4.2.

2 - Basic bond valuation

1 of 2

http://users.wfu.edu/palmitar/Law&Valuation/chapter 4/4-2-2.htm

Table of Contents

Introduction

1-Time Value

2-Risk/Return

3-Accounting

4-Securities

5-Business

6-Regulatory

Case Studies

Student Papers

4.2.1 Bond Fundamentals

4.2.3 Behavior of Bond Prices

4.2.2 Basic Bond Valuation

Basic bond valuation formula

Semiannual interest
Basic bond valuation formula
A bond's value is the present value of the payments the
issuer is contractually obligated to make -- from the
present until maturity. The discount rate depends on the
prevailing interest rate for debt obligations with similar
risks and maturities.
Using the basic DCF method, a bond's value is --

Example
Suppose Play Now, Inc. issues ten-year bonds (par
$1,000) with an annual coupon of 8.6%. Similar
ten-year bonds are paying 8.0% interest. What is the
value of one of Play Now's new bonds -- that is, what
should be its price?
Answer (using tables). You can use present value and
present value annuity tables:
B0 = C/(1+i)n + M/(1+i)n

B0 = Sum (1 to n) I / (1+i)n
+ M/ (1+i)n
OR

B0 = I *[(1+i)n - 1] / [(1+i)n * i]
+ M/ (1+i)n
B0 = bond's value at time zero
I

= annual interest payments

= discount rate

= number of years to maturity

= par value (payment at maturity)

Look at the example to the right to see the formula in

action.
Computing bond price. If you know the bond's par
value, coupon rate, time to maturity and current yield,
you can compute its price. See attached spreadsheet for
computing prices and yields for bonds paying
semi-annual interest.

$86 x (PV of ten year $1 annuity at

= 8.0%) + $1,000 x (PV of $1 to be
paid in 10 years at 8.0%)
= $86 x 6.710) + ($1,000 x .4632)
= 577.06 + $463.20
= $1,040.26
Answer (using spreadsheet). You can also use a
spreadsheet:
End of year
1
2
3
4
5
6
7
8
9
10

Semiannual interest
Most bonds, although the coupon rate is stated as an
annual interest rate, actually pay interest semiannually.
Valuing bonds that pay interest semiannually involves
three steps:
Convert bond's annual interest (I) to semiannual
interest -- divide I by 2
Convert the years to maturity (n) to semiannual
periods -- multiply n by 2
Convert annual required return (i) to semiannual
discount rate -- divide i by 2

Interest Principal Present value

$86
$79.63
$86
$73.73
$86
$68.27
$86
$63.21
$86
$58.53
$86
$54.19
$86
$50.18
$86
$46.46
$86
$43.02
$86
$1000
$503.03
Discount Rate
8.0%
Bond Value
$1,040.26

Example
Returning to our example, suppose Play Now issues
ten-year bonds (par $1,000) with an annual coupon rate
of 8.6% that pay interest semiannually. Similar ten-year
bonds are paying 8.0% interest. What is the value of
one of Play Now's new bonds -- that is, what should be
its price?
Answer. You can use present value and present value
annuity tables:
B0

C/2/(1+ i/2)2n + M/(1+i/2)2n

The bond valuation formula for a bond paying interest

semiannually is:

2/6/2015 9:24 AM

4.2.2 - Basic bond valuation

2 of 2

http://users.wfu.edu/palmitar/Law&Valuation/chapter 4/4-2-2.htm

$43 x (PV of 20-period $1

annuity at 4.0% per period) +
$1,000 x (PV of $1 after 20
periods at 4.0% per period

($43 x 13.590) + ($1,000 x

.4564)

$584.37 + $456.40

$1,040.77

B0 = Sum (1 to n) I/2 / (1+i/2)2n

+ M/ (1+i/2)2n
OR
B0 = I/2 *[(1+i/2)2n - 1] / [(1+i/2)2n * i/2]
+ M/ (1+i/2)2n
B0

= bond's value at time zero

= annual interest payments

= discount rate

= number of years to maturity

= par value (payment at maturity)

Computing bond price. If you know the bond's par

value, coupon rate, time to maturity and current yield,
you can compute its price. See attached spreadsheet for
computing prices and yields for bonds paying
semi-annual interest.
Continuous compounding. [Example of continuous
compounding]

Notice that this bond is identical to the bond in the

previous example with the exception that it pays
interest semiannually. The effect of the semiannual
payments is to increase the price of the bond -- from
$1,040.26 to $1,040.77.
Answer. You can also use a spreadsheet.
End of
year

2003 Professor Alan R. Palmiter

Present
value

0.5

$43

$41.35

1.0

$43

$39.76

1.5

$43

$38.23

2.0

$43

$36.76

2.5

$43

$35.34

3.0

$43

$33.98

3.5

$43

$32.68

4.0

$43

$31.42

4.5

$43

$30.21

5.0

$43

$29.05

5.5

$43

$27.93

6.0

$43

$26.86

6.5

$43

$25.82

7.0

$43

$24.83

7.5

$43

$23.88

8.0

$43

$22.96

8.5

$43

$22.08

9.0

$43

$21.23

9.5

$43

$20.41

10.0

$43

10.0

4.2.1 Bond Fundamentals

Interest Principal

$19.62
$1000

$456.39

TOTAL

$1,040.77

4.2.3 Behavior of Bond Prices

This page was last updated on: April 2, 2004

2/6/2015 9:24 AM