Page 31 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes Illustration 10
Mr. Nandan intends to have a return of ` 10,000 p.a. for perpetuity, Incase the discount rate is
20%, calculate the present value of this perpetuity.

Solution:
A 10,000
P = = = 50,000
i .20
This means that, Mr. Nandan should invest ` 50,000 at 20% to get an annual return of ` 10,000 for
perpetuity.

2.5 Valuation of Bonds or Debentures

Meaning: A bond or debenture is an instrument of long-term debt issued by a borrower.
Technique of Valuation of Bonds or Debentures: The value of bonds or debentures is, generally,
determined through the technique known as the Capitalization technique.
The process of determination of the present value of a bond or debenture can be considered
under two headings viz.,
1. When a bond or debenture is redeemable (i.e. definite maturity period).
2. When a bond or debenture is irredeemable (i.e. as no specified definite maturity period).

Present Value of a Redeemable Bond or Debenture

When a bond or debenture is redeemable, its present value can be determined by estimating its
future cash flows, and then, discounting the estimated future cash flows at an appropriate
capitalisation rate or discount rate.
The estimated cash flows from the bond or debenture consists of the stream of future interest
payments plus the principal repayment.
The appropriate capitalization rate or discount rate to be applied to discount the cash flows from
the bond or debenture will depend upon the risk associated with the bond or debenture. If the
risk is low, a lower discount rate will be applied. On the other hand, if the risk is high, a higher
discount rate would be applied.
The following formula may be used to find out the present value of the bond or debenture
(assuming that the bond has a maturity period of 4 years):

I I I I + M
V = 1 1 + 2 2 + 3 3 + 4 4
(1K d ) (1 K d ) (1K d ) (1K d )
+
+
+
+
Where,
V = the present value of the bond or debenture.
I = annual interest payment.
K = the capitalization rate or the discount rate.
d
M = The maturity value of the bond or debenture.

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