The concept of present value is based on the time value of money-the idea that receiving money today is preferable to receiving money at some later date. Assume. for example, that.a bond will have a maturity value of $1,000 five years from today but will. pay no interest in the meantime. Investors would not pay $1,000 for this bond today. because they would receive no return’ on their investment over the next five years. There are prices less than $1,000, however, at which investors would buy the bond. For example, if the bond could be purchased for $600, the investor could expect a return (interest) ,of $400 from the investment over the five-year period.’The parent value of a future cash receipt ,is the amount-that a knowledgeable ‘investor will Pay for the right to receive that future payment.
The exact amount of , the present value depends on
(1) the amount of the future payment,
(2) the length of time until the payment will be received, and
(3) the rate of return required by the in Nestor.
However, the present value will always be less than the future amount. This is , because money received today can be invested to earn interest and grow to a larger amount in the future The rate of interest that will cause a given present value to grow to a given future amount is called the discount rate or effective rate. The effective interest rate required by investors at any given time is regarded as the going market rate of interest. (The procedures for computing the present value of a future amount are illustrated in Appendix Cut the end of thus textbook. The concept of present value is very useful in managing your personal financial affairs. We snuggest that you read Appendix C-even if it has not been assigned.) The Present Value Concept and Bond Prices The price at which bonds will sell is the present value to investors of the future principal and interest payments. If the bonds sell at par, the market rate is equal to the contract interest rate (or nominal rate) printed on the bonds. The higher the effective interest rate that investors require; the less they will pay for bonds with a given contract rate of interest.
For example, if investors insist on a 1O%.retum, they will pay less than $1,000 for a 9%.,$1,000 bond. Thus, if investors. require an effective interest rate greater than the contract rate of interest, the bonds will sell at a discount (a price less than their face value). On the other hand, if market conditions support an effective interest rate of less than the contract rate, the bonds will sell at a premium (a price above their face value). A corporation wishing to borrow money by issuing bonds must pay the going market rate of interest. Since market rates of interest fluctuate constantly, it must be expected that the contract rate of interest may vary somewhat from the market rate at the date the bonds are issued. Thus bonds may be issued at a slight discount or premium. (The issuance of bonds at a discount or premium is discussed in Supplemental Topic B at the end of this chapter Bond Prices After Issuance As stated earlier, many corporate bonds are traded daily on organized securities exchanges at quoted market prices. After bonds are issued, their market prices vary inversely with changes in uninteresting fates. As interest rates rise, investors will be willing to pay less money to own a bond that pays a given contract rate of interest. Conversely, as interest rates decline, the market prices of bonds rise.
Changes in the current level of interest rates arc not the only factors influencing the market prices of bonds. The length of time remaining until the bonds mature is another major force. As a bond nears its maturity date, its market price normally moves closer and closer to the maturity value. This trend is dependable because ‘the bonds are redeemed at par value on the maturity date Volatility of Short-Term and long-Term Bond Prices When interest rates fluctuate, the . market prices of long-term bonds are affected to a far greater extent than are the market prices of bonds due to mature in the near future.
To illustrate, assume that market interest rates suddenly soar- from 9% to 12%. A 9% bond scheduled to mature in but a few days will still have a market value of approximately $1,OOO the amount to be collected in a ‘few days from the issuing corporation, However, the market price of a’ 9% bond maturing in 10 years will drop significantly. Investors who must accept these below market interest payments for many years will buy the bonds only at a discounted price. In summary, fluctuations in interest rates have a far greater effect on the market prices of long-term bonds than on the prices of short-term bonds. Remember that after bonds have been issued, they belong to the bondholder, not to . the issuing corporation. Therefore, changes in the market price of bonds subsequent to their issuance do not affect the amounts shown in the financial statements of the issuing corporation, and these changes are not recorded in the company’s accounting records.