Question

Please give us one example from your research, work, or personal life using the concepts of present value, future value and discounting cash flows and applying it to bond valuation and pricing.

Answer 1

A offer is received from an investment company where in $10,000 is to be invested now, and $4000 is received at the end of each of the next three years. To find out whether this is an appropriate investment for me, I use the concepts of time value of money. Let me assume that my required rate of return on investment is 11%.

Present value = Future cash flow / (1 + 11%)^year

Present value of the cash flows of the investment = ($4000 / 1.11¹) + ($4000 / 1.11²) + ($4000 / 1.11³) = $9,774.86.

The initial investment required is $10,000. As the present value of the cash flows is less than the initial investment, I can conclude that this investment is not appropriate.

Bonds are valued using the same concepts of time value. Price of bond = present value of its cash flows. The cash flows of a bond are its coupon payments and redemption value. These cash flows are discounted at the appropriate discount rate to calculate the present value of the bond. The present value should be the price of the bond.