Solving Present and Future Value Problems Essay

Introduction

Comprehending the idea of the time value of money is important and essential in the management of finances. This concept helps in determining the value of different investment options.

The future value and present values are necessary when valuing investment options because they enumerate the amount of money that an investment will be worth in the future. The 10-year investment with an interest of 10%, for instance, is more rewarding compared with the five-year investment at an interest rate of 5% in the long run. Investing in corporate bonds will also yield future returns for the company. The future value that will be obtained and the cash flows to be generated from investing in the bonds should offset the present value and have a premium. The level of risk from the bonds varies from company to company depending on each corporation’s portfolio. A corporate bond bought or issued to subscribers has a rate at which it has to pay or be paid as interest. If the interest rates are high, the bonds are more attractive to buyers than to the issuers and vice versa. Bonds are a good source of finances for corporations as the firms determine the rates to be regained from the bonds.

The rate of interest and time greatly influence the returns (cash flows). Therefore, the two should be considered keenly. The rate of interest varies depending on the investment. Thus, the investment chosen should be one that yields the maximum returns. Investing in projects with high interests is preferred as the future value of the amount invested will be high.

Bonds

Bonds are long-term contracts where a borrower agrees to make payments of principal and interest on precise dates to the bearers of the bond (Vaitilingam, 2013). Bondholders invest their money to receive premiums on the invested amounts by lending their money to the bond issuers. The company or bond issuers commit themselves legally to pay interest on the principal when the bond matures and return the principal. The companies that float their bonds usually aim at raising finances to fund projects such as purchasing of equipment, investment in research and development, buying back their own stock, paying shareholders’ dividends, refinancing debt, as well as financing mergers and acquisitions (Steiner, 2007).

There are four types of bonds namely treasury bonds, corporate bonds, municipal bonds, and foreign bonds. The type of bond determines the return and the degree of risk involved. The current yield of a bond is the annual interest payment divided by the bond’s current price (Brett, 2011). The current yield gives information on the cash income a bond can generate in a given period (a year). Bonds that have longer maturity expose investors to interest rate risks while short-term maturity bonds have a risk of reduced interest rates. Therefore, investment decisions using bonds have to be determined accurately to ensure maximum returns.

Types of Bonds

Treasury Bonds

Treasury bonds are also referred to as government bonds, which are issued by the Federal government and are cushioned against default risk (Brealey & Myers, 2005).

Corporate Bonds

Corporate bonds are bonds issued by corporations. These bonds are exposed to default risk as corporations may run at losses leading to their closure. Corporate bonds have varying degrees of default risk, which varies with the company that issues them and the terms as outlined for a specified bond (Brett, 2011).

Municipal Bonds

Municipal bonds are bonds that are issued by state and local governments. These bonds are normally attractive to state residents as they do not charge any taxes as long as the bondholder is from the state issuing the bonds. States issue these bonds to finance their local or state projects. The state issuing the bonds establishes the residence of the bond subscribers to ascertain their locality before paying them to exempt them from taxation.

Foreign Bonds

Foreign bonds are bonds that are issued by governments in other countries or by corporations from foreign countries. These bonds have an advantage as they are not affected by the default risk. The only risk involved regards the fluctuations of foreign currency exchange (Vaitilingam, 2013). The currency of the state that issues the bonds is different from the currency of the buyer hence bringing about the problem of currency exchange rates. Exposure to risk is high with foreign bonds because the international market is prone to inter-trade relationships among countries.

Conclusion

Bonds are mainly issued by governments to raise money for development projects. Bonds are thus useful in assisting governments or corporations to raise finances that they need while offering an opportunity to investors. Therefore, bonds can be instruments that link investors and the government or corporations, which enables both entities to progress and achieve the desired goals.

References

Brealey, R & Myers, S. (2005). Principles of corporate finance (8^th ed.). U.S.A: McGraw-Hill.

Brett, M. (2011). How to read the financial pages (5^th ed.). New York: Random House.

Carther, S. (2015). Calculating the present and future value of annuities. Web.

Financial calculators. (2015). Calculator soup. Web.

Garrett, S. (2013). An introduction to the mathematics of finance: A deterministic approach. New York: Elsevier.

Ross, S. M. (2011). An elementary introduction to mathematical finance CUP (3rd ed.). Cambridge: Cambridge University Press.

Steiner, R. (2007). Mastering financial calculations. (2^nd ed.). Upper Saddle River: Prentice-Hall.

Vaitilingam, R. (2013). FT Guide to using the financial pages (6^th ed.). Upper Saddle River: Prentice-Hall.