Basic Long-Term Financial Concepts - Find out how understanding the stock

market can help you weather its highs

Time Value of Money and lows.
- The most important financial concept, - After all, people fear what they don't
describes how important the value of understand and most beginners don't
time is in building wealth. really understand the stock market.
- Money invested today is worth more Heck, even most advanced investors
than money invested at any point in the don't understand the stock market.
future. That's because it has more time Keep a Budget
to grow and compound.
- It is also the main reason that you'll - This basic financial concept is needed to
want to get started with your investing really understand the breakdown of
as early as possible. your company's finances and to learn
how to optimize them.
Diversify (expand) Your Risks and Investments - If there is one tool you use to keep your
- Another Important: Keep your business spending in check and help you save
finances balanced. money each month and year, it should
- Don't keep all of your money in just a be a well-crafted budget worksheet
few assets like your house or your Opportunity Costs
company stock. Make sure that you
spread your investments over many - Understand that wherever you spend
different asset classes. If you hold a lot your time and money is a cost that
of mutual funds, that they do not elsewhere.
overlap, or you may not be diversified - The money spent on a car could be
as you think. invested in the stock market. The car
- Don’t invest into one the investments will thrive.
- Make each decision while paying
Compounding Effects of Money attention to other ways that you could
- Second Most Important spend or invest that money. Choose the
- Able to forecast future growth. opportunity that maximizes your long-
- Your money may grow at the same rate term wealth.
each year in terms of percent, but in Interest Rates
terms of actual dollar growth
- Compounding: your money will grow - You must understand [the power] how
faster and faster each year as a result of interest rates and overall rate of returns
earning money not just on your affect almost everything in your
investment, but also on the returns financial life.
from that investment - This is also the precise reason that it is
so important to lower your investment
Understand the Stock Market
Example: Investing your money versus 5%,
- A basic understanding of the stock over 40 years, means that you will have
market can be applied to your everyday twice as much money, that's right, twice as
finances to help you manage your much money, for retirement.
business money better.
Basic Concepts of Risk and Returns - Various changes occur in a society like
economic, political and social systems that have
- Returns: the outcomes or the benefits
influence on the performance of companies and
that the investment generates.
thereby on their expected returns.
- Wealth maximization approach is based
- These changes affect all organizations to
on the concept of future value of
varying degrees. Hence the impact of these
expected cash flows from a prospective
changes is system- -wide and the portion of
project.
total variability in returns caused by such across
- So, cash flows are nothing but the
the board factors is referred to as systematic
earnings generated by the project that
risk.
we refer to as returns. Since future is
- These risks are further subdivided into interest
uncertain, so returns are associated
rate risk, market risk, and purchasing power
with some degree of uncertainty.
risk.
- There will be some variability in
generating cash flows, which we call as Unsystematic Risk
risk. - The returns of a company may vary due to
certain factors that affect only that company.
Concept of Risk
- When the variability in returns occurs due to
- As future is uncertain, the future expected
such firm specific factors it is known as
returns too are uncertain. It is the uncertainty
unsystematic risk.
associated with the returns from an investment
- This risk is unique or peculiar to a specific
that introduces a risk into a project.
organization and affects it in addition to the
a. The Expected Return: the uncertain future systematic risk.
return that a firm expects to get from its - These risks are subdivided into business risk
project. and financial risk.

b. The Realized Return: the certain return that a Examples: raw material scarcity, labor strike,
firm has actually earned; it may not correspond management inefficiency, etc.
to the expected return.
Measurement of Risk: Quantification of risk is
- This possibility of variation of the actual return known as measurement of risk.
from the expected return is termed as risk.
a. Mean-Variance Approach
Risk - Used to measure the total risk, i.e.,
- The variability in the expected return from a sum of systematic and unsystematic
project. In other words, it is the degree of risks.
deviation (difference) from expected return. - Under this approach the variance and
- Associated with the possibility that realized standard deviation measure the extent
returns will be less than the returns that were of variability of possible returns from
expected. So, when realizations correspond to the expected return
expectations exactly, there would be no risk.

