COM505 | Prelims

F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Chapter 1: Overview of Financial Management - Provide an adequate return on investment bearing

in mind the risks that the business is taking, and the
Financial Management resources invested
- plan and control the company’s finances.
- concerned with raising financial resources. Three Key Elements to the Process of Financial
- effective utilization of funds towards achieving the Management
firm’s goal. 1. Financial Planning - the long-term method of wisely
managing your finances so you can achieve your goals
“Financial management is concerned with raising and dreams, while at the same time negotiating the
financial resources and their effective utilization towards financial barriers that inevitably arise in every stage of
achieving the organizational goals”. Dr. S. N. Maheshwari life.
2. Financial Control - the procedures, policies, and
“Financial management is the process of putting the means by which an organization monitors and controls
available funds to the best advantage from the long- the direction, allocation, and usage of its financial
term point of view of business objectives”. Richard A. resources.
Brealey 3. Financial Decision Making - making decisions that will
shape the financial fortunes of the business and
Basic Function of Financial Management maximize returns for the business owner.
- to raise capital.
- to use efficiently the financial resources of the Areas of Financial Management
company. 1. Financial Markets and Institutions - include banks,
- to manage the resources of the firm towards achieving insurance companies, savings and loans, and credit
the goal of the company. unions, are an integral part of the general financial
services marketplace.
Function of Financial Management 2. Investments - focuses on the decisions made by
- financial management applies the basic principles of businesses and individuals as they choose securities for
General Management. their investment portfolios.
• determining the values, risks, and returns
associated with such financial assets as stocks
and bonds.
• determining the optimal mix (combination) of
securities that should be held in a portfolio of
investments, such as a retirement fund.
3. Financial Services - functions provided by
organizations that deal with the management of money.
Provide services that help individuals and companies
determine how to invest money to achieve such goals
4. Managerial Finance - deals with decisions all firms
make concerning their cash flows, both inflows and
Goal of the Company
outflows.
- to maximize the value of the firm.

Relating Finance with Non-Finance Areas

Taking a commercial business as the most common
• Management – personnel decisions and
organizational structure, the key objectives of financial
employee relations, strategic planning, and the
management is to:
general operations of the firm.
- Create wealth for the business
- Generate cash, and
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

• Marketing – the four Ps of marketing—product, 3. S Corporation - no more than 100 stockholders- its
price, place, and promotion—determine the income is taxed the same as income earned by
success of products that are manufactured and proprietorships and partnerships; that is, income passes
sold by companies. through the company to the owners so that it is taxed
• Accounting – financial managers rely heavily on only once.
accounting information because making decisions
about the future requires information that Goals of the Corporation
accountants provide about the past. - Primary goal: stockholder wealth maximization,
• Information Systems – to make sound decisions, which is the same as maximizing the stock price.
financial managers rely on accurate information - Managerial incentives.
that is available when needed. - Corporate social responsibility.
• Economics – focuses on public policy, while the - Environmental, social, and corporate governance.
focus of finance is more company- or industry-
specific. Business Organized as a Corporation: Value Maximized
• Limited liability – reduces risk which increases
Comparing Finance with Other Areas market value.
(Finance vs Accounting) • Ease of raising capital – allows corporation to take
• Finance – applies tools to financial information to advantage of growth opportunities.
generate new information. • Ownership can be easily transferred (via stock
o Ratio analysis transactions) – thus investors are willing to pay
o Breakeven analysis more for a corporation.
• Accounting – financial accounting involves
recording and classifying financial information. Value of the Firm
o Completion of accounting cycle Market Factors/Considerations
o Compilation of financial statements - Economic conditions.
- Government regulations and rules.
Primary Forms of Business Organization - Competitive environment-domestic and foreign
1. Sole Proprietorship – an unincorporated business with Firm Factors: Investor Factors:
only one owner who pays personal income tax on profits - Normal operations- - Income/savings
earned. revenues and - Age/lifestyles
2. Partnership – two or more people share ownership, as expenses - Interest rates
well as the responsibility for managing the company and - Financing (capital - Risk
the income or losses the business generates. structure) policy attitude/preference
3. Corporation – owned by its shareholder(s), who elect - Investment (capital
a board of directors to oversee the organization's budgeting) policy
activities. - Dividend policy
4. One Person Corporation – a business entity with just Net cash flows, CF Rate of return, r
one stockholder. This single stockholder is also the sole Value of the Firm
incorporator, director, and president of the company. Value = current (present) value of expected (future)
cash flows (CF) based on the return demanded by the
Hybrid Forms of Business investors (r), which is dependent on the risk
1. Limited Liability Proprietorship (LLP) - least one associated with the firm.
partner is designated a general partner and the others
are limited partners.
2. Limited Liability Company (LLC) - it combines the
features of a corporation and a partnership.
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Factors Influenced by Managers that affect Stock Price Ethics – a conception of right and wrong behavior,
• Projected cash flows defining for us when our actions are moral and when
• Timing of cash flow streams immoral.
• Risk of projected cash flows (earnings)
• Use of debt (capital structure) Corporate Governance
• Dividend policy - In a narrow sense, this deals with maximizing the
shareholder’s wealth.
Corporate Organization Structure - In a broader perspective, it considers the welfare of
the all stakeholders and the society.

