Question

Briefly explain the following Conceptual Understanding question parts (a) and (b)

a)   Explain the concept of time value of money, how that relates to the discount factor and the Net Present Value

b)  A bond with a par value of £1000 and a coupon rate of 5% is currently trading at £800, work out its current yield

Answer 1

Answer (a)

Time Value of money means money has time value. Its conceptual meaning defines that a Pound today is more valuable than a Pound year after. We use desirable interest rate yield as the discounting factor to express the time value of money.

Further, time value of money means that worth of a pound received today is different from the worth of a pound to be received in future. The preference of money now as compared to future money brings into light the time value of money.

Further, Present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period.

Also, Present Value is the current value of Future amount. It can be defined as the amount to be invested today (Present value) at a given rate over specified period to equal the Future amount.

Further, (NPV) Net Present Value = Present value of future cash inflows - Present of cash outflows

While calculating Net Present Value, it takes into account the time value of money and discounting factor to determine the present value of future cash inflows.

Future Value = Present Value (1 + i)^n

Present Value = Future Value / (1 + i)^n

where, i = interest rate i.e. discount factor.

Answer (b)

Current yield = Interest / Price of Bond

= 50 / 800

= 0.0625

= 6.25 %

Workings:

Interest = coupon rate * Par Value = 5% * 1000 = 50

Price of Bond = 800

Should you have any query, please comment.

Good Luck!