How to Use EDGAR to Find Investment Banking Information
Investment Banking: What Happens to Bondholders in Mergers and Acquisitions?
What Investment Bankers Should Know about Venture Capital

Investment Banking: How to Determine a Bond’s Present Value

Valuing bonds for investment banking relies on the basic principle of present value (a dollar to be received today is worth more than a dollar to be received tomorrow or at some point in the future). The rationale is that a dollar received today can be invested to earn interest and will be worth more at a later date.

It may seem like a great deal of math is required to value bonds — and it is — but the mathematical proficiency needed is around a junior-high level, so don't be intimidated by it!

The present value of an amount to be received one year (or one period) in the future is

image0.jpg

Where r is the appropriate interest rate or discount rate (more about that in a bit).

So, the present value of a dollar to be received a year from today if the appropriate interest rate is 6 percent is:

image1.jpg

In other words, a rational investor shouldn't care whether she receives $0.9434 today or $1.00 a year from now. The difference between the two amounts — $0.0566 — represents the interest she could earn on the $0.9434 at the rate of 6 percent. This simple idea is the basis for all discounted cash-flow models in finance and investments.

Extending this idea beyond a year, the present value of a dollar to be received in two years is

image2.jpg

The subscript 2 after Future Value indicates that the amount is to be received two periods (or two years) from today, and the superscript 2 after (1 + r) indicates that interest on that amount could be earned for two periods (or two years) if it was received today instead of in two years.

So, the present value of a dollar to be received in two years if the appropriate interest rate is 6 percent is

image3.jpg

In other words, a rational investor shouldn't care whether he receives $0.8900 today or $1.00 two years from now. The difference between the two amounts — $0.1100 — represents the interest he could earn on the $0.8900 at the rate of 6 percent compounded for two years.

Compounding refers to the ability to reinvest the interest earned in year 1 and earn interest in year 2 on both the original amount and the year 1 interest.

image4.jpg

So, the present value of a dollar to be received in ten years if the appropriate interest rate is 6 percent is

image5.jpg

Again, a rational investor shouldn't care whether she receives $0.5584 today or $1.00 in ten years. The difference between the two amounts — $0.4416 — represents the interest she could earn on the $0.5584 at the rate of 6 percent compounded annually.

By the way, this is an illustration of compound interest, a concept that none other than Albert Einstein called the eighth wonder of the world.

blog comments powered by Disqus
Investment Banking: Characteristics of Stock
What Investment Bankers Should Know about the Capital Asset Pricing Model
How to Forecast Free Cash Flow for Investment Banking
Types of Mergers Investment Bankers Should Know
The Position of Bondholders in Investment Banking
Advertisement

Inside Dummies.com