Financial Institutions, Markets, and Money, Eleventh Edition

CHAPTER FIVE

Bond Prices and Interest Rate Risk

BUSINESS EXECUTIVES ARE frequently asked to make decisions that require them to determine the value or price of cash flows over time. The value of the future cash flows depends not only on the size of the cash flow (the dollar amount), but also on when the dollars are received. It makes intuitive sense that a dollar received today is more valuable than a dollar received in the future. Dollars received today can be deposited in a bank and earn interest; future dollars cannot. Thus, the timing of when you receive money is important. Let's look at an example to illustrate the timing of money problem.

You just bought a ticket to the popular Mega Millions lottery game, which is played in 41 states and in the District of Columbia. In Mega Millions, the jackpot continues to build each week until some lucky person buys a winning ticket. A number of winning ticketholders have collected prizes exceeding $100 million, and the largest jackpot prize so far was $390 million. (The largest Mega Millions lottery prize occurred on March 6, 2007, and had two winning tickets, one each from Georgia and New Jersey. The two winners split a prize of $390 million, each receiving $195 million.)

Suppose you won a $100 million jackpot. Does that mean your ticket is worth $100 million on the day you won the lottery? The answer is no! A Mega Millions jackpot winner is paid in one of two ways: (1) a series of 26 cash payments over 25 years, or (2) a lump sum cash ...