Present and Future Values - and Expected Returns

Questions: 1. Importance of Present and Future values.2. Factors to be considered while computing Present value (PV) and Future value (FV).3. Practical applications of PV and FV method.4. Bond prices is inversely related to rising market rates. Answers: 1. Importance of Present and Future values PV is the current value on a given date of payment on a series of payments made at different times. The discounting method is used to find out the current value of a future payment. As such, the understanding of the concept of Present value of money, for a future investment becomes essential for future investments .A future value method estimates the future nominal value of the existing monetary amount. These two techniques are used in Capital budgeting techniques to assess the profitability of an investment. However, this does not include attributes like inflation, market demand while calculating the future sum. The capitalization method is used to find out the future value of an existing amount of money. 2. Factors to be considered while computing Present value (PV) and Future value (FV) Future payoff Hirsa and Neftci, (2013) mentioned that money at hand is offers more value than its future payoff. Thus, it becomes essential that the future payoff of money is considered, while calculating PV and FV value of money. Risk -There exists a certain risks in measuring Present (PV) and Future value(FV) of money, inspite of its usefulness and accuracies (DeFusco et al., 2015).As these factors do not consider market demands, inflation rate, and the average purchasing power of consumers the values calculated may differ with the actual, present and future value of money. Discount Rate As money derived from a third party incurs a bigger risk than money placed in a bank, such possibilities must be taken into account. In business finance, it is done through developing a certain discount rate. As such, the discount rate offered by banks is not accepted by corporate house, and settle for a higher discount rate. According to Hirsa and Neftci (2013), higher the risk, greater the discount rate assumed for calculating PV and FV. 3. Practical applications of PV and FV method The future value of money can be used in judging the financial viability investments of an investment. If $100 is made as an investment, the value of that amount in the span of one year can be calculated by using the future value (FV) formula. Besides this PV and FV, method can be used to calculate the cash flows of present day investments 4. Bond prices is inversely related to rising market rates When market interest rate rises, prices of bonds reduce. As such, this occurrence is known as interest rate risk. If we consider zero coupon bonds, which relates the monetary amount between the cost price and par value of bond at maturity. As an example- We take a zero-coupon bond, which is trading at the market at $950 and has a par value of $1,000 (paid at the bonds maturity in one year). The bond's rate of return at current time would be (1000-950) / 950 = 5.26% In this case, if current interest rates were to rise, it would result in bonds yielding at 10% rate if return. Thus, investors would not be interested in a zero-coupon yielding an return rate of 5.26%. Therefore, to create market demand, the cost of zero coupon bond shall have to fall, to match level of income in the existing yield rates. Thus, it can be seen that the bonds price is inversely related to the market interest rates. References DeFusco, R. A., McLeavey, D. W., Pinto, J., Runkle, D. E., Anson, M. J. (2015).Quantitative investment analysis. John Wiley Sons. Hirsa, A., Neftci, S. N. (2013).An introduction to the mathematics of financial derivatives. Academic Press.