Valuation of Bonds

Session Objective
What is a security?
Valuation and Concept of Value
Bond Valuation
Bond Yield Measure
Bond Value Theorems
Equity Valuation: Dividend Capitalisation
Approach
Equity Valuation: Ratio Approach
 Security
All financial assets (Shares, Bonds, Debentures
etc.) are termed as financial securities/assets.
The value of these assets are the money value
printed/written on it.
Physically it can be in a paper form or can be
in electronic form
These assets are traded in the financial
markets
 Valuation
It is a systematic process through which the
price to sell the security is established
Also referred to as intrinsic value of the
security
Every financial assets depends on its future
cash flows that come with it, for its value.
The present value of all the future cash flows
of a security is the value of that security
 Contd.
Mathematically it can be calculated as follows:
CF1 CF2 CF3 CFn
V0 = + + + ..+
(1+K)1 (1+K)2 (1+K)3 (1+K)n

V0 = Value of the security/ Intrinsic value

CF1 . CFn= Each year cash flows
K = Rate of discount
n= No. of years
 Concept of Value
Book Value: It is an accounting concept in which
assets are valued at historical cost and are
depreciated over the years.
Replacement Value: The amount required to
replace the existing asset in current condition.
Liquidation Value: The amount that can be realised
if the company closes down its operation.
Going concern value: Value in a operating condition
Market Value: The current price at which the assets
can be bought or sold
 Bond and its Features
It is a long term contract under which a borrower
agrees to make payments of interest and
principal, on specific dates, to the holder of the
bond.
Features:
Face value: Value written on the bond
Coupon rate: Interest rate
Maturity: Date at which the principal amount is paid
Redemption value: Value on maturity (Par, Premium
or Discount)
Market Value: Price at which bond is sold or bought
 Bond Valuation
Bondholders receive interest payments periodically and a
lump sum return of principal at the bonds maturity. Hence
the price or intrinsic value of the bond is the present value of
the stream of interest payments plus the present value of the
principal repayment,

where I is the annual coupon payment

k is the required rate of return (discount rate)
F is the principal payable at maturity.
n is the maturity period of the bond.
 Contd.
As the interest payments are made regularly
and are constant in amount, they can be
treated as an annuity.

Therefore, V0 = I (PVIFAk%,n) + F (PVIFk%,n)

 Bond Value with semi-annual
interest
The value of the bonds paying interest semi-
annually
2n

I/2 F
V0 = (1+K/2)t + (1+K/2)2n
t=1

where I is the annual coupon payment

k is the required rate of return
F is the principal payable at maturity.
n is the maturity period of the bond.
 Value of a Perpetual Bond
The bond having no maturity period is known
as a perpetual bond.
The formula is:
I
V0 =
k
Where V0 = the value of the bond
k = Required rate of return
I = Annual interest payable in Rs.
 Relationship between Coupon Rate,
Rqrd Rate and Price
The basic property of a bond is that its price
varies inversely with yield.
As the required yield decreases, the present
value of the cash flow increases; hence the price
increases and vice-versa.
Coupon rate > Required Yield; Price > Par (Premium)
Coupon rate = Required Yield; Price = Par
Coupon rate < Required Yield; Price < Par (Discount)
 Price Yield Relationship

Premium

Par

Discount
Price

Yield
 Bond Yields
The various yields measures are:
Current Yield
Yield to Maturity
Yield to call
 Current Yield
The current yield relates the annual coupon
interest to the market price.

Annual Interest
Current yield =
Market Price
 Yield to Maturity
It is the interest rate that makes the present
value of the cash flows receivable form
owning the bond equal to the price of the
bond.

where P0 is the Market Price

I is the annual coupon payment in amount
k is the Yield to Maturity (required rate of return)
F is the principal payable at maturity.
n is the maturity period of the bond.
 Short cuts to YTM
I + (F - P)/n
YTM =
(F + P )/2
OR

I + (F - P)/n
YTM =
0.4 F + 0.6 P
Where
I = Coupon interest in Rs.
F = Maturity value
P = Market Price
 Yield to Call
Some bonds carry a call feature that entitles
the issuer to call (buy back)the bond prior to
the stated maturity date in accordance with a
call schedule (Which specifies a call price for
each call date).
For such bonds it is a practice to calculate YTC
as well as YTM
n
I F*
P0 = (1+YTC)t + (1+YTC)n*
t=1

Where F* is the call Price in Rs. and

n* is the number of years until the assumed call date
Price of
Change in Price with Time
bond
Premium bond: k = 11%, C = 12%
1,100

