BASICS OF VALUATION

AND BONDS
VALUATION
CHAP 2

Learning Objectives

Characteristics of bonds
Types of bonds
Valuation concepts
Bond valuation
Yield to maturity
Important factors in bond
relationships
2

WHAT IS BOND?
Bonds - Long-term debt instruments (maturity - over
1 year)
Provide periodic interest income annuity series
Return of the principal amount at maturity future lump
sum
Prices can be calculated by using present value (PV)
techniques i.e. discounting of future cash flows.
Combination of PV of an annuity and of a lump sum

$I
0

$I
1

$I

$I
2

$I
...

$I+$M
n
3

Example: Corporation A
Par value = $1,000
Coupon = 6.5% or par value per year,
or $65 per year ($32.50 every six
months).
Maturity = 22 years (matures in
2032).
$32.50

$32.50 $32.50 $32.50 $32.50

$32.50+$1000

22
4

Typical Cash Flows on a

Bond
(for Corporation)
Time
0
1- Maturity
Maturity

Cash flow
Cash inflow from Bond Issue
Pay Interest
Repay Principal

Exceptions: Bankruptcy, bond recalled

and paid off before the due date, mergers
and acquisitions.
Keown, Martin, Petty - Chapter 7

Key Components of a Bond

(continued):
Merrill Lynch corporate
bond
Par value : Typically $1000
Par value :

Coupon rate: Annual rate of

interest paid.

Coupon: Regular interest

payment received by holder per
year.

Maturity date: Expiration date of

bond when par value is paid back.

Yield to maturity: Expected rate of

return based on current market
price of bond

Typical Cash Flows on a

Bond
(for
Timebondholder)
Cash flow
0
Pay for bond (Buy)
1 Maturity Receive Interest
Maturity
Receive Par value back
Exceptions: Bankruptcy, bond recalled,
bond sold by investor in the market before
maturity date, mergers & acquisitions.

Keown, Martin, Petty - Chapter 7

TERMINOLOGY AND
CHARACTERISTIC
OF and
Some of the more important terms
characteristics that you might hear about
BONDS
bonds are as follows:
Claims on Assets and Income
Par value
Coupon interest rate
Maturity
Indenture
Bond ratings
Lets consider each in turn.

Characteristic of Bonds
Claims on Asset and Income
In the case of insolvency, claims of debt bonds are
honored to come ahead those of common or preferred stock.
Par value (M)
Its face value that is returned the bondholder at
maturity.
Coupon Interest Rate (I)
The percentage of the par value of the bond that will
be paid out annually in the form of interest.
Maturity (n)
The length of time until the bond issuer returns the par
value to the bondholder and terminates or redeems the bond.

Characteristics of
Bonds

Indenture
-The bond contract between the firm and the
trustee representing the bondholders.
-An indenture sets the terms of the bond; for
example, the coupon rate, par value, the period until
maturity, any special features like convertibility or
whether it is callable, repayment provision and (if
any) lists restrictive provisions which are designed to
protect bondholders.
Bond Ratings
These ratings involve a judgment about the future
risk potential of the bond. The poorer the bond rating,
the higher the rate of return demanded in the capital
markets.
10

Example:
Standard and Poors Corporate Bond Ratings
AAA
This is the highest rating assigned by Standard and Poors for debt
obligation and indicates an extremely strong capacity to pay principal and
interest.
AA
Bonds rated AA also qualify as high-quality debt obligations. Their
capacity to pay principal and interest is very strong, and in the majority of
instances they differ from AAA issues only in small degree.
A
Bonds rated A have a strong capacity to pay principal and interest,
although they are somewhat susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB
Bonds rated BBB are regarded as having an adequate capacity to pay
principal and interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay principal and interest for bonds in
this category than for bonds n the A category.
BB
Bonds rated BB, B, CCC, and CC are regarded, on balance, as
B
predominantly speculative with respect to the issuers capacity to pay
CCC
interest and repay principal in accordance with the terms of the
obligation.
CC
BB indicates the lowest degree of speculation and CC the highest.
While such bonds will likely have some quality and protective characteristics,
these are outweighed by large uncertainties or major risk exposures to
adverse conditions.
C
The rating C is reserved for income bonds on which no interest is being
paid
D
Bonds rated D are in default, and payment of principal and/or interest
is in arrears. Plus (+) or Minus (-): To provide more detailed indications of

