Question

What is the time value of money? What is market rate? If a bond's stated interest rate is the same as the market rate, what does this mean? If a bond's stated interest rate is below the market rate, what does this mean? If a bond's stated interest rate is above the market rate, what does this mean?

Answer 1

(1) Time value money:

The finance manager of a firm has to take appropriate decisions on financing,investment and dividend.While taking these decisions the finance manager must keep the time factor in mind and should consider the money value.

The time value of money is that the value of money received today is more than the value of same amount of money received after a certain period.In other words money received in the future is not as valuable as money received today. Purchasing power of money decrease due to inflation.It is therefore desirable to calculate the present value of future earnings by discounting them with the rate of inflation for ascertaining present value of earnings.Money has time value because

(a) Individuals generally prefer current consumption.

(b)An investor can profitably employ a dollar received today to give him a higher value on tomorrow or after a certain period.

Thus the fundamental concept is that a sum of money received today is worth more than the sum received after some time.

(2) Market rate : It is the rate fixed in market by demand supply forces.It is the price charged for goods or services in a free market .When demand goes down the market rate also goes down .This is because when demand of a product goes down the manufactures reduce the price of the product so as to sell more products at cheaper price.Similarly when they go up, market rate of products rise.In case of shares and other securities it is the price at which they can be readily be sold and bought in a market.This rate is also called going rate.

(3)Bonds have an inverse relation to interest rates ;when interest rate rise bond price fall and vice versa.A bond’s maturity and coupon rate generally affect how much its price will change as a result of changes in market interest rates. This is called interest rate risk.

If a bond's market rate is same as its stated interest rate then the bond's price will be same as the bond's maturity value.It will not become much attractive in the market nor will it create a decline in its price.For example , there is a bond 200000 with 9% stated interest rate. Thus the investor gets 9000 semiannually{(200000*9/100)/2}.If an investor's goal is to earn a 9% interest rate and he the market rate is 9% then he pays 200000.Thus he will neither suffer loss nor earn profit out of the sale of bonds.The market value is same as 100000 dollars

4 Market rategoes up when the investors forsee inflation .They begin to demand huge interest rates.For example,let us consider a bond issued in the market at 100000 dollars at 9% interest rate and is sold to investors.But after a year the market price increased to 11%.The semiannual payments for 9% bonds will be 4500 and that of 11% bonds is 5500 showing a difference of 1000.Obviously the 9%bonds will see a decline in the demand. An existing bond's market value will decrease when the market interest rate increase.The reason being the existing bond's fixed interest rates are smaller than the demanded market rates .Here, the market value will be less than 100000 dollars.

(5)Market interest rate decrease due to a downturn in economic activity.For example the market rate of bond is 8% and the stated value of the bond is 9%. Thus the semiannual payments of the corporation will continue at 4500 even when the market demands only 4000.Thus the bonds will become more valuable due to the investors gaining 500 extra.An existing bond 's market value will increase when the market interest rate decrease.This also means that the market value of the bond will be more than 100000 dollars now.