In many ways, the present value process is the same as the concepts used for notes payable. Assume a company issues a $100,000 bond due in four years paying seven percent interest annually at year-end. Here are the steps to compute the present value of the bond:
Compute annual interest expense.
The interest expense is $100,000 x 0.07 = $7,000 interest expense per year.
Find the market interest rate for similar bonds.
You can check a financial publication, such as The Wall Street Journal, for current market rates on bonds. The market interest rate may differ from the rate actually being paid. You want the market rate, because in the next step you use the market rate to look up the present value factor for the interest payments.
Assume that the market rate for similar bonds is 11 percent. Specifically, similar bonds (with similar credit rating, stated interest rate, and maturity date) are priced to yield 11 percent. Because the stated rate is 7 percent, the bond must be priced at a discount. The discount is amortized into income, which increases the yield to maturity.
Find the present value factors for the face value of the bond and interest payments.
Use the present value of $1 table to find the present value factor for the bond’s face amount. Use the present value of an annuity table to find the present value factor for the interest payments.
In each case, find the factor for four periods (years) at 11 percent interest. In this example, the present value factor for the bond’s face amount is 0.65873, and the present value factor of the interest payments is 3.1025.
Search the web to find a present value of $1 table and a present value of an annuity table. Look for tables that list the factors out to the fifth decimal place.
Use the present value factors to calculate the present value of each amount in dollars.
The present value of the bond is $100,000 x 0.65873 = $65,873. The present value of the interest payments is $7,000 x 3.10245 = $21,717, with rounding.
Add the present value of the two cash flows to determine the total present value of the bond.
In this example, $65,873 + $21,717 = $87,590.