Par Value bond: k = 12%, C=12%

1,000

900
Discount bond: k = 15%, C = 12%

6 5 4 3 2 1 0
Years to Maturity
 Bond Duration and Interest Rate Sensitivity
The longer the maturity of a bond, the higher will
be its sensitivity to the interest rate changes.
Similarly, the price of a bond with low coupon
rate will be more sensitive to the interest rate
changes.
However, the bonds price sensitivity can be
more accurately estimated by its duration. A
bonds duration is measured as the weighted
average of times to each cash flow (interest
payment or repayment of principal).
20
 The yield curve
Yield curve shows the relationship between the yields to
maturity of bonds and their maturities. It is also called the
term structure of interest rates.
Yield Curve
Yield (%)
7.5%
7.18%
7.0%

6.5%

6.0%
5.90%
5.5%
Maturity
5.0% (Years )

21
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10
 Contd....
The upward sloping yield curve implies that the
long-term yields are higher than the short-term
yields.
This is the normal shape of the yield curve,
which is generally verified by historical evidence.
However, many economies in high-inflation
periods have witnessed the short-term yields
being higher than the long-term yields.
The inverted yield curves result when the short-
term rates are higher than the long-term rates.
23
 The Expectation Theory
The expectation theory supports the
upward sloping yield curve since investors
always expect the short-term rates to
increase in the future.
The expectation theory assumes
capital markets are efficient
there are no transaction costs and
investors sole purpose is to maximize their
returns
24
 Contd
The long-term rates are geometric average of
current and expected short-term rates.
A significant implication of the expectation
theory is that given their investment horizon,
investors will earn the same average expected
returns on all maturity combinations.
Hence, a firm will not be able to lower its
interest cost in the long-run by the maturity
structure of its debt.
 The Liquidity Premium Theory
Long-term bonds are more sensitive than the
prices of the short-term bonds to the changes in
the market rates of interest.
Hence, investors prefer short-term bonds to the
long-term bonds.
The investors will be compensated for this risk by
offering higher returns on long-term bonds.
This extra return, which is called liquidity
premium, gives the yield curve its upward bias.

26
 Contd.....
The liquidity premium theory means that rates
on long-term bonds will be higher than on the
short-term bonds.
From a firms point of view, the liquidity
premium theory suggests that as the cost of
short-term debt is less, the firm could
minimize the cost of its borrowings by
continuously refinancing its short-term debt
rather taking on long-term debt.

27
 The Segmented Markets Theory
The segmented markets theory assumes that
the debt market is divided into several
segments based on the maturity of debt.
In each segment, the yield of debt depends on
the demand and supply.
Investors preferences of each segment arise
because they want to match the maturities of
assets and liabilities to reduce the
susceptibility to interest rate changes.
28
 Contd.....
The segmented markets theory approach
assumes investors do not shift from one
maturity to another in their borrowing
lending activities and therefore, the shift in
yields are caused by changes in the demand
and supply for bonds of different maturities.

29
 Bond Value Theorems
Based on the bond valuation model, several
bond value theorems have been derived
which state the effect of the following factors
on bond values:
I. Relationship between the required rate of
return and the coupon rate
II. Number of years to maturity
III. Yield to maturity (5 rules)
 I. Required rate and coupon rate

Coupon rate > Required Yield; Price > Par (Premium)

Coupon rate = Required Yield; Price = Par

Coupon rate < Required Yield; Price < Par (Discount)

 When C = k, P = F
Consider a bond of KenStar Intermediaries Ltd.
with the following features:
Par value = Rs. 100, Coupon Rate = 12%
Maturity period = 5 years
Find out the value of the bond if k = 12%
V0 = I (PVIFA 12%, 5) + F (PVIF 12%, 5)

= 12 x 3.605 + 100 x 0.567

= 43.26 + 56.7 = 99.96 ~ 100

 When C < k; P < F
If k = 14% of the same bond then value of the
bond is;

V0 = I (PVIFA 14%, 5) + F (PVIF 14%, 5)

= 12 x 3.433 + 100 x 0.519

= 41.196 + 51.9 = 91.3

 When C > k; P > F
If k = 10%; value of the bond

V0 = I (PVIFA 10%, 5) + F (PVIF 10%, 5)