Business Ethics and Good Governance

- Most of the benefits received from the business
ethics are the goals of the corporate governance.
- Thus, we can say that ethics have a strong impact
on corporate governance and the implementation
of business ethics can ensure good governance.

Business Ethics
- Dictionary: “A standard of conduct and moral
Agency Relationships behavior.”
- An agency relationship exists whenever a principal - Business Ethics: A company’s attitude and conduct
(an owner) hires an agent (management) to act toward its employees, customers, community, and
on his or her behalf. stockholders (i.e., the firm’s stakeholders).
- An agency problem results when the agent - Business ethics refer to a set of professional or
(management) makes decisions that are not in the applied ethics that review or study ethical or moral
best interests of principals (owners). principles and ethical or moral problems that
Agency problem appear in any business environment.
- The possibility of conflict of interest between the
stockholders (principal) and the management
(agent) of the firm.
• Owners’ main priority involves seeking new
investments to raise share value.
• Management may pursue job security,
corporate luxury, and higher compensation at
the expense of stockholders.

Resolving Agency Conflict:

- Managers Managers are naturally inclined to act in
their own best interests. Corporate Governance
- Mechanisms to motivate managers to act in - The “set of rules’ that a firm follows when
shareholder’s best interest conducting business
• Managerial compensation (incentives) - As a result of the Sarbanes-Oxley Act of 2002, firms
• Shareholder intervention have substantially revised their corporate
• Threat of takeover governance policies
- Good corporate governance generally generates
higher returns to stockholders
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Functions: 8. Taxes Bias Business Decision

