A fair price can be determined by finding the present value of all future cash flows. This concept is demonstrated by pricing bonds and stocks. In chapter 9, a similar approach will be used to choose appropriate projects. In chapter 7, we will consider how to price bonds. Next, in chapter 8, we will try to price stocks.
Bonds are financial instruments that corporations and governments use to borrow money.
On the other side of the transaction are investors who are evaluating investments in terms of a return for a given level of risk. Bonds identify in advance all of the future cash flows. For example, the amount of interest and principal is identified in advance for each bond. The face value of the bond will be returned to the investor at the maturity date of the bond. The coupon rate on the bond identifies the amount of interest to be paid.