Elements of Risk: b. Correlation or Regression Method

Systematic Risk - Used to measure the systematic risk.
- Business organizations are part of society that - Using regression method, we may
is dynamic. measure the systematic risk. See
Concept of Return: Compound interest
- Return can be defined as the actual income - Interest earn interest
from a project as well as appreciation in the - Good for investments and savings
value of capital. - Earned from the previous year
- Two components in return the basic - On the principal amount and the interest that
component or the periodic cash flows from the accumulates on it in every period.
investment, either in the form of interest or - Often a factor in business transactions,
dividends; and the change in the price of the investments, and financial products intended to
asset, commonly called as the capital gain or extend for multiple periods or years.
loss. - "Interest on interest," or the power of
- The term yield is often used in connection to compound interest, is believed to have
return, which refers to the income component originated in 17th-century Italy.
in relation to some price for the asset. The total - Charged on the principal plus any interest
return of an asset for the holding period relates accrued till the point of time at which interest is
to all the cash flows received by an investor being calculated. In other words, compound
during any designated time period to the interest system works as follow:
amount of money invested in the asset.
1. Interest for the first period charged on
Realized return principle amount.
- The return 2. For the second period, it's charged on
the sum of principle amount and
Interest
interest charged during the first period.
- The charge against the use of money by the
3. For the third period, it is charged on the
borrower. The same is profit earned by the
sum of principle amount and interest
lender of money. The amount which is invested
charged during first and second period,
in a bank in order to earn Interest is called
and so on...
principal.
Time Value of Money (TVM)
Interest rate
- Idea that money that is available at the preset
- Normally expressed in percentage and
time is worth more than the same amount in
represents the dollar interest earned per P 100
the future, due to its potential earning capacity
of principal in a specific time, usually a year.
invest early
Simple interest - An important concept in financial
- Charged only on the principal amount. No management. It can be used to compare
interest earned on top of interest investment alternatives and to solve problems
- A quick and easy method of calculating the involving loans, mortgages, leases, savings, and
interest charge on a loan. annuities.
- Determined by multiplying the daily interest - Based on the concept that a dollar that you
rate by the principal by the number of days that have today is worth more than the promise or
elapse between payments. expectation that you will receive a dollar in the
- Often calculated on a daily basis, it mostly future. Money that you hold today is worth
benefits consumers who pay their bills or loans more because you can invest it and earn
on time or early each month. interest. After all, you should receive some
- Applies to open-ended situations, such as compensation for foregoing spending.
credit card balances.
Key Concept of TVM compounding period for a single amount or a
- A single sum of money or a series of equal, payment period for an annuity.
evenly--spaced payments or receipts promised
Payments
in the future can be converted to an equivalent
- A series of equal, evenly-spaced cash flows
value today. Conversely, you can determine the
TVM applications, payments must represent all
value to which a single sum or a series of future
outflows (negative amount) all inflows (positive
payments will grow to at some future date. You
amount)
can calculate the fifth value if you are given any
four of: Present Value of Money
- Single Amount
Interest Rate, Number of Periods, Payments,
- Annuity
Present Value, and Future Value. Each of these
- Invest today – certain amount of cash flow
factors is very briefly defined in the right-hand
- An amount today equivalent to a future
column below.
payment, or series of payments, that has been
The left column has references to more detailed discounted by an appropriate interest rate. The
explanations, formulas, and examples. future amount can be a single sum that will be
received at the end of the last period, as a
For instance, you can invest your dollar for one
series of equally spaced payments (an annuity),
year at a 6% annual interest rate and
or both Since money has time vale, the present
accumulate Peso 1.06 at the end of the year.
value of a promised future amount is worth less
You can say that the future value of the dollar is
the longer you have to wait to receive it
Peso 1.06 given a 6% interest rate and a one--
year period. It follows that the present value of Future Value of Money
the Peso 1.06 you expect to receive in one year - Singe Amount
is only Peso 1. - Annuity
- Investment grow after earning interest
Interest
- The amount of money that an investment with
- A charge for borrowing money, usually stated
a fixed, compounded interest rate will grow to
as a percentage of the amount borrowed over a
by some future date. The investment can be a
specific period of time.
single sum deposited at the beginning of the
a. Simple interest is computed only on the firm period, a series of equally spaced payments
original amount borrowed. It is the (an annuity), or both. Since money has time
return on that principal for one time value, we naturally expect the future value to
period. be greater than the present value The
b. Compound interest is calculated each difference between the two depends on the
period on the original amount number of compounding periods involved and
borrowed plus all unpaid interest the going interest rate
accumulated to date. Compound
Loan Amortization
interest is always assumed in TVM
- A method for repaying a loan in equal
problems.
installments. Part of each payment goes toward
Number of Periods interest and any remainder is used to reduce
- Periods are evenly-spaced intervals of time. the principal. As the balance of the loan is