• Accountability – keeping the company 9. All Risk is not Equal-some Risk can be Diversified Away
accountable to stakeholders, investors, and the 10. Ethical Behavior Means Doing the Right Thing, but
public. Ethical Dilemmas are Everywhere
• Transparency – remaining transparent about
company operations, earnings, successes, and Chapter 2: Analysis of Financial Statements
failures.
• Ethics – holding the company and all employees The Annual Report
to a high ethical standard. • discussion of operations
• Compliance – maintaining compliance with the • generally, a letter from the chairman.
laws and regulations set for the company. • financial reporting
• Company Vision – guiding the company toward • basic financial statements
future goals through strategic planning. o balance sheet
o income statement
Forms of Business in Other Countries o statement of cash flows
- Foreign firms have higher concentrations of o statement of retained earnings
ownership—i.e., fewer owners—than U.S. firms
- Foreign firms have much different relationships Financial Statement Analysis
with financial institutions differs than do U.S. firms - the process of analyzing a company’s financial
statements for decision making.
Multinational Corporation - external stakeholders use it to understand the overall
- Five reasons firms “go international”: health of an organization as well as to evaluate financial
• To seek new markets performance and business value.
• To seek raw materials • Investors
• To seek new technology • Creditors
• To seek production efficiency • Government
• To avoid political and regulatory hurdles • Suppliers
- internal constituents use it as a monitoring tool for
Factors Distinguishing Domestic Firms from managing the finances.
Multinational Firms • Owners
- Different currency denominations • Employees
- Economic and legal ramifications
- Language differences The Balance Sheet
- Cultural differences - represents a “picture” taken on a specific date that
- Roles of governments shows a firm’s assets (investments) and how these
- Political risk assets are financed (amount of debt and amount of
equity).
Ten Principles that Form the Foundation of Financial
Management:
1. The Risk-Return Trade-off
2. The Time Value of Money
3. Cash-not the Profit-is King
4. Incremental Cash Flows
5. The Curse of Competitive Markets
6. Efficient Capital Markets
7. The Agency Problem-Managers won’t Work for the
Firm’s Owners unless it’s in their Best Interest
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Investments = Financing Two Forms of Balance Sheet

Current Assets Current Liabilities Account Form Report Form
(Short-term Investments) (Short-term Debt)
- cash and equivalents - accounts payable
- accounts receivable - accruals (wages and
- inventory taxes)
- notes payable
Fixed Assets Long-Term Debts
(Long-term Investments) - corporate bonds
- property, plant, and
equipment
Owner’s (Stockholders’)
Equity
- common stock
- retained earnings
Total Assets = Total Liabilities and Equity

Assets:
Assets = Liabilities + Equity
(CA) CRISP – cash, receivable, inventories, supplies, and
pre-payments.
Assets – what you own.
(NCA) PIO – property, plant and equipment, intangible,
Liabilities – what you owe.
and other assets.
Equity – what you get

Liabilities:
Important Considerations
(CL) ANA – accounts payable, notes payable, and
- cash and equivalents versus other assets
accrued expenses.
Þ all assets are stated in dollars – only cash and
(NCL) – bonds and insurance in banks.
equivalents represent money that can be spent.

Equity:
Owner’s investments – paid-up capital.
Fruit of the investments - retained earnings.

- Accounting Alternatives – e.g., FIFO versus LIFO and

accelerated depreciation versus straight-line
depreciation affect the “bottom-line” numbers.
- break down of the common equity account
Þ common stock
Þ paid-in capital
Þ retained earnings
- book values often do not equal market values.
- the time dimensions
Þ a “snapshot of the firm’s financial position at a
particular point in time; i.e., on a specific date.
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

The Income Statement Statement of Retained Earnings

- prepare the results of business operations during a - changes in the common equity accounts between
specified period of time. balance sheet dates.
- summarizes the revenues generated and the expenses
incurred during a particular accounting period, such as
one fiscal year.
- it will became comprehensive if it includes the income
generated from non-operating activities.

Example of Retained Earnings

Statement of Cash Flow

- reports the effect of the firm’s activities – operating,
investing, and financing – on its cash position over some
Solving: Financial Statement Analysis
period.
- provides information concerning investment decisions
Balance Sheet
(use of cash) and financing decisions (sources of cash).
- Assets = Liabilities + Equity
• Inflow – goes in the company.
- TCA = add all current assets
• Outflow – used.
- investments aren’t CA nor NCA.
- TNCA = add all non-current assets
Example of SCF
- (depends) less accumulated depreciation to NCA to
Direct Indirect get total NCA.
- TA = add TCA and TNCA
- TCL = add all current liabilities
- TNCL = add all non-current liabilities
- TSHE = add all equity minus treasury stock
- add total SHE and total liabilities to balance with total
assets
- investments in operations = current asset
- financed from borrowing = borrowed from the bank
(payables)
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Income Statement Direct Method – operating activities section prepared

