Bond Valuation

Important Bond Terms

• A bond is a long-term debt instrument issued by a
corporation or government.
• The maturity value (MV) [or face value] of a bond is the
stated value. In the case of a U.S. bond, the face value
is usually 1,000.
• The bond’s coupon rate is the stated rate of interest;
the annual interest payment divided by the bond’s face
value.
• The discount rate (capitalization rate) is dependent on
the risk of the bond and is composed of the risk-free
rate plus a premium for risk.
 Other types (features) of bonds
• Convertible bond – may be
exchanged for common stock of the
firm, at the holder’s option.
• Putable bond – allows holder to sell
the bond back to the company prior
to maturity.
• Indexed bond – interest rate paid is
based upon the rate of inflation.
 What is Value?
• Market value represents the market price at
which an asset trades.
• Intrinsic value represents the price a security
“ought to have” based on all factors bearing
on valuation.
 The value of financial assets

0 1 2 n
k ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value = 1
+ 2
+ ... + n
(1 + k) (1 + k) (1 + k)
 What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?

0 1 2 n
k ...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB = 1
+ ... + 10
+
(1.10) (1.10) (1.10)10
VB = $90.91 + ... + $38.55 + $385.54
VB = $1,000
• Coupon= Coupon
rate *Face Value
• =10%*1000
• =100
 • PV=M/(1+k)^n
• =1000/(1.1)^10
• =385.54
• Value of a bond,
• Vb=PV of coupon +
• =100*[1-
PV of Face Value
{1/(1+.1)^10}]/.1
• =614.46+385.54
• =614.46 • =1000
 Example 1
Beximco Pharma has a outstanding bond
with face value of Tk. 1000, coupon rate
of 16% and annual coupon. The bond
was issued 5 years ago with original
maturity of 10 years. The appropriate
required rate of return on this bond is
18%.
a. Draw timeline
b. Calculate the price of this bond.
 0 1 2 5
k ...
VB = ? 160 160 160 + 1,000
 • PV=M/(1+k)^n
• =1000/(1.18)^5
• =437.10
• Value of a bond
• Vb=PV of coupon +
• =160*[1-
PV of Face Value
{1/(1+.18)^5}]/.1
• =500.34+437.10
• =500.34 • =937.44
 Example 2
Square Pharma wants to issue a 10 year
coupon bond. The coupon rate is 14%
and the face value is Tk. 1000. If the
appropriate discount rate for this bond is
12% ,
a. What should be the price of this bond?
b. If Square pays coupon semiannually,
what should be the price of this bond?
 Example 2(a)
• Vb= PV of Coupon + PV of Face Value
• PV of coupon= Coupon*[1-1/(1+K)^n]/K
• =140*[1-1/(1.12)^10]/.12
• =791.031
• PV of Face Value
• =M/(1+K)^10
• =1000/(1.12)^10
• =321.97
• Vb=791.031+321.97
• =1113.00
 Example 2(b)
• Vb= PV of Coupon + PV of Face Value
• PV of coupon= Coupon*[1-1/(1+K)^n]/K
• =70*[1-1/(1.06)^20]/.06
• =802.8944
• PV of Face Value
• =M/(1+K)^n
• =1000/(1.06)^20
• =311.80
• Vb=802.8944+311.80
• =1114.70
 Example 3
United Circuits sold a 25 year, 15%
annual coupon bond issue at a par
value of TK.1000 in September 2000.
In September 2016 the bond issue
yield to maturity was 12%; what will
be the price of the bond ? Ans:
1159.85
 Example 4
• Assume the same facts as for
Example 3 , except that, rather than
issuing annual coupon bonds, united
circuits had issued semiannual
coupon bonds. What would be the
price in September 2016 of these
semiannual coupon bonds ? Ans:
1162.38
• Vb= PV of Coupon + PV of Face Value
• PV of coupon= Coupon*[1-1/(1+K)^n]/K
• =75*[1-1/(1.06)^18]/.06
• =812.07
• PV of Face Value
• =M/(1+K)^n
• =1000/(1.06)^18
• =350.31
• Vb=812.07+350.31
• =1162.38
 Definitions

Annual coupon payment

Current yield (CY) =
Current price

Change in price
Capital gains yield (CGY) =
Beginning price

 Expected  Expected
Expected total return = YTM =   +  
 CY   CGY 
 Example 5
Hopewell & James Inc. sold a 20 year,
14% annual coupon, TK.1000 par
value bond issue 10 years ago. Today
the bond issue is selling for
TK.1,113.03; what is the bond
a) Current yield ?
b) Yield to maturity ?
 Example 5
• Current yield = 140/1113.03
• =0.1257
• =12.57%
• Capital gain yield= Change in price/beginning
price= 113.03/1000
• =0.1130
• =11.30%
• YTM=12.57%+11.30%
• =23.87%
• Q.1- Gonzalez Electric company has outstanding a
10 percent bond issue with a face value of
TK.1,000 per bond and three years to maturity.
Interest is payable annually. The bonds are
privately held by Suresafe fire insurance
company. Suresafe wishes to sell the bonds and is
negotiating with another party. It estimates that
in current market conditions, the bonds should
provide (nominal annual) return of 14 percent.
What price per bond should Suresafe be able to
realize on the sale ? Ans: 907.13
• Q.2- What would be the price per bond in
problem (1) if interest payments were made
semiannually ? Ans:904.66
 The price path of a bond
• What would happen to the value of this bond
if its required rate of return remained at 10%,
or
V
at 13%, or at 7% until maturity?
B

