Time value of money is a concept that states that a dollar or shilling today is worth more than a dollar or shilling in the future. This is because the shilling or dollar can be put into immediate productive use and secondly it is free from the uncertainties of future expectations. It has a big impact in business finance, company finance and government finance. An important factor such as inflation rates existing in the economy impacts on the discounting rate that will be utilized. Another factor that would influence the discount rate used is the current economic climate such as whether the economy is experiencing a depression. In recent times, discounted cash flow statement has become a major tool in decision-making for businessmen (Banks, 2011). Thorough analysis has to be done before investing in a given venture such as the purchase of equipment and shares or bonds. This is necessary in determining whether the project will yield sufficient returns to justify the investment.
Given that the bond for SLP Company, Bharat Heavy Electricals Limited, is worth $100,000, and is to be paid back in 1 year, I would purchase it at $90,910 since a bond is purchased at a discount. This is after taking into consideration various factors such as inflation rate in the US of 1.7%, and interest rates which is about 7% according to the Federal Reserve report. The fact that the company is also experiencing financial difficulties makes the bond very risky since repayment depends on profitability. Therefore, the investor is not attracted to buy this bond and the company has to offer high interest rates so as to attract buyers. It is, therefore, important to ensure that the company will be in a position to pay back the money borrowed from the investors. The company has a profit margin of 14.89%, debt to equity of 1.29, current ratio of 1.68, return on assets of 9.09%, return on equity of 31.11% and an operating margin of 19.41%. The profitability of this company enables it to repay the bond at a market price that is fair and attractive to the investors.
I would purchase the bond at a discount rate of 10% given the various factors I have outlined above. The bond’s true value according to computations is shown below:
$100,000× (PVIF 10%, 1year) =$ 90,910
I will only purchase the bond if the debt to equity ratio of the company is less than 1, because it means that the level of equity financed by debt is less than 100%. The acceptable profitability ratio is at least 100% meaning that the company is making a profit of 10% of the revenues made. A return on assets of more than 50% is acceptable to me, because it means that the company is efficiently utilizing its assets in the pursuit of the profits. A return on equity greater than 10% is preferred, because it means that the amount invested by the shareholders is utilized to generate company profits.
General Electric Company and General Motors Limited are two other companies in the same industry as the SLP Company. The total debt to equity ratio for General Electric is 322.51 and that for General Motors is 39.07. The investor should pay more for the General Motors bond for $100,000 and a less discount rate for a $100,000 bond for the General Electric bond, since the beta for General Motors is higher, hence higher risk is involved. The higher the risk, the higher the discount rate will be for the company. The profit margin for General Motors is 3.79% and that for General Electric is 9.26%. The return on assets for General Motors is 2.90% and that for General Electric is 1.62%. The return on equity for General Motors is 13.26% and that for General Electric is 12.09%. Current ratio for General Motors is 1.25, while that for General Electric is 168.76. The beta for General Motors is 1.69, while that of General Electric is 1.45. Based on the above information, a suitable discount rate would be 24%. The computation will be
$100,000× (PVIF 24%, 1year) =$80,650
The riskiness of the three companies is that they will pay different prices for the bond based on the discount rate used to calculate bond prices. The higher the beta for the companies, the more the risk the investor anticipates and the lesser the returns generated (Madura, 2003).
Learning how the discounted cash flows work is very important in business and it teaches people to factor in many aspects such as inflation, profitability of the company, interest rates fluctuations in the economy and the risk level of the company. If the company profitability is low, it will offer higher interest rates to compensate for the low profits. The debt level is an important factor, since very high debt levels make the venture unattractive to investors. The debt levels also determine the company’s ability not to default financial obligations to its creditors (Gitman, 2003). Hence, the company has to give high interest rates on its bonds, so as to attract the buyers.
The lower the return on assets, the higher the interest rates demanded by investors, hence all these factors will come into force when making the decision about the discounted rate in order to get the present value of the bond. This is the amount at which the investor will buy the bond. I have mastered the concept of bond pricing based on the discounted rates. The present value is determined by factors such as in the cost of capital, the rate of inflation and the interest rates. The present value seeks to determine the amount of money that can be invested currently to earn a future value amount of shillings in a given number of periods. The future value, also known as the terminal value, is the value at some time in future of a present sum of money or a series of payments or receipts (Banks, 2011).
The basic objective of this paper is to give an informative knowledge about the methods used to determine the pricing of bonds and how factors like interest rates and inflation influence those prices. Investors should take ample time to make sound investment decisions before engaging their money in any profit generating venture. They should also be keen to follow on company’s profitability over long progressive years to determine the overall financial direction of the company. Investors will only succeed if they ensure that they place their money in sound investments and long-term profitable ventures.