MSG Team's other articles

12682 Why Should Central Banks Be Independent?

Last month Donald Trump fueled a debate when he called the Fed “crazy.” Political accusations started flying all across the media. However, it raised a very important point. The world realized that Donald Trump is not in control of the Federal Reserve which is the central bank of the United States. To the financially savvy, […]

12336 The Anatomy of Commodity Indices

Movements in the stock markets are easy to track. This is because instead of looking at the movements in the price of several different stocks, investors can simply look at the movement in the underlying index. This is where the concept of index is derived from. It provides a pulse of the market wherein one […]

8797 Strategic Financial Management – Meaning and Its Functions

The study of financial management is imperative for anyone trying to make a career in the industry. However, traditional financial management helps to make short-term decisions. For example, the main purpose of financial management is to guide corporations about making three decisions viz. the investment decision, the financing decision as well as the dividend decision. […]

9794 Impact of Liquidity on Pension Funds

Liquidity management has become an important buzzword in the pension fund industry. This is because of the fact that recessions, slowdowns, and the recent market crash caused by Covid-19 have left the pension funds exposed. Many studies have been conducted into the matter and the results from these studies are simply astonishing. Pensions funds are […]

8755 Money Market – Definition, Participants and its Types

Retail investors across the world do not have a high level of knowledge when it comes to money markets. This is because of the fact that money markets have been largely invisible to retail investors. For a significant amount of time, money markets have only been used by large corporations, banks, and other entities to […]

Search with tags

  • No tags available.

One of the Most Important Uses of Discounting

The present value of a bond is the sum of all the future cash flows that can be derived from it. In this sense, the valuation of bonds really becomes simple, isn’t it? All we need to do is find out the future stream of payments that are due on the bond and then find out their present value and we call find out what the valuation of that bond is. Well, this may be theoretically this simple.

However, in practical life estimating the parameters like discount rate which go into the calculation can be very difficult. Also, using different discount rates can cause us to come up with very different valuations. So, bond valuation really is a game about guessing what the future discount rate will be.

Now, let’s have a look at a theoretical example of bond valuation. Here is a step by step procedure of how the calculation must be done:

Two Components

The calculation of the present value of the bond is done in two components. They are as follows:

  • Annuity: Bonds have a series of coupon payments that are due. Coupon payments are interest payments that are made periodically. Usually the frequency of paying interest is semi-annual. Corporations all over the world pay interest twice a year because it is a bond market convention.

    Also, it must be understood that bonds can have 2 values. The face value is the original issue value of the bond whereas the market value is its current market price. So, if the interest payments are not directly given, we need to compute them using the face value. Remember that interest payments are always computed using face value and not market value!

    Hence, the annual interest rate needs to be converted into a semi-annual rate or whatever rate is appropriate. Then, it must be plugged into the annuity formula along with the other details to derive the present value of the coupon payments that are due.

  • Lump sum: Bonds usually pay interest throughout their lives. However, they pay back the principal at the end of their lives. The principal therefore is a lump sum payment that may have to be discounted many years into the future. Now, even though this payment is not being received twice a year, we will still consider the semi-annual interest rates to find out the present value of the lump sum payment.

The final step is to add the present value of the annuity as well as of the lump sum payment. This adds the present values of the interest payments as well as the principal payments. Hence, we get the present value of the bond.

Example:

Let’s find the present value of a bond whose face value is $100. Interest rate is 12% on an annual basis. The bond will make semi-annual interest payments for 10 years after which the principal has to be repaid and the bond expires.

Present Value of Interest Payments

Number of periods = 20 periods (10 years, however the payment is semi-annual)

Discount Rate = 6% per period (Since we have doubled the number of periods, we need to cut the discount rate into half)

Payment: $6 per period (6% * face value of $100)

Therefore, present value of the annuity equals $68.82. This is the present value of the interest payments due.

Present Value of Principal Due

The principal that needs to be repaid is $100. It needs to be repaid after 20 periods and the discount rate we are considering is 6% per period. The present value of the principal therefore is $31.18

To find the present value of the bond we need to add $68.82 + $31.18. In this case, this adds up to $100. Therefore the present value of the bond is $100.

It must, however be noted that in real life bond values swing based on the expectation of what the future discount rate will be like. It is not really the current discount rate which determines the bond value!

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

What is Cost of Equity? – Meaning, Concept and Formula

MSG Team

Cross Border Credit Reporting

MSG Team

What is Corporate Finance? – Meaning and Important Concepts

MSG Team