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
 Bond values over time
• At maturity, the value of any bond must equal
its par value.
• If kd remains constant:
– The value of a premium bond would
decrease over time, until it reached
TK.1,000.
– The value of a discount bond would
increase over time, until it reached
TK.1,000.
– A value of a par bond stays at TK.1,000.
 Example 6

• J. Lizotte and Company wants to

sell 15 year zero coupon bonds.
The bonds will mature at TK.1000
and will be sold to yield 10%. At
what price will these bonds
offered ?
• Vb=PV of Face Value
• =M/(1+k)^n
• =1000/(1+.1)^15
• =239.39
 Example 7
a) Hytec Electronics bonds pay TK.50 semiannual interest, mature in 5 years and
pay TK.1000 on maturity. What will be the value of this bonds when the going
annual rate of interest is (1) 8% (2) 10% and (3) 12% ?
Ans: (1) 1081.11
(2) Vb= PV of Coupon + PV of Face Value
=Coupon*[1-1/(1+K)^n]/K +M/(1+K)^n
=50*[1-1/(1+.05)^10]/.05+1000/(1+.05)^10
=386.09+613.91
=1000
(3) 926.40

b) Now suppose that Hytec has issued some other bonds that pay TK.50 semiannual
interest, TK.1000 at maturity, and mature in 1 year. What is the price of these
bonds if the going annual rate of interest is (1) 8% (2) 10% (3) 12% ?
(1) 1018.86 (2) 1000 (3) 981.67
c) Why do the longer term bond prices fluctuate more when interest rates change
than do the shorter term bond prices ?
 Example 8
The 9 percent coupon rate bonds of the Melbourne
mining company has exactly 15 years remaining
to maturity. The current market value of one of
these TK.1,000 par value bonds is TK.700; Interest
is paid semi-annually. Melanie Gibson places a
nominal annual required rate of return of 14
percent on these bonds. What dollar intrinsic
value should Melanie place on one of these
bonds ( assuming semi-annual discounting ) ?
Ans: 689.77
 Example 9
The Miller Company’s bonds have 5 years remaining
to maturity. Interest is paid annually, the bonds
have a TK.1000 par value and the annual coupon
interest rate is 9%;
a) What is the yield to maturity at a current market
price of (1) TK.892 and (2) TK.1,126 ? You may
wish to use the approximation formula
b) Would you pay TK.892 for the bond described in
part a if you thought that the appropriate rate of
interest for these bonds was 10% ? Explain your
answer.
• a(1)YTM= I + [(M-V)/n]/(M+V)/2
• =[90+{(1000-892)/5}]/{(1000+892)/2}
• =.11797
• =11.80%
• a(2)
• ={90+(1000-1126)/5}/{(1000+1126)/2}
• =(90-126/5)/1063
• =6.07%
 Example 10
• Suppose Wibisono Industries sold an issue of
bonds with a 10 year maturity, a TK.1000 par
value , and a 10% coupon rate paid annually.
• a) Suppose that 4 years after that issue, the going
rate of interest had risen to 14%; at what price
would the bond sell .
• b) Suppose the conditions in part a continue (that
is interest rate remained at 14% throughout the
bonds life ) what would happen to the price of
Wibisono's bonds overtime ?
 Example 11
• Blessing Inc. has two bonds issues
outstanding, and both sell for TK.668.84. The
first issue has an annual coupon rate of 9%
and 20 years to maturity. The 2nd has a yield
to maturity identical to the first but only five
years until maturity. Both issues pay interest
annually. What is the annual interest payment
on the 2nd issue ?
• YTM1= {I + [(M-V)/n]}/(M+V)/2
={90+(1000-668.84)/20}/(1000+668.84)/2
=(90+16.558)/834.42
=.1277
=12.77%
YTM1=YTM2
.1277={I+(1000-668.84)/5}/(1000+668.84)/2
 Example 12
Red frog brewery has TK.1000 par value bonds outstanding with
the following characteristics: currently selling at par; 5 years
until final maturity; and a 9 percent coupon rate ( with interest
paid semiannually ). Interestingly, old Chicago brewery has a
very similar bond issue outstanding. In fact every bond feature is
the same as for the