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As explained in Financial Markets , the prices of stocks and bonds depend on future events. The price of a bond depends on the future payments that the bond is expected to make, including both payments of interest and the repayment of the face value of the bond. The price of a stock depends on the expected future profits earned by the firm. The concept of a present discounted value (PDV) , which is defined as the amount you should be willing to pay in the present for a stream of expected future payments, can be used to calculate appropriate prices for stocks and bonds. To place a present discounted value on a future payment, think about what amount of money you would need to have in the present to equal a certain amount in the future. This calculation will require an interest rate . For example, if the interest rate is 10%, then a payment of $110 a year from now will have a present discounted value of $100—that is, you could take $100 in the present and have $110 in the future. We will first shows how to apply the idea of present discounted value to a stock and then we will show how to apply it to a bond.
Consider the case of Babble, Inc., a company that offers speaking lessons. For the sake of simplicity, say that the founder of Babble is 63 years old and plans to retire in two years, at which point the company will be disbanded. The company is selling 200 shares of stock and profits are expected to be $15 million right away, in the present, $20 million one year from now, and $25 million two years from now. All profits will be paid out as dividends to shareholders as they occur. Given this information, what will an investor pay for a share of stock in this company?
A financial investor, thinking about what future payments are worth in the present, will need to choose an interest rate. This interest rate will reflect the rate of return on other available financial investment opportunities, which is the opportunity cost of investing financial capital, and also a risk premium (that is, using a higher interest rate than the rates available elsewhere if this investment appears especially risky). In this example, say that the financial investor decides that appropriate interest rate to value these future payments is 15%.
[link] shows how to calculate the present discounted value of the future profits. For each time period, when a benefit is going to be received, apply the formula:
Payments from Firm | Present Value |
---|---|
$15 million in present | $15 million |
$20 million in one year | $20 million/(1 + 0.15) ^{1} = $17.4 million |
$25 million in two years | $25 million/(1 + 0.15) ^{2} = $18.9 million |
Total | $51.3 million |
Next, add up all the present values for the different time periods to get a final answer. The present value calculations ask what the amount in the future is worth in the present, given the 15% interest rate. Notice that a different PDV calculation needs to be done separately for amounts received at different times. Then, divide the PDV of total profits by the number of shares, 200 in this case: 51.3 million/200 = 0.2565 million. The price per share should be about $256,500 per share.
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