= 12 x 3.791 + 100 x 0.621

= 45.492 + 62.1 = 107.59

II. The Number of Years to Maturity
When the required rate of return (k) is greater
than the coupon rate, the discount on the
bond declines as maturity approaches
When the required rate of return (k) is less
than coupon rate the premium on the bond
declines as maturity approaches
 The
Price of
Number of Years to Maturity
bond
Premium bond: k = 11%, C = 12%
1,100

Par Value bond: k = 12%, C=12%

1,000

900
Discount bond: k = 15%, C = 12%

6 5 4 3 2 1 0
Years to Maturity
 III. YTM, Interest Rate & Value
As YTM determines a bonds market price and
vice-versa, we can say that the bonds price will
fluctuate in response to the change in market
interest rates in the following five ways;
 1

A bonds price moves inversely proportional to

its yield to maturity
(As present value principle states that the
Present value varies in inverse proportion to the
interest rate)
 Contd
The YTM of a Rs. 1000 par value bond bearing a
coupon rate of 10% and maturing in 10 years is
12%. The market value of the bond is:

= 100(PVIFA12%, 10) + 1000 (PVIF 12%, 10)

= 100 x 5.650 + 1000 x 0.322
= Rs. 887
 Contd.
If YTM increases to 14%:
Market Price
= 100(PVIFA14%, 10) + 1000 (PVIF 14%, 10)
= 100 x 5.216 + 1000 x 0.270 = Rs. 791
If YTM moves down to 8%
Market price
= 100(PVIFA8%, 10) + 1000 (PVIF 8%, 10) = Rs 1,134
 2

For a given difference between YTM and coupon

rate of the bonds, the longer the term to
maturity, the greater will be the change in price
with change in YTM.
 Example
Bond A Bond B
Face Value Rs. 1000 Rs. 1000

Coupon rate 10% 10%

YTM 11% 11%

Year to Maturity 3 years 6 years

Market Value at Rs. 1000 Rs. 1000

YTM 10%

Market Value at 100 (PVIFA11%, 3) + 1000 (PVIF 11%, 3) 100 (PVIFA11%, 6) + 1000
YTM 11% = Rs. 975 (PVIF 11%, 6) = Rs. 958

Change in price 2.5% 4.2%

 3
Given the maturity, the change in bond price will
be greater with a decrease in the bonds YTM
than the change in bond price with an equal
increase in the bonds YTM.
For equal sized increase and decrease in the
YTM, price movements are not symmetrical.
 Contd..
Take Rs. 1000/- par value bond with a coupon
rate of 10% and maturity period of 5 years. Let
the YTM be 10%. The Market price will be Rs.
1000.
A 1% increase in YTM to 11% changes price to
Rs. 962.6, a decrease of 3.74%. A decrease of
1% YTM to 9% changes the price to Rs.1039
(i.e. an increase of 3.9%)
 4

For any given change in YTM, the percentage

price change in case of bonds of high coupon rate
will be smaller than in case of the bonds low
coupon rate, other things remaining the same.
Consider two bonds A and B with the par value of
Rs.1000, maturing in 4 years and YTM of 10%. Bond
A bears coupon rate of 10% whereas bond B bears a
coupon rate of 12%
Bond A (C=10%) Bond B (C=12%)
Market Price at YTM of Rs. 1000 Rs. 1063
10%
Market Price at the Rs. 939.7 Rs. 1000.44
Changed YTM 12%
Change in price 6.03% 5.92%

Change in the price with the change in YTM in case

of bond B carrying a higher coupon rate of 12% is
only 5.92%, whereas in case of bond A with a coupon
rate of 10% the change in the price is 6.03%.
 5
A change in the YTM affects the bonds with a higher
YTM more than it does with a lower YTM.
e.g.: Consider a Rs. 1000 par value ABC bond with a
coupon rate of 12% maturity period of 6 years and
YTM of 10%. The market value of bond is Rs. 1087.
Consider another identical bond XYZ but with
differing YTM of 20%. The market value of this bond
will be Rs. 734.
Suppose there is an increase in YTM by 20% i.e. YTM
of A = 12% and bond XYZ = 24%
 Contd.
Bothe the value changes to:
Bond ABC
= 120 (PVIFA 12%, 6) + 1000 (PVIF 12%, 6) = Rs. 1000
Bond XYZ
= 120 (PVIFA 24%, 6) + 1000 (PVIF 24%, 6) = Rs. 637.4
Decrease in market value of Bond ABC with lower
YTM is 8% [i.e.(1087-1000)/1087] and decrease in
Market value of bond XYZ is 13.16% [i.e. (734
637.4)/ 734]