- Gross Profit = Net Sales – COGS using the direct method.
- Total Operating Expense = add all OPEX
- Operating Income = GP – TOPEX Cash received from customers:
- Net Income = OPI + Total non-operating Sales (+decrease in A/R or -increase in A/R)
- Net Income before Tax = GP – OPEX Less: Payments to creditors and for expenses
- Net income after Tax = NIBT – Tax Cost of Merchandise Sold
+increase in inventories / -decrease in inv.
Statement of Retained Earnings +decrease in A/P / -increase in A/P
Format (2021 & 2022) Operating Expense
+decrease in accrued exp / -increase in AE
2021 | 2022 (same) Interest Expense
Retained Earnings, Beginning xxx +decrease in interest payable / -increase in IP
Net Income after Tax xxx Income Tax Expense
Total xxx +decrease in income tax payable /
Less: Dividends Paid xxx -increase in income tax payable
Retained Earnings, End xxx = Net Cash Flows from Operating Activities

Statement of Cash Flow Continuation: Financial Statement Analysis

Typical Transactions:
1. purchased a patent – outflow | investing Objectives:
2. sold treasury stock – inflow | financing • Horizontal Analysis – used in the review of a
3. net income – for adjustment | operating company’s financial statements over multiple
4. sold long-term investments – inflow | investing periods.
5. purchased a building – outflow | investing • Vertical Analysis – a method of financial
6. issued bonds – inflow | financing statement analysis in which each line item is listed
7. paid dividends – outflow | financing as a percentage of a base figure within the
8. recorded depreciation expense for the year – statement.
adjustment to net income • Ratio Analysis – a quantitative method of gaining
9. issued common stock to retire a mortgage – non- insight into a company’s liquidity, operational
cash activity efficiency, and profitability by studying its financial
10. purchased treasury stock – outflow | financing statements such as the balance sheet and income
statement.
Indirect Method – starts with net income and adjusts it
for non-cash transactions and other cash used by or How FSA is being used:
provided by normal daily activities • External – outside the company.
Þ Alternative options
Net Income Þ Certainty/uncertainty
Add: Non-cash expenses Þ Risk
Losses on sales or retirements Þ Environment
Decreases in Current Assets Þ Complexity
Increases in Current Liabilities related to operations • Internal – inside the company. (management)
Deduct: Increases in Current Assets Þ Strength
Decreases in Current Liabilities related to Þ Weaknesses
operations Þ Assessment or evaluation
Gains on Sales or Retirements Þ Remedy/future action
= Net Cash Flows from Operating Activities
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Financial Statement Analysis and the remaining current assets decrease as a percent
- process of analyzing a company’s financial statement of total assets.
for decision-making purposes. - long-term investments decreased as a percent of total
assets. Property, plant and equipment increased slightly,
Financial Statements and intangible assets had a notable increase.
1. Balance Sheet – A, L, E (resources, obligations, and net - accounts payable and accrued liabilities decreased
worth) along with loans and notes payable. Other liabilities
Þ Assets – Liabilities = Net Worth increased.
2. Income Statement – profit/loss (profitability). Results - long-term debt increased significantly from 10.4% to
of the operation. 19.3%. other liabilities and deferred taxes increased from
3. Cashflow Statement – actual cash. Liquidity à ability 9.3% to 12.4%.
to pay. - common stock and retained earnings decreased.
4. Changes in Equity – ownership, retained earnings. Accumulated loss increased, and treasury stock
decreased as a percent of total liabilities and
Horizontal Analysis shareholders’ equity.
- used in the review of a company’s financial statements
over multiple periods. Continuation: Ratio Analysis
- usually depicted as percentage growth over the same
line item in the base year. Financial Ratio Analysis
- allows financial statement users to easily spot trends - the technique of comparing the relationship (or ratio)
and growth patterns. between two or more items of financial data from a
company’s financial statements. It is mainly used as a
Computation: way of making fair comparisons across time and
Change in Amount = Current – Prior between different companies or industries.
Percentage Change = Change in Amt/Prior • Trend Analysis – within the business.
• Industry Analysis – competitors.
Vertical Analysis
- a method of financial statement analysis in which each Key Financial Ratios