12

Characteristics of Bonds
Other Characteristics:
Convertibility
May allow the investor to exchange the bond for a
predetermined number of the firms shares of
common stock
Call Provision
A provision (if it exits on a bond) gives a
corporation the option to redeem the bonds
before the maturity date. For instance, if the
prevailing interest rate declines, the firm may
want to pay off the bonds early and reissue at a
more favorable interest rate. Issuer must pay the
bondholders a premium.
13

TYPES OF BONDS
Debentures
Unsecured long-term debt (no collateral).
Viewed as more risky than secured bonds and
provide a higher yield than secured bonds.
Subordinated debentures
Unsecured junior debt.
It has lower priority for payment than other
debentures which are designated as senior.
Mortgage bonds
Secured bonds for which real estate or other
physical property has been pledged as collateral.
Zeros bonds
Bonds do not pay interest and it is redeemed at full
face value at the maturity date (no coupons).
14

Types of Bonds
Junk bonds
A high-risk, non-investment-grade bond with a
low credit rating, usually BB or lower; as a
consequence, it usually has a high yield.
Eurobonds
An international bond
denominated in a currency not native to the
country where it is issued.
are named after the currency they are
denominated in.
For example, Euroyen and Eurodollar bonds are
denominated in Japanese yen and American
dollars respectively.
15

Bond/Stock Risk Hierarchy

Common Stock
Preferred Stock

More
Risk

Subordinated Debentures
Senior Debentures
2nd Collateralized Bonds
1st Collateralized Bonds

Less
Risk
Higher

Priority of Claim

Lower
16

DEFINITION OF
Book Value
VALUE

Value of an asset as shown on a firms balance

sheet; historical cost.
Liquidation Value
Amount that could be received if an asset were
sold individually.
Market Value
Observed value of an asset in the marketplace;
determined by supply and demand.
Intrinsic Value
Economic or fair value of an asset; the present
value of the assets expected future cash flows.
17

DETERMINANTS OF
VALUE
In general, the Value of an asset = the present value
of the stream of expected future cash flows discounted
at an appropriate required rate of return.

Thus value is affected by three elements:

1. Amount and timing of the assets expected future
cash flows.
2. Riskiness of the cash flows.
3. Investors required rate of return for undertaking
the investment.
Can the intrinsic value of an asset differ from its
market value?
A: In an efficient market, the values of all securities at
any instant fully reflect all available public information
which results in the market value and the intrinsic
value being the same.

18

Determinants of Value

19

Time to Maturity and Bond

Values

BASIC PROCESS OF
VALUATION
n

V =

(1 + k)
t=1

$Ct

Ct = cash flow to be received at time t.

k = the investors required rate of return.
V = the intrinsic value of the asset.

21

Pricing a Bond in Steps

Since bonds involve a combination of

an annuity (coupons) and a lump
sum (par value) its price is best
calculated by using the following
steps

22

BOND VALUATION
The essential elements in bond valuation
are:
- Interest rate and par value (I & M)
- the time to maturity of the bond (n)
- the investors required rate of return
(kb)
Discount the bonds cash flows at the
investors required rate of return.
the coupon interest rate (an
annuity;PVIFA).
the par value payment (a single
sum;PVIF).
23

Bond Valuation
n

Vb =

t=1

$It
(1 + kb)t

Vb : value of bond

+
I

$M
(1 + kb)n
: interest

rate
M : par value
n : time to maturity
Kb : investors required rate of return

Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)

24

Bond Example Annually Interest

Payment
Example
Calculate the value of a bond that expects to
mature in 5 years and has a $1000 face
value. The coupon interest rate is 8% and
the investors required rate of return is
12%
I = $80, M = $1000, n = 5 years,
kb = 12%
80
80

80

1
4

80

2
5

100080

Bond Example Compounded

Annually
Vb =

$80

(1 + 0.12)t

$1000

+ (1 + 0.12)

(by using the table of PV)

$80(PVIFA 12%,5) + $1000(PVIF 12%,5)
= $80(3.6048) + $1000(0.5674)
= $288.38 + $567.40
= $855.78
26

Bond Example Semiannually

Interest Payment

Example
XYZ Co. bonds mature in 3 years and pay 10% interest semiannually. Their par value is $1000. If your required rate
of return is 8%, what is the value of bond?
.: Formula for semiannually interest payment :

