of periods. If the payment occurs at the end of the period, it is called
ordinary annuity. Examples are mortgages on housing, car loans and bank loans. If the
payment occurs at the beginning of the period, it is called annuity due. Life and car
insurance premiums and rental payments are some typical examples of an annuity due.
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Between the two types of annuities, the ordinary annuity is more common practice
(Timbang, 2016).
Example:
Aiza wants to determine the sum of money she will have in her savings account at the end
of 5 years by depositing Php 1,000 at the end of each year for the next 5 years. The annual
interest rate is 8%
Each deposit is made at the end of the year and compounded at the end of the period n.
The sum of the compounded deposits is the future value of an annuity.
Another way of solving this problem is by using the future value of an annuity formula.
Assume the following:
FV = amount of an annuity
PV = present value of an annuity
A = annuity due
Thus
FV = A ((1+i)^n-1)/i)
=1,000 ((1+.08)^4-1)/0.08
=5,866.60
Example:
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Aiza wants to determine the sum of money she will have in her savings account at the
end of 5 years by depositing Php 1,000 at the beginning of the year for the next 5 years.
The annual interest rate is 8%.
0 1 2 3 4 5
1,000 1,000 1,000 1,000 1,000
1,080.00 (1.08)^1
1,116.40 (1.08)^2
1,259.71 (1.08)^3
1,360.49 (1.08)^4
1,469.33 (1.08)^5
6,335.93
Since the deposits started at the beginning of each year, more interest is earned as
compared to deposits made at the end of the year. Another way of solving this problem is by
using the future value of an annuity formula. Again, the formula to be given will only be
useful if it has an equal cash flow. The formula is as follows:
=1000 (1+.08)^(1.08)
0.08
= 6,335.93
The present value of a future sum is the amount that must be invested today at
compound interest to reach a desired sum in the future. The process of calculating present
values, or discounting, is usually the opposite of finding the compounded future value. In
connection with present value calculations, the interest rate is called the discount rate.
Recall that:
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FV = PV(1+i)^n
Example:
Roval Toro is given the opportunity to receive Php 50,000 10 years from now. If he
can earn 15% on his investment compounded annually, what is the most he should pay to
benefit from this opportunity?
PV = FV (1+i)^-n
= 50,000 (1.15)^-10
=50,000 (0.247)
=12,350.00
Interest received from bonds, pension funds, and insurance obligations all involve annuities.
To compare these financial instruments, the present value of each must be known
(Timbang, 2016).
The present value of an annuity can be found using the following equation.
PVa =A 1- (1+i)^n
i
Example:
Martha Fobre is offered the opportunity to receive the following equal cash flow over the
next 3 years.
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Year Revenue
1 10,000
2 10,000
3 10,000
If she must earn a minimum of 8% on her investment, what is the most she should pay
today? The present value of the equal cash flow is as follows:
Martha has to deposit Php 25,770.97 to receive a yearly amount of Php 10,000 for three
years. Another way of solving this problem is by using the present value of an annuity
formula. The formula to be given is only useful if it has an equal cash flow. The formula is as
follows.
PVa =A 1- (1+i)^n
i
Time value of money problems may revolve around a series of payments or cash receipts.
However, not every situation involves a single amount of annuity. A problem may involve an
unequal cash flow each period for a certain number of years. The present value of unequal
cash flows is the sum of the present values of each unequal cash flow (Timbang, 2016).
Example:
Xenetea Trias was offered the opportunity to receive the following unequal cash flows
over the next 3 years.
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Year Revenue
1 10,000
2 12,500
3 9,500
If she must earn a minimum of 8% on her investment, what amount should she pay
today? The present value of unequal cash flows of revenue is as follows:
Year Revenue (1+i)^-n Present Value
1 10,000 0.926 9,260.00
2 12,500 0.857 10,712.50
3 9,500 0.794 7,543.00
27,515.50
Future and present values have numerous applications in financial and investment
decisions. They are useful in decision-making whether for personal reasons (e.g. how much
deposit must be made to acquire a certain amount of money, amortize a loan, or pay off a
sinking fund?) or corporate reasons (e.g., capital budgeting, bond and stock valuation and
right financing mix) (Timbang, 2016).
An individual may want to know the annual deposit (or payment) necessary to accumulate a
future sum. To determine the future amount, the formula in computing the future value of an
annuity can be used.
Example:
Ziram Ilamu is interested to know the equal annual, end of year deposits required to
accumulate Php 15,000 at the end of 10 years when her son enters college. The interest
rate is 12%. The annual deposits are as follows.