line item is listed as a percentage of a base figure within Debt Management - debt ratio
the statement. - times-interest-earned
- the first line of the statement always shows the base ratio
figure at 100%, with each following line item representing Market Trend - P/E ratio
a percentage of the whole. - market/book ratio
- balance sheet = TA = TL&E Profitability - profit margin on sales
- income statement = Sales = Net Sales - return on total assets
- return on common
Computation: equity
Account title/Total Asset = VAP Asset Management - inventory turnover ratio
Account title/Net Sales = VAP - day’s sales outstanding
ratio
Interpreting Horizontal and Vertical Analysis - total assets turnover
(example) ratio
Liquidity - current ratio
Balance Sheet - quick ratio
- cash and cash equivalents decrease from 18.8% of
total assets to 15.4%. Marketable Securities increased,
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Liquidity Ratios - measure a company’s ability to repay • Debt to Equity Ratio – calculates the weight of total
both short- and long-term obligations. debt and financial liabilities against shareholders’
• Current Ratio – measures a company’s ability to equity.
pay off short-term liabilities with current assets. D2E = Total Liabilities / Shareholder’s Equity
CR = Current Assets / Current Liabilities • Interest Coverage Ratio – shows how easily a
• Acid-test Ratio – also known as quick ratio. It company can pay its interest expenses.
measures a company’s ability to pay off short- ICR = Operating Income / Interest Expenses
term liabilities with quick assets. • Debt Service Coverage Ratio – reveals how easily
QR = Current Assets – Inventories / Current a company can pay its debt obligations.
Liabilities DSCR = Operating Income / Total Debt Service
• Cash Ratio - shows a company's ability to cover its
short-term obligations using only cash and cash Profitability Ratios - measure a company’s ability to
equivalents. generate income relative to revenue, balance sheet
Cash Ratio = Cash & Cash Equivalents / CL assets, operating costs, and equity.
• Operating Cash Flow Ratio - measure of the • Gross Margin Ratio – compares the gross profit of
number of times a company can pay off current a company to its net sales to show how much profit
debts with cash generated within the same period. a company makes after paying its cost of goods
OCF = Cash Flow from Operations / CL sold.
GMR = Gross Profit / Net Sales
Efficiency Ratios - also known as activity financial ratios, • Operating Margin Ratio – compares the operating
are used to measure how well a company is utilizing its income of a company to its net sales to determine
assets and resources. operating efficiency.
• Asset Turnover Ratio – measures a company’s OMR = Operating Income / Net Sales
ability to generate sales from assets. • Return on Assets Ratio – measures how efficiently
ATR = Net Sales / Average Total Assets a company is using its assets to generate profit.
• Inventory Turnover Ratio – measures how many ROA = Net Income / Total Assets
times a company’s inventory is sold and replaced • Return on Equity Ratio – measures how efficiently
over a given period. a company is using its equity to generate profit.
ITR = COGS / Average Inventory ROE = Net Income / Shareholder’s Equity
• Accounts Receivable Turnover Ratio – measures
how many times a company can turn receivables Market Value Ratios - used to evaluate the share price
into cash over a given period. of a company’s stock.
RTR = Net Credit Sales / Average Accounts Rec. • Book Value per Share Ratio – calculates the per-
• Days Sales in Inventory Ratio – measures the share value of a company based on the equity
average number of days that a company holds on available to shareholders.
to inventory before selling it to customers. BV = Shareholder’s Equity / Total Common Shares
DS = 365 days / ITR Outstanding
• Dividend Yield Ratio – measures the amount of
Leverage or Solvency Financial Ratios - measure the dividends attributed to shareholders relative to the
amount of capital that comes from debt. In other words, market value per share.
leverage financial ratios are used to evaluate a DYR = Dividend per Share / Share Price
company’s debt levels. • Earnings per Share Ratio – measures the amount
• Debt Ratio – measures the relative amount of a of net income earned for each share outstanding.
company’s assets that are provided from debt. EPSR = Net Earnings / Total Shares Outstanding
DR = Total Liabilities / Total Assets • Price-earnings Ratio – compares a company’s
share price to its earnings per share.
PR = Share Price / Earnings per Share
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

