QE and bonds economics

bobhopeful

seacaitch brilliant explanation thank you.

All very clear, except could you or anyone else put this bit in layman's language:

"Lowering longer term rates lowers the discount rate used to value the cash flows generated by assets, thereby increasing the price of those assets."

Discount rate? The value of cash flows generated by assets? What assets?

Thank you.

bobhopeful

...and why does the price of the assets increase? You mean the market value increases if they were sold, or the book value is increased on a balance sheet?

AlanP_2

bobhopeful wrote: »

seacaitch brilliant explanation thank you.

All very clear, except could you or anyone else put this bit in layman's language:

"Lowering longer term rates lowers the discount rate used to value the cash flows generated by assets, thereby increasing the price of those assets."

Discount rate? The value of cash flows generated by assets? What assets?

Thank you.

When a firm is considering an investment, a new factory say, they will look at the CASH FLOW it will generate for them over the next number of years (might be 30/40/50 years for a factory or maybe 5-10 for a new machine of some kind) and the cost to finance the investment (the interest rate they will pay).

100k cash generated by new factory next year is worth a lot more in real terms than 100K generated in Year 5, which will be worth more than 100k in Year 10 and so on.

These future cash flows will use the DISCOUNT RATE calculated from their borrowing costs and inflation estimates to bring all those 100k chunks back to "today's money" value. They do this by discounting them at the DISCOUNT RATE per year.

As an example if we take 3% Discount Rate:

Year 1 = 100k
Year 2 = 97k
Year 3 = 94,090
Year 4 = 91, 267
and so on

Equally the payments they will make to repay the LOAN + INTEREST need to be discounted back to today's value as well.

What they then arrive at is a "today's money" comparison between costs and revenues generated.

Sounds a bit pointless if they need a new factory anyway but most firms are considering Investment Option A v Investment Option B v Investment Option C, potentially across the globe so need to get everything down to the same baseline to make effective decisions.

In our personal lives you can do the same thing with comparing buying & leasing a car, house purchase with larger or smaller mortgage or renting and so on.

Google Net Present Value and Discounted Cash Flow for more detail, and probably a better explanation.

Avenarius

What a fascinating thread - thank you to all those who have taken so much time to compose such educational explanations.


How wonderful to find a place on the internet where people are writing things I can only just understand!