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FVa = A (1+i)^n-1
i
15,000 = A (1+0.12)^10-1
0.12
15,000 = A (17.549)
A =15,000/17.549
A =854.75
If Ziram Ilamu deposits 854.75 at the end of every year for 10 years at 12% interest, she
will accumulate 15,000 at the end of the fifth year.
Amortized Loans
Payments of obligations are made in equal installments which may be monthly, quarterly,
semi-annually or annually. Amortized loans include housing loans and auto loans. Other
loans are classified as long-term loans. The periodic payment can be computed using the
present value of an annuity of 1.
PVa = A 1-(1+i)^-n
i
A = PVa
1-(1+i)^-n
i
Example
Ferlie Shells has a 60-month auto loan of Php 650,000 at a 12% annual interest rate.
She wants to find out how much the monthly payment should be.
A = PVa
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1-(1+i)^-n
i
A =650,000
1-(1.01)^-60
0.01
A =650,000
44.955
A =14,458.90
To repay the principal and interest on a Php 650,000 12% 60-month auto loan, She
has to pay Php 14,458.90 a month for the next 60 months.
Example :
Assume that a firm borrows Php 120,000 to be repaid annually for the next 5 years.
The creditor-bank stipulated a 12% interest. Compute the amount of each payment.
A = 120,000 A = 120,000
1-(1.12)^-5 3.605
0.12 =33,287.10
Each loan payment made is distributed partly to the interest and partly to the principal.
the breakdown is often displayed in a loan amortization schedule. The interest component is
largest in the first period and subsequently declines, whereas the principal portion is smallest
in the first period and increases thereafter.
Example:
Using the same data in example, the amortization schedule is as follows:
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166,435.50 46,448.63 120,000.00
The different types of financial instruments use various compounding periods. Bonds, for
instance usually pay interest semi-annually, banks pay on deposits quarterly, and firms
offering credit cards pay interest monthly. If an investor wants to compare financial
instruments with different compounding periods, a mathematical tool should be used to
make the comparison possible. For this purpose, the effective annual rate also known as
annual
percentage rate is used (Timbang, 2016).
Where:
r = nominal rate
m = number of compounded periods in a year
Example:
This means that if an investment offers 12% interest compounded quarterly, the investor
is actually receiving an APR or effective interest rate of 12.55%. That is to say, if one
investment offers a 12% interest compounded quarterly while the other one offers a 12.55%
interest compounded annually, the same amount of money will be received at the end of the
year.
38
39
$150,000 in etotal cash flows
amount to
f(ca23415EprUnGiveeachTotal
Cash Flowb. Comparehe
undiscounteda) erc4$320llows
Compute for the following. Given the uneven streams of cash flows shown in the following
Assessment task 3 table, answers parts A & B:
Cash Flow Stream
End of Year A B
1 Php 50,000 Php 10,000
2 40,000 20,000
3 30,000 30,000
4 20,000 40,000
5 10,000 50,000
a. Find the present value of each stream, using a 15 percent discount rate
b. Compare the calculated present values, and discuss them in the light of the fact that the
undiscounted toal cash flows amount to Php 150,0000 in each case
Assume that you just won the state lottery . Your prize can be taken either in the form of
Php 40,000 at the end of the next 25 years or as a single payment of Php 500,000 paid
immediately.
a. If you expect to be able to earn 5% annually on your investments over the next 25
year (i.e. 5 % is the appropriate discount rate), ignoring taxes and other
considerations, which alternative should you take? Assume that your only decision 40
criteria is selecting the options with the highest present value.
Find the present value of
discountedm in light of tsent10
5 of Year,nd
Assessment task 3
(b):flowsstre$150,000
00,,hegdiscount rate.valu
40,0032tunevem, using
showStrble, the s,ach
cas$10,50,000
amcalculaA$150,000 e fact
that nd discuss swerinstrB 0the
15 msparts ed of
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Summary
• Time value of money is based on the idea that people would rather have money today
than in the future.
• Given that money can earn compound interest, it is more valuable in the present rather
than the future.
• The formula for computing time value of money considers the payment now, the future
value, the interest rate, and the time frame.
References
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Block S.B., & Hirt, G.A. (2006) Foundations of Financial Management (9th Edition).Blackwell
Publishing Limited, Florida.
Time Value of Money Practice Problems & Solutions. (2016). Retrieved from:
https://www.studocu.com/en-us/document/wichita-state-
university/financialmanagement-ii
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