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http://TheValueatRisk.blogspot.com
 
November
 
4,
 
2009
 
Bond
 
Pricing
 
101
 
If you're going to learn how to effectively interpret corporate financial statements, it's a goodidea to possess at least a cursory understanding of the pricing of long-term non-operatingliabilities
‐
also known as bonds.To start off, you need to know that bond pricing involves two separate interest rates, the CouponRate and the Market Rate. The coupon rate, also known as the contract or stated rate, is theinterest rate listed in the bond contract, and is used to compute the amount of the cash interestpayments that are due periodically from the issuer. The market rate is the interest ratedemanded by investors, and is usually referred to as the bond's "yield".
 
Next, you need to think of a bond in terms of the two distinct cash flows involved; the bond paysperiodic, usually semiannual interest payments (interest annuity), as well as the lump sumprincipal amount (face value) which is returned at maturity.
 
Moving on, the next distinction which needs to be made is that the price of the bond variesdepending upon the relationship between the coupon and the yield. If the two are the same, thebond is priced at what is known as "par". If the market rate is greater than the coupon rate, thebond will be priced at a discount; conversely, if the coupon rate exceeds the market rate, thebond is priced at a premium. I'll start with pricing a bond at par; it's a much simpler process, forreasons I'll touch on a bit later. The assumptions used in this example of pricing a bond at facevalue are as follows: Face amount of $800,000, annual coupon rate of 6%, semi-annual interestpayments, and a 5 year maturity. The first step involves calculating the interest payment, theformula for which is:Interest Payment = Face Value X Annual Coupon Rate X Payment Period (time)= $800,000 X 6% X 6/12= $24,000
 
http://TheValueatRisk.blogspot.com
 
November
 
4,
 
2009
 
Next you need to calculate the present value of both sets of cash flows. Instead of going intodetail on the present value calculation, I'll just direct you to the PV() function in Excel. Presentvalue is built on the concept that $24,000 today is worth less to the investor than $24,000 inthree years, simply due to the time value of money. In the current example, it's easy to ascertainthat the sum of the bonds interest payments over the five year period is $240,000 ($24,000 X 5(years) X 2 (payments per year). However, the present value of those five years worth ofpayments is only $204,724.87. Along those same lines, the present value of (the lump sumprincipal payment of) $800,000 is only $595,275.13. Now, we sum the present value of thebonds future cash flows:Present Value of Cash Flows = $595,275.13 + $204,724.87 = $800,000Well then, this all looks pretty simple: the present value of a par priced bond's future cash flowsis in fact the face value of the bond. For bonds sold at a premium or a discount however, theequation shakes up a little differently. For a discount example, let's assume that all of thevariables are identical to the par example above, except that the market is demanding an 8%yield. The calculation of the cash interest payment still uses the coupon rate, so we arrive at anidentical $24,000 semi-annual interest obligation for the issuer. The curve ball arrives whencalculating the present value of the bond's future cash flows; these cash flows must bediscounted using the bond's yield rate of 8%. Therefore, the present value of the discountbond's interest payments is $194,661.50, and the principal payment's present value is$540,451.34. Add them together, and you arrive at $735,112.83. What this means is that thebond issuer will receive $735,112.83 in cash from investors, but will still be required to make$24,000 interest payments (that were calculated using a face value of $800,000). The differenceof $64,887.17 (discount balance) shows up on the balance sheet as a contra-liability accountwhich reduces bonds payable in line with the amount of cash actually received by the issuer.The discount balance is then amortized over the life of the bond, and falls into the incomestatement as successively higher amounts of interest expense (although not an actual cashoutlay). The amortization table for this example is below:As you can see above, the bond discount amount feeds - in entirety - into the income statementthroughout the 10 periods, until it is no more. A bond sold at a premium works in the exactinverse way; a premium balance is created on the balance sheet which effectively reduces the
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