DuPont Analysis – an expansion of company’s ROE, 2. Annuity – multiple payments of the same amount
which concludes that company can earn higher ROE if: over equal time periods. For example, an investment of
Þ It earns higher net profit margins. $400 in each of the next three years represent an
Þ Uses assets efficiently to generate higher sales. annuity.
Þ Is not highly leveraged. • Ordinary Annuity - if the payment is made at the
end of the period. This is the way most payments
Formula: are made between businesses.
Return on Equity = Net Profit Margins x Asset Turnover x • Annuity Due – if the payment is made at the
Financial Leverage beginning of the period. In such situations a
business has paid for and therefore is due to
Return on Equity = Net Income / Sales x Sales / Totals receive certain products.
Assets x Total Assets / Total Equity 3. Uneven Cash Flows – multiple payments of different
amounts over a period of time. For example, investments
Analysis: of $400 this year, $300 next year, and $250 the following
- DuPont Analysis is a great tool to understand the year represent an uneven cash flow stream.
broader picture of return on equity of the company.
- it gives you insights on where the strength of the Future Value of a Lump-sum Amount
company lies and where work needs to be done. Formula:
𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)!
Chapter 3: Time Value of Money
Examples:
Key Time Value of Money Concepts 1. If Samantha invests $700 today in an account that
- before making financial decisions, dollars from pays 4% interest compounded annually, how much
different time periods must be stated in the same “time will she have in her account today four years from
value”—that is, all dollars must be valued at the same today?
time period before they can be compared. Solution:
- “everything else equal, an amount invested at a higher 𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)!
rate or for a longer time period will grow to a greater 𝐹𝑉 = 700 (1 + 0.04)"
future amount (future value) because a greater amount 𝑭𝑽 = $𝟖𝟏𝟖. 𝟗𝟎
of interest is earned”.
- “the further in the future an amount is received (paid) 2. Find the future value of Samantha’s $500 when
or the higher the interest rate, the lower the present value placed in Time Deposit in 6 years at 9%.
of the future amount.” Solution:
- “everything else equal, the greater the number of 𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)!
compounding periods per year, the greater the effective
𝐹𝑉 = 500 (1 + 0.09)#
𝑭𝑽 = $𝟖𝟑𝟖. 𝟓𝟓
rate of return that is earned on an investment”.

3. Happy Harry has just bought a scratch lottery ticket

Present and Future Values
and won $10,000. He wants to finance the future study
- the value of money can be expressed as the present
of his newly born daughter and invests this money in
value (discounted) or future value (compounded).
a fund with a maturity of 18 years offering a promising
- these both are the concepts of the time value of
yearly return of 6%. What is the amount available on
money.
the 18th birthday of his daughter?
Solution:
Cash Flow Patters
𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)!
1. Lump-sum Amount – a single, or one-time, payment
𝐹𝑉 = 10,000 (1 + 0.06)$%
(received or made) that occurs either today or at some 𝑭𝑽 = $𝟐𝟖, 𝟓𝟒𝟑. 𝟑𝟗
date in the future.
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Future Value of an Ordinary Annuity Examples:

