Question

Describe how the concept of the time value of money is incorporated into the valuation of bonds, long-term leases, and pension obligations.

Answer 1

Valuation of bonds:

The value of a bond is the present value of the cash flows expected from the bond if, it is held till maturity. To find the PV, the required rate of return for the risks associated with the cash flows from the bond, is used as the discount rate.

The cash flows from a bond comprise the following:

• The maturity value of the bond which, is received at the end of the term of the bond or, if it is a callable bond, the amount for which the bond can be called at the specified call date.
• The periodic interest income which, may be either annual or semi-annual. These cash flows constitute an annuity.

The sum of the PVs of the above two cash flows will be the bond's value.

Valuation of long term lease:

A lease, results in a payment (for the lessee)/receipt (for the lessor) of periodic lease rent, which is in the form of an annuity. The payment may have to be made at the beginning of the period, in which case it is an annuity due, or at the end of the period. in which case, it is an ordinary annuity. In addition, a lease may contain a clause for payment of residual value which, is to be effected at the end of the lease. Maintenance costs are also to be met, which may be the obligation of either the lessee or lessor.

To evaluate the lease of an asset from the point of view of the lessee, in lieu of its purchase, the time value concept is used.

The after tax cash flows arising out of the lease are to be discounted at the after tax cost of debt. The PV so obtained constitutes the NPV of the lease. Similarly, the after tax cash flows that would arise if the asset is purchased (instead of leasing it) are also discounted at the after tax cost of debt to get the NPV of the purchase. For the lessee, the lease is advantageous if the 'Net advantage of lease', that is the differenece between the NPV of lease and NPV of purchase, is positive.

From the point of view of the lessor, the lessor fixes the lease rent in such a manner that, he is able to earn the desired rate of return from the lease. For this he discounts the cash flows using his desired rate of return to get a NPV.

Pension obligations:

Pension obligations of an employer under a defined benefit plan are to be found out by discounting the estimated future liability of the employer.The use of actuarial science would be required to estimate the future obligations.