Tutorial: Present Values and Debt Pricing
This material involves a review of topics covered during your FIN 214 course. You may also find more information on it in Chapter 6 of the AC 305/306 textbook (the first half of the book may be accessed through the “Read, Study, & Practice” module of WileyPlus).
When you are considering any type of long-term investment – whether you are making the investment in a project, or making an investment in a long-term asset, or attempting to get long-term financing for your own projects or investments – it is not OK to consider the cash flows in terms of current dollars. The existence of inflation means that a dollar today will buy more than that ...view middle of the document...
The interest that you receive on a savings account is the “price” of money for the bank – they have to pay this to you in order for you to let them use your money. The dividends that a company pays, or its commitment to raising the share price, are the “price” of money for a company that issues stock – they have to pay this to the investors in order to get to use the investor’s financial capital. In the business world, we refer to the “price” of money as a “return”. A return is what an investor gets in exchange for letting someone else use their money for a while.
Just like everything else, the return is subject to inflation…because you can probably buy more gas with $1 today than you will be able to 10 years from now. The return is also affected by factors like risk. If you, the investor, are less certain of the company’s ability to deliver the promised return, you’re going to charge them more, or you’re going to demand that they deliver the return more quickly, than you would if you were more confident in their ability to pay for your money.
This is why we don’t look at long-term investments of any kind in terms of current dollars, but in terms of present values. We want to know how much the investment – after we factor in how long the investment period is and how risky the project or company is – is worth in current dollars.
How exactly you do this is the same, regardless of whether you’re looking to sell bonds and need to price them, or you’re looking to buy bonds and need to price them, or you’re buying a long-lived asset, or making a capital budgeting decision. You should always base these decision on an analysis of present values – not current dollars.
The process of computing present values is also exactly the same. The first thing you need to do is determine what kind of cash flow you’re looking at. Are you lending (borrowing) a roll of cash today, and will be getting it back (repaying it) in a lump sum in several years? Or are you lending (borrowing) a lump of cash today and you expect a to receive (to make) a series of payments over the next years, with maybe a lump sum as well at the end?
You need to figure this out, because the time value of money is sensitive to exactly how much time you’re talking about.
If you put down $10,000 today and expect to get that $10,000, plus another $1,000 in interest, all at the same time, five years from now, there’s only a single time-value adjustment you need to make (and it will affect the repayment of the principle, and the payment of interest, equally).
But what if you put down $10,000 today, and expect to get that $10,000 in five years, and in the meantime, you’re expecting to get 5 annual payments of $200 in interest? That’s actually five different time value adjustments…because $1 next year is not worth $1 a year after that, and that’s not worth $1 a year after that, etc.
Fortunately, we have some shortcuts. We have present value tables...