Formula: 1. Kym plans to deposit $100 in an account each month
for the next five (5) years at 6% so she can take a trip.
How much will be in the account if the deposits are
made at the beginning of each month?
Solution:
(1 + 𝑟)! − 1
𝐹𝑉 = 𝑃𝑀𝑇 G@ B (1 + 𝑟)H
𝑟
(1 + 𝑟)! − 1 (1 + 0.06)' − 1
𝐹𝑉 = 𝑃𝑀𝑇 @ B 𝐹𝑉 = 100 G@ B (1 + 0.06)H
𝑟 0.06
𝑭𝑽 = $𝟓𝟎𝟕. 𝟓𝟑
Examples:
1. Suppose you invest $385 at the end of each of the 2. Suppose that you start a savings plan by depositing
next eight years. If your opportunity cost rate is 7 . $1,000 at the beginning of every year into an account
percent compounded annually, how much will your that offers 8% per year. If you make the first deposit
investment be worth after the last $385 payment is today, and then three additional ones, how much will
made? have accumulated after four years?
Solution: Solution:
(1 + 𝑟)! − 1 (1 + 𝑟)! − 1
𝐹𝑉 = 𝑃𝑀𝑇 @ B 𝐹𝑉 = 𝑃𝑀𝑇 G@ B (1 + 𝑟)H
𝑟 𝑟
(1 + 0.07)% − 1 (1 + 0.08)" − 1
𝐹𝑉 = 385 @ B 𝐹𝑉 = 1,000 G@ B (1 + 0.08)H
0.07 0.08
𝑭𝑽 = $𝟑, 𝟗𝟓𝟎 𝑭𝑽 = $𝟒, 𝟖𝟔𝟔. 𝟔𝟎

Cash Flow Streams

2. What is the future value (as of 10 years from now) of
- payment (PMT) designates constant cash flows-that is, an
an annuity that makes 10 annual payments of $5,000,
annuity stream.
if the interest rate is 7% per year compounded
- cash flow (CF) designates cash flows in general, both constant
quarterly? cash flows (i.e., annuities) and uneven cash flows.
Solution:
(1 + 𝑟)! − 1 Future Value of an Uneven Cash Flow
𝐹𝑉 = 𝑃𝑀𝑇 @ B Formula:
𝑟
(1 + 0.07)$& − 1 𝐹𝑉 = 𝐶𝐹1(1 + 𝑟)!($ + ⋯ + 𝐶𝐹𝑛(1 + 𝑟)&
𝐹𝑉 = 5,000 @ B
0.07
Examples:
𝑭𝑽 = $𝟐𝟖𝟔, 𝟏𝟕𝟎. 𝟔𝟕
Interest (r)= 12% | Term of the loan (n) = 5 years
Y1 Y2 Y3 Y4 Y5 FVCF
Future value of an Annuity Due
1 250,000 225,000 185,000 220,000 250,000 1,437,953
2 50,000 25,000 18,000 20,000 25,000 183,778
3 150,000 125,000 155,000 220,000 250,000 1,102,475

Present Value

Discounting – to compute the present value of an amount we

bring back to the present a future amount by taking out the
interest for each period in which the money can earn interest in
the future.

(1 + 𝑟)! − 1
𝐹𝑉 = 𝑃𝑀𝑇 G@ B (1 + 𝑟)H
𝑟
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Present Value of a Lump-sum

Example:
Formula:
𝐹𝑉 1. What is the PV of a three-year $400 annuity due if r
𝑃𝑉 = is 5%?
(1 + 𝑟)!
Solution:
Examples: 1
1−
FV Period (n) Interest (r) PV (1 + 𝑟)!
𝑃𝑉 = 𝑃𝑀𝑇 OL M (1 + 𝑟)P
250,000 5 5% 195,882 𝑟
75,000 10 8% 34,740
1
100,000 6 10% 56.447 1−
(1 + .05))
50,000 3 12% 35,589 𝑃𝑉 = 400 OL M (1 + 0.05)P
150,000 15 5% 72,153
0.05

