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Bond

# Bond

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09/23/2013

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Group 06
Habiba Mustafa Sumaiya Nishan Muhammad Kashif Hafiz Aamir Sohail Altaf Hussain

BOND VALUATION

BOND: long term debt
A security that pays a stated amount of interest to the investor, period after period until its maturity. Face value Coupon maturity

BOND VALUE  PV(bond)=PV(coupon payments)+PV(final payment) PV= PMT(1-1/(1+i)^n)/i + MV/(1+i)^n .

Factors affecting Bond prices Credit Quality Interest Rate Yield Tax Status .

Interest rate .

yield Yield is a figure that shows the return you get on a bond. Simplest version Yield= coupon amount/price .

until the yield of older bonds is low enough to match the lower interest rate on new issues. prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues **When prevailing prices fall. prices of outstanding bonds rise.YIELD (Linking price and yield) • Most important thing to remember!!!! **When prevailing interest rates rise. .

BOND VOLATILITY Volatility refers to the amount of uncertainty or risk about the size of changes in security’s value. Volatility=Duration/1+yield .

• Unlike maturity. duration takes into account interest payments that occur throughout the course of holding the bond. .BOND DURATION • Duration is a weighted measure of the length of time the bond will pay out.

Cont’d… .

.Term structure/Yield Curve A "term structure of interest rates.“ also known as yield curve is a graph that plots the yield/spot rates of bonds against their maturities. ranging from shortest to longest.

Forms of yield curve .

Cont’d… .

” .EXPECTATION THEORY The expectation theory says that: “Bonds are priced so that an investor who holds a succession of short bonds can expect the same return as another investor who holds a long bond.

If predicted future level of interest rates. select strategy offering highest return. .INTRODUCING RISK In expectation theory risk factor must be considered.

Inflation and Term structure • Suppose u are saving for your retirement. which of the following strategies is the more risky? • Invest in one-year or invest in 20-year bond? .

Inflation and nominal interest rates • How does inflation affect the nominal rate of interest? .

1+rnominal=(1+rreal)(1+i) .FISHER’S THEORY “A change in the expected inflation rate will cause the same proportionate change in the nominal interest rate. no effect on the required real interest rate”.

Inflation rate higher real return will be lower. .REAL & NOMINAL INTEREST RATE In Real interest rate no inflation factor while in Nominal interest rate inflation factor exists.

100/1.100.0620=\$342. final payment would be \$1.99 .NOMINAL INTEREST RATE Real cash flowt=nominal cash flowt/1+inflation rate)t FOR EXAMPLE: If u were to invest \$1.000 in a 20-year bond with a 10% coupon. if inflation rate=6% then real value would be =1.

.INDEXED BONDS Bonds promised you a fixed nominal rate of interest.

Valuation of common stock .

How Common Stocks are Traded • Primary Market Trading through bank and OTC • Secondary Market Trading through Stock Exchange .

How Common Stocks are valued • PV(stock) = PV(expected future dividends) • Today’s Price The cash payoff to the owners of common stocks comes in two forms • Cash dividends • Capital gains or losses .

They also expect stock to sell for \$110 a year (p1=110) . Investors expect a \$5 cash dividend over the next year (Div1=5).Conti…d • Expected return = r = Divi1 + p1-p0/p0 Example Suppose Fledgling Electronics stock is selling for \$100 a share (p0=100).

if you are given investors forecasts of dividend and price and the expected return is same then you can predict today’s price. Price = po = Div1+p1/(1+r) .15 or 15% On the other hand.Conti’d Expected return = r = 5+(110-100)/100 r = 0.

Conit’d • If DIV1=5 and p1=110 and r=15%. then today's price should be 100: P0 = 5+110/1.15 =\$100 .

and p2: . DIV2. a year from now investor will be looking out at dividends in year 2 and price at the end of year 2. thus we can forecast p1 by forecasting DIV2 and p2 and we can express po in terms of DIV1.But what determines the Next Year’s Price • P1 = DIV2 + P2/(1+r) That is.

that implies a price at the end of the year 1 of P1 = 5.50+121/1.5 in year 2 and subsequent price of \$121.Conit…’d • Po=1/1+r(DIV1+p1)=1/1+r(DIV1+DIV2+p2/1+r) =DIV1/(1+r) + DIV2+p2/(1+r)*2 Example Suppose they are looking today for dividends of \$5.15 = \$110 .

15 + 5.15)*2 = \$100 .50+121/(1.Conti…d • From our expended formula P0 = 5/1.

Estimating the Cost of Equity Capital • Po = DIV1/ (r-g) • r = (DIV 1/p0) + g .

Danger lurk in Constant-Growth formula • Dividend growth rate = plowback ratio*ROE .

The link between stock price and Earning per share • Growth stock • Income stock Expected return =dividend yield=earning-p ratio If dividend is \$10 a share and stock price is \$100 then: Expected return=DIV1/P0 = 10/100 = .10 .

d The price equals P0= DIV1/r = EPS1/r = 10/.Conti. EPS/Po= r ( 1..10 =100 Po =EPS1/r+PVGO So.PVGO/Po) It will underestimate r if PVGO is +ve and overestimate it if PVGO is -ve .

Calculating PV of Growth Opportunities • Po= DIV1/r-g • Payout ratio = DIV1/EPS1 • Growth rate= g = plowback ratio*ROE • Present value of level stream of earnings= EPS/r • PVGO = NPV1/r-g • Share price = EPS1/r +PVGO .

• Value today always equals future cash flow discounted at the opportunity cost of capital .Valuing a Business by Discounting Cash Flow • In this you forecast dividend per share or total free cash flow of a business.

+FCF/(1+r)^H + PV/(1+r)^H .Valuing the Concatenator Business • PV= FCF/1+r + FCF2/(1+r)^2 +….

Estimating Horizon Value • Forecasting reasonable horizon is particularly difficult. The usual assumption is moderate long rum growth after the horizon. which allow us to growing-perpatuity DCF formula. • It can also be calculated normal price-earnings or market-book ratios at the horizon date .

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