The present value of the Garcia Company’s bond cash flow can be determined by using the discounted cash flow model, which takes into account the time value of money.
These are the steps for calculating the current value of bond cash flows:
- The coupon rate of 16% is multiplied with the $1000 face price to calculate the annual payment, which will equal $160.
- To get $80, divide the coupon payment by 2.
- Since coupon payments are semi-annually, divide the return rate by 2. The result is 16.64%/2 = 8.32%.
- You can use the following formula to calculate PV: (1 + r).t where C represents the semi-annual coupon, r indicates the semi-annual return required rate, and t refers to the number semi-annual periods.
- Use the formula for all semi-annual periods until maturity 10 years, in this case 10*2 =20 semi-annual periods
- Add the present value of the bond’s cash flows to the present value of the face value, which is $1000 / (1 + 8.32%)^20
The present value of the bond’s cash flows is the sum of the present value of all semi-annual cash flows plus the present value of the face value, which is the amount that the bond would be worth if it were sold today.
The present value of the bond’s cash flow is less than the face value of the bond, because the bondholder will receive cash flows in the future and these cash flows are discounted to take account of the time value of money, which is the required rate of return.