𝑷𝑽 = 𝟏, 𝟏𝟒𝟑, 𝟕𝟔
Present Value of an Ordinary Annuity
- each payment is discounted, and the sum of the
Perpetuities - PVP
discounted payments is the present value of the annuity.
- streams of equal payments that are expected to go on
Formula:
forever.
1
1− Formula:
(1 + 𝑟)!
𝑃𝑉 = 𝑃𝑀𝑇 L M 𝑃𝑀𝑇
𝑟 𝑃𝑉𝑃 =
𝑟

Example: Examples:
100
1. What is the PV of a three-year $400 ordinary annuity 𝑃𝑉𝑃1 = = 2,000
0.05
if r is 5%?
Solution: 100
1 𝑃𝑉𝑃2 = = 1,000
1− 0.10
(1 + 𝑟)!
𝑃𝑉 = 𝑃𝑀𝑇 L M
𝑟
Distinguishing between Different Interest Rates
1
1−
(1 + 0.05))
𝑃𝑉 = 400 L M rSIMPLE = Simple (Quoted) Rate
0.05
- used to compute the interest paid per period.
𝑷𝑽 = 𝟏, 𝟎𝟖𝟗. 𝟑𝟎
APR = Annual Percentage Rate = rSIMPLE
Present Value of an Annuity Due
Formula: rEAR = Effective Annual Rate
1 - the annual rate of interest actually being earned.
1−
(1 + 𝑟)!
𝑃𝑉 = 𝑃𝑀𝑇 OL M (1 + 𝑟)P
𝑟
Comparison of Different Types of Interest Rates
• rSIMPLE: written into contracts, quoted by banks and
brokers. Not used in calculations or shown on
timelines.
• rPER: interest rate per period (e.g., per year, per
month, etc.); used in calculations; shown on
timelines.
• rEAR: used to compare returns on investments with
different payments per year.
COM505 | Prelims
F. Manzana | 1FM3 | Assoc. Prof. Imelda Angeles | Introduction to Financial Management | Second Semester

Periodic Rate, rPER Example:

Formula: Year Balance Payment Interest Principal Remaining

𝑟𝑆𝐼𝑀𝑃𝐿𝐸 1 $33,000.00 $12,460 2,145.00 $10,315.00 22,685.00

rPER = 2 22,685.00 12,460 1,474.53 10,985.48 11,699.53
𝑚
3 11,699.53 12,460 760.47 11,699.53 0.00

where m is the number of compounding periods per

Beginning Balance (1) = 1 is given then the others came
year.
from the remaining balance (5).

Examples:
8% Payment (2) = given.
8% compounded quarterly: rPER = = 2%
4
8%
8% compounded monthly: rPER = 12
= 0.667% Interest (3) = rate is given. Beginning balance (1) x rate

Effective Annual Rate

Repayment of Principal (4) = Payment (2) – Interest (3)
- the annual rate that causes PV to grow to the same FV as it
would with multi-period compounding.
Formula: Remaining Balance = Beg. Balance (1) – Principal (4)
𝑚
𝑟𝑆𝐼𝑀𝑃𝐿𝐸
rEAR = '1 + ( − 1.0
𝑚

Example:
What is the effective annual return (EAR) for an
investment that pays 12 percent interest,
compounded monthly?
Solution:
𝑚
𝑟𝑆𝐼𝑀𝑃𝐿𝐸
rEAR = '1 + ( − 1.0
𝑚
12
12%
rEAR = '1 + ( − 1.0
12
𝐫𝐄𝐀𝐑 = 𝟏𝟐. 𝟔𝟖%

Amortized Loans
- a loan that is repaid in equal payments over its life.
- a portion of the payment represents interest, and the
remainder represents repayment of the amount that
was borrowed.
- amortization schedules are widely used for home
mortgages, auto loans, and so forth to determine how
much of each payment represents principal repayment
and how much represents interest.