They are intentionally not stated in years since gradually reduced, a progressively larger
each interval must correspond to a
portion of each payment goes toward reducing payments or receipts occur at the end of each
principal. period for an ordinary annuity while they occur
at the beginning of each period for an annuity
Cash Flow Diagram
due.
- A picture of a financial problem that shows all
cash inflows and outflows along a time line. It Present Value of an Ordinary Annuity (PVoa)
can help you to visualize a problem and to - Discounted at a single equal value today
determine if it can be solved by TVM methods. - The value of a stream of expected or promised
future payments that have been discounted to a
Annuities
single equivalent value today. It is extremely
- Equal payments at fixed intervals for a
useful for comparing two separate cash flows
specified number of periods
that differ in some way.
- Contract between you and an insurance
- PVoa can also be thought of as the amount
company that requires the insurer to make
you must invest today at a specific interest rate
payments to you, either immediately or in the
so that when you withdraw an equal amount
future.
each period, the original principal and all
- An insurance contract issued and distributed
accumulated interest will be completely
by financial institutions with the intention of
exhausted at the end of the annuity.
paying out invested funds in a fixed income
- The Present Value of an Ordinary Annuity
stream in the future.
could be solved by calculating the present value
Ordinary Annuity of each payment in the series using the present
- Occurs at the end of the period value formula and then summing the results.
- An annuity in which the cash flows, or
Present Value of an Annuity Due (PVad)
payments, occur at the end of the period.
- Identical to an ordinary annuity except that
Annuity Due each payment occurs at the beginning of a
- Occurs at the beginning at each period period rather than at the end. Since each
- An annuity in which the cash flows, or payment occurs one period earlier, we can
payments, occur at the beginning of the period. calculate the present value of an ordinary
annuity and then multiply the result by (1 + i).
Present Value
Present Value of a Single Amount Combined Formula
- An amount today that is equivalent to a future - You can also combine these formulas and the
payment, or series of payments, that has been present value of single amount formula into
discounted by an appropriate interest rate. one.
Since money has time value, the present value
Future Value
of a promised future amount is worth less the
Future Value of a Single Amount
longer you have to wait to receive it. The
- The amount of money that an investment
difference between the two depends on the
made today (the present value) will grow to by
number of compounding periods Involved and
some future date. Since money has time value,
the interest (discount) rate.
we naturally expect the future value to be
Present Value of Annuities greater than the present value. The difference
- An annuity is a series of equal payments or between the two depends on the number of
receipts that occur at evenly spaced Intervals. compounding periods involved and the going
Leases and rental payments are examples. The interest rate.
Future Value of Annuities a small adjustment at the end to account for
- An annuity is a series of equal payments or rounding). P 583.33 of the first payment goes
receipts that occur at evenly spaced Intervals. toward interest and P 315.50 is used to reduce
Leases and rental payments are examples. The principal. But by payment 179, only P 10.40 is
payments or receipts occur at the end of each needed for interest and P 888.43 is used to
period for an ordinary annuity while they occur reduce principal.
at the beginning of each period for an annuity
Amortization Schedule
due.
- A table with a row for each payment period of
Future Value of an Ordinary Annuity (FVoa) an amortized loan. Each row shows the amount
- The value that a stream of expected or of the payment that is needed to pay interest,
promised future payments will grow to after a the amount that is used to reduce principal, and
given number of periods at a specific the balance of the loan remaining at the end of
compounded interest. The Future Value of an the period The first and last 5 months of an
Ordinary Annuity could be solved by calculating amortization schedule for a P 100,000, 15 year,
the future value of each individual payment in 7%, fixed-rate mortgage.
the series using the future value formula and
Negative Amortization
then summing the results.
- Occurs when the payment is not large enough
Future Value of an Annuity Due (FVad) to cover the interest due for a period. This will
- Identical to an ordinary annuity except that cause the loan balance to increase after each a
each payment occurs at the beginning of a situation that should certainly be avoided. This
period rather than at the end. Since each might occur, for Increases, but the payment
payment occurs one period earlier, we can does not. payment
calculate the present value of an ordinary
Cash Flow Diagrams
annuity and then multiply the result by (1 + i).
- A cash flow diagram is a picture of a financial
Combined Formula problem that shows all cash inflows and
- You can also combine these formulas and the outflows plotted along a horizontal time line. It
future value of a single amount formula into can help you to visualize a financial problem
one. and to determine if it can be solved using TVM
methods.
Loan Amortization Table
Amortization Constructing a Cash Flow Diagram
- A method for repaying a loan in equal - The time line is a horizontal line divided into
installments. Part of each payment goes toward equal periods such as days, months, or years.
interest due for the period and the remainder is Each cash flow, such as a payment or receipt, is
used to reduce the principal (the loan balance). plotted along this line at the beginning or end of
As the balance of the loan is gradually reduced, the period in which it occurs. Funds that you
a progressively larger portion of each payment pay out such as savings deposits or lease
goes toward reducing principal. payments are negative cash flows that are
represented by arrows which extend downward
For Example, the 15 and 30 year fixed-rate