Thus = I : 10%/2, Kb : 8%/2, n : 3x2,

M : $1000

Vb = ($It /2 )(PVIFA kb/2, 2n) + $M (PVIF kb/2,

2n)

50

50

50

50

1000
50

50
0

1
5

6
27

Bond Example Semiannually

Interest Payment
Vb = ($It /2 )(PVIFA kb/2, 2n) + $M (PVIF kb/2, 2n)
= ($100/2)(PVIFA

8%/2, 3 x 2

) + $1000 (PVIF

8%/2, 3 x 2

= $50(5.2421) + $1000 (0.7903)

= $262.11 + $790.30
= $1052.41

28

Bond Example
1. Suppose our firm decides to issue 20year bonds with a par value of
$1,000 and annual coupon payments.
The return on other corporate bonds
of similar risk is currently 12%, so we
decide to offer a 12% coupon interest
rate.
What would be a fair price for these
bonds?
29

Mathematical Solution:
PV = PMT (PVIFA

k, n

PV = 120 (PVIFA

.12, 20

1
PV = PMT

1-

) + M (PVIF

k, n

) + 1000 (PVIF

(1 + k)n

.12, 20

+ M/(1 + k)n

k
1
PV = 120 1 - (1.12 )20
.12
= $1000

+ 1000/ (1.12)

20

30

120

120

1000
+ 120

120

. . . 20

Note: If the coupon rate = discount

rate, the bond will sell for par value.

31

2. Suppose interest rates fall

immediately after we issue the
bonds. The required return on
bonds of similar risk drops to
10%.
What would happen to the bonds
intrinsic value?
32

Mathematical Solution:
PV = PMT (PVIFA k, n ) + M (PVIF k, n )
PV = 120 (PVIFA .10, 20 )+ 1000 (PVIF 10, 20 )

PV = PMT
M / (1 + k)n

1
1 - (1 + k)n

PV = 120
1000/ (1.10) 20

1
1 - (1.10 )20

0.10
33

Note:
If the coupon rate >
discount rate,
the bond will sell for a
premium.

34

Premium Bond
The market value of a bond will be
above the par or face value when the
investors required rate is lower than
the coupon interest rate. The bond will
sell at a premium or above face value.

35

Suppose interest rates rise

immediately after we issue the
bonds. The required return on
bonds of similar risk rises to 14%.
What would happen to the bonds
intrinsic value?

36

Bond Exercise
Question 1
You own a bond that pay $100 in annual interest, with a
$1000 par value. It matures in 15 years. Your required
rate of return is 12%. Calculate the value of the bond
Question 2
Telink Corporation bonds pay $110 in annual interest,
with a $1000 par value. The bond mature in 20 years.
Your required rate of return is 9%. Calculate the value
of the bond
Question 3
Calculate the value of a bond that expects to mature in 10
years and has a $1000 face value. The coupon interest
rate is 9% that paid semiannually and the investors
required rate of return is 16%.

37

Mathematical Solution
PV = PMT (PVIFA
PV = 120 (PVIFA
1
PV = PMT

k, n

) + M (PVIF

.14, 20

k, n

)+1000 (PVIF.14, 20 )

1 - (1 + k)n
k

+M / (1+ k)n

1
PV = 120

1 - (1.14 )20
.14
= $867.54

+1000/(1.14)20

38

Note:
If the coupon rate <
discount rate, the bond will
sell for a discount.

39

Discount Bond
The market value of a bond will be
below the par or face when the
investors required rate is greater than
the coupon interest rate. The bond will
sell at a discount or below face value.

40

Bond Exercise
Question 4
A bond have a 10% coupon rate. The interest is paid
semiannually and the bond mature in 11 years. Their
par value is $1000. If your required rate of return is
8%, what is the value of the bond? What is the value of
you required rate of return increases to 10%?
Question 5
Suppose our firm decides to issue 20-year bonds with
a par value of $1,000 and annual coupon payments.
The return on other corporate bonds of similar risk is
currently 12%, so we decide to offer a 12% coupon
interest rate.
a)What would be a fair price for these bonds?

