Present Value of a Bond
The present value of a bond is the total value of the bond’s future interest payments and its face value (the value at maturity), discounted back to the present using a rate of return (or discount rate) that represents the investor’s required rate of return.
The present value of a bond is calculated as the sum of the present values of its future cash flows, which consist of:
- Periodic coupon payments: These are the interest payments that the bond issuer pays to the bondholder at regular intervals until maturity. The present value of these periodic payments is calculated using the formula for the present value of an ordinary annuity.
- The face value or par value: This is the amount the bond issuer agrees to pay back at maturity. The present value of the face value is calculated using the formula for the present value of a single sum.
The formula to calculate the present value of a bond is as follows:
PV = C * [1 – (1 + r)^-n] / r + FV / (1 + r)^n
Where:
- PV is the present value of the bond
- C is the annual coupon payment
- r is the discount rate (or required rate of return)
- n is the number of periods until maturity
- FV is the face value of the bond
The present value of a bond helps investors to determine how much they should be willing to pay for a bond. If the present value of the bond‘s future cash flows is greater than the bond’s market price, the bond could be considered a good buy, and vice versa.
Example of the Present Value of a Bond
Let’s consider an example of a bond with the following characteristics:
- Face value (FV): $1,000 (This is the amount the bond will be worth at maturity)
- Coupon rate: 5% (This is the interest rate the bond pays annually)
- Number of years to maturity (n): 10 years
- Discount rate (r): 4% (This is the required rate of return for the investor)
First, we need to calculate the annual coupon payment (C). This is the face value times the annual coupon rate:
C = FV * coupon rate
C = $1,000 * 5% = $50
The bond pays $50 in interest per year.
Now, let’s calculate the present value of the bond:
PV = C * [1 – (1 + r)^-n] / r + FV / (1 + r)^n
Substituting the known values:
PV = $50 * [1 – (1 + 0.04)^-10] / 0.04 + $1,000 / (1 + 0.04)^10
Solving the calculations inside the brackets first:
PV = $50 * [1 – 0.67556] / 0.04 + $1,000 / 1.48024
Further calculating:
PV = $50 * 0.32444 / 0.04 + $1,000 / 1.48024
And then:
PV = $1,286.1 + $675.56
So:
PV = $1,961.66
Therefore, given a 4% required rate of return, the present value of this bond, or what an investor would be willing to pay for it today, is approximately $1,961.66. If the bond was being sold for less than this, it would be a good buy, and if it was being sold for more, the investor may want to consider other options.