from the time line with their bases at the
mortgages common in the Philippines are fully
appropriate positions along the line. Funds that
amortized loans. To pay off a P 100,000, 15
you receive such as proceeds from a mortgage
year, 7%, fixed-rate mortgage, a person must
or withdrawals from a saving account are
pay P 898.83 each month for 180 months (with
positive cash flows represented by arrows say P 500,000. If the owner of the store were
extending upward from the line. willing to sell his or her business for less than P
500,000, the purchasing company would likely
Net Present Value (NPV)
accept the offer as it presents a positive NPV
- The difference between the present value of
investment. If the owner agreed to sell the store
cash inflows and the present value of cash
for P 300,000, then the investment Enter You
outflows. NPV is used in capital budgeting to
sent investment. If the owner agreed to sell the
analyze the profitability of a projected
store for P 300,000, then the investment
investment or project.
represents a P 200,000 net gain (P 500,000-P
- A positive net present value indicates that the
300,000) during the calculated investment
projected earnings generated by a project or
period. This P 200,000, or the net gain of an
Investment (in present dollars) exceed the
investment, is called the Investment's intrinsic
anticipated costs (also in present dollars).
value. Conversely, if the owner would not sell
Generally, an investment with a positive NPV
for less than P 500,000, the purchaser would
will be a profitable one and one with a negative
not buy the store, as the acquisition would
NPV will result in a net loss. This concept is the
present a negative NPV at that time and would,
basis for the Net Present Value Rule, which
therefore, reduce the overall value of the larger
dictates that the only investments that should
clothing company. Let's look at how this
be made are those with positive NPV values.
example fits into the formula above. The lump-
- Determining the value of a project is sum present value of P 500,000 represents the
challenging because there are different ways to part of the formula between the equal sign and
measure the value of future cash flows. Because the minus sign. The amount the retail clothing
of the time value of money (TVM), money in the business pays for the store represents C,
present is worth more than the same amount in Subtract C, from P 500,000 to get the NPV: if C,
the future. This is both because of earnings that is less than P 500,000, the resulting NPV is
could potentially be made using the money positive; if C is more than P 500,000, the NPV is
during the intervening time and because of negative and is not a profitable investment.
inflation. In other words, a dollar earned in the
Risk And Return Trade Off
future won't be worth as much as one earned in
- The principle that potential return rises with
the present. The discount rate element of the
an increase in risk. Low levels of uncertainty or
NPV formula is a way to account for this.
risk are associated with low potential returns,
Companies may often have different ways of
whereas high levels of uncertainty or risk are
identifying the discount rate. Common methods
associated with high potential returns.
for determining the discount rate include using
According to the risk-return trade off, invested
the expected return of other investment
money can render higher profits only if the
choices with a similar level of risk (rates of
investor is willing to accept the possibility of
return investors will expect), or the costs
losses.
associated with borrowing money needed to
finance the project. - The appropriate risk-return trade off depends
on a variety of factors including risk tolerance,
For example, if a retail clothing business wants
years to retirement and the potential to replace
to purchase an existing store, it would first
lost funds. Time can also play an essential role
estimate the future cash flows that store would
in determining a portfolio with the appropriate
generate, and then discount those cash flows (r)
levels of risk and reward. For example, the
into one lump-sum present value amount of,
ability to invest in equities over the long-term investors, assessing the cumulative risk-return
provides the potential to recover from the risks tradeoff of all positions can provide insight on
of bear markets and participate in bull markets, whether a portfolio has assumed enough risk to
while a short time frame makes equities a achieve long-term return objectives or that risk
higher risk proposition. For Investors, the risk-- levels are too high with the existing mix of
return trade-off is one of the essential holdings.
components of each investment decision as
well as in the assessment of portfolios as a
whole. At the foundation of this assessment,
the consideration of the risk as well as the
reward of an investment can determine
whether taking action makes sense or not. At
the portfolio level, the risk-return tradeoff can
include assessments on the concentration or
the diversity of holdings and whether the mix
presents too much risk or a lower than desired
potential for returns.

Measuring Singular Risk in Context

- Examples of high risk--high return investments
include options, penny stocks and leveraged
exchange-traded funds (ETFs). When these
types of investments are being considered, the
risk-- return trade off can be applied to the
vehicle on a singular basis as well as within the
context of the portfolio as a whole. Generally
speaking, a diversified portfolio reduces the
risks presented by individual positions. For
example, a penny stock position may be
extremely high risk on a singular basis, but if it is
the only position of its kind and represents a
small percentage of the portfolio, the overall
risk may be minimal.

Portfolio Level Risk

- The risk-return tradeoff also exists at the
portfolio level. For example, a portfolio
composed of all equities presents both higher
risk and the potential for higher returns. Within
an all-equity portfolio, risk and reward can be
increased by concentrations in specific sectors
or single positions that represent a large
percentage of holdings. Conversely, a portfolio
holding short-term Treasury's presents low risk
levels combined with limited returns. For