Valuing a bond

Chapter 6 page 10 - 11

Imagine you sell a car for $5,000. Would you be as happy to accept the $5,000 one year from today as you would be if the $5,000 were given to you immediately?

You would be losing money if you agree to accept the $5,000 in one year from now, because if you had the money, you could invest it for a year.

Assume that you could earn 10% interest on the $5,000 you received for you car. In one year, the original $5,000 amount would grow to $5,500.

Accepting $5,000 in one year's time rather than today will cost you the opportunity of earning that additional $500.

Cash flows (payments) in the bond value calculation are made comparable by putting them all in the same time period. The common time frame is zero, where zero equals today.

The cash flows are discounted to reflex the opportunity to earn a return if the money were in your hands today.

In the car example, if the cash flow to be received in one year is $5,000, then the discounted equivalent today (its present value, assuming a 10% interest rate, is $5,000. The present value of a future amount to be received is calculated by dividing that future amount by (1 + interest rate) raised to the power of the number of years in the future that amount will be be paid.


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