(^50) Financial Management
1 2 2
2
2
t 1
t
( 1. 1 )
100
( 1. 1 )
10
( 1. 1 )
10
Present Value of a Bond( 1. 1 )
Principal Amount
(1.1)Present Value of a Bond Interest Amount= + +
= +
=Or to use the tables the change would be:
Present Value = 10 * (PVAF2,0.1)
+ 100 * (PVIF2,0.1)
Substituting the values we find that
Present Value = 100
This is no magic. When you are getting a 10 % return and also expect a 10 % return,
the price you would pay would equal the par value of the bond. This means that if we
expect higher return i.e. 15% in situation (iii) above, the price that we would be willing
to pay for a bond returning only 10 % would be less than the par value. Similarly, if we
expect lower return, i.e., 7% in situation (i) above, the price that we would be willing to
pay for a bond returning 10 % would be higher than the par value. Can you find out the
values for these two cases?
There are five variables in this case: (1) present value, (2) future value, (3) interest
amount paid, (4) return expected and (5) time period. Properties of mathematics say
that if any four of these five variables are given, you can always find the value of the
fifth variable. You can attempt that yourself or turn over to solved examples to look at
a similar case.Valuing Equity Securities
Unlike debt and money market instruments, equity instruments represent the ownership
interest in the company. As owners must put in their money in the venture before
anybody would lend to them, equity is always issued before debt is released by the
institutions. In fact the incorporation of the company requires that the promoters must
pick up some shares in the company, only then the company can be incorporated. As
equity represents the owners it is but logical that all the debt holders must be paid off
before owners can claim any returns from the company. So the equity has the lowest-
priority claim on earnings. Equity also has the last claim on the assets in case the
company is liquidated (closed down).
This means that the equity carries the highest risk. Not without reason. The flip side of
the coin is that the equity owners are also the owners of all the profits that remain after
all the debt holders are paid their interest. The interest payment is fixed while there is
no limit on the levels of profits that can accrue to the equity holders. Vice Versa does
not apply here, the liability of the equity holders is limited to the level of investments that