41

Bond Exercise
b) Suppose interest rates fall immediately after we
issue the bonds. The required return on bonds of
similar risk drops to 10%.
What would happen to the bonds intrinsic value?
c) Suppose interest rates rise immediately after we
issue the bonds. The required return on bonds of
similar risk rises to 14%.
What would happen to the bonds intrinsic value?
d) Suppose coupons are semi-annual. What would
happen to the bonds intrinsic value?

42

YIELD TO MATURITY
(YTM)
The expected rate of return on a bond.
The rate of return investors earn on a bond if they
hold it to maturity.
Example
A bonds market price is $1100. It has a $1000 par
value, will mature in 5 years and pays interest 10%
annually. What is your expected rate of return
(YTM)?
1000
1100
100
0

100

100
100

1
4

100

5
43

Yield To Maturity (YTM)

YTM :

M - MP
I+ n
M + MP
2

: Interest @
Coupun

M : Par Value
MP : Market Price
n : year

YTM :

100 + (1000 -1100) / 5

7.6%

1000 + 1100 / 2

44

Relationship of Yield to
Maturity and Coupon Rate
Bond prices and interest rates move in opposite directions.
(continued)

45

Exercise YTM
Question 1
The market price is $900 for a 10 years bond ($1000 par
value) that pay interest 8% semiannually. What is the
bonds expected rate of return?
Question 2
Exxon 20 years bond pay 9% interest annually on a
$1000 par value. If bonds sell at $945, what is the
bonds yield to maturity?
Question 3
A bonds market price is $950. It has a $1000 par value,
will mature in 8 years, and pay 9% interest (4.5%
semiannually). What is your expected rate of return?
Question 4
Zebners Corporation bonds mature in 14 years and pay
7% annually. If you purchase the bonds for $1110,
what is your expected rate of return?
46

CURRENT YIELD
The ratio of the interest payment to the bonds
current market price.
Current Yield = Annual Coupon Payment
Current Market Price
Example
A $1,000 bond with 8% coupon rate and market
price of $700
Current yield = $80 / $700 = 11.4 %

47

Zero Coupon Bonds

No coupon interest
payments.
The bond holders
return is determined
entirely by the price
discount.

Zero
Coupon Example
Suppose you
pay RM508 for
a zero coupon -$508
bond that has
10 years left
to maturity.
0
What is your
10
yield to
maturity?

$1000

49

PV =

508

FV = 1000

10

Mathematical Solution:
PV = FV (PVIF i, n )
508 = 1000 (PVIF i, 10 )
.508 = (PVIF i, 10 ) [use PVIF table]
PV = FV /(1 + i) 10
508 = 1000 /(1 + i)10
1.9685 = (1 + i)10
i = 7%

50

BOND VALUATION: FIVE

IMPORTANT RELATIONSHIPS
FIRST RELATIONSHIP
The value of a bond is inversely related to
changes in the investors present required rate
of return (the current interest rate).
As interest rates increase(decrease), the
value of the bond decreases(increases).

51

Bond Valuation: Five Important

Relationships

52

Bond Valuation: Five Important

Relationships
SECOND RELATIONSHIP
The market value of a bond will be less THAN the
par value IF the investors required rate of return
is above the coupon interest rate, BUT it will be
valued above par value IF the investors required
rate of return is below the coupon interest rate.
required rate = coupon rate, THEN market value = par value
required rate > coupon rate, THEN market value < par value
(DISCOUNT)
required rate < coupon rate, THEN market value > par value
(PREMIUM)

53

Bond Valuation: Five Important

Relationships
THIRD RELATIONSHIP
As the maturity date approaches, the market
value of a bond approaches its par value.

54

Bond Valuation: Five

Important Relationships
FOURTH RELATIONSHIP
Long-term bonds have greater interest rate risk
than do short-term bonds.
In other words, a change in interest rate will have
relatively greater impact on long-term bonds.

56

Bond Valuation: Five Important

Relationships
FIFTH RELATIONSHIP
The sensitivity of a bonds value to changing
interest rates depends not only on the length of
time to maturity, but also on the pattern of cash
flows provided by the bond.

57

Main Risks for

Bondholders

Changes in current Interest rates if

interest rates rise, the market value of
bonds will fall.
Default Risk this may mean no or partial
payment on debt as in bankruptcy cases.
Call Risk If bonds are called before
maturity date. Bond are generally called
when interest rates drop. Thus investors
will have to reinvest the money received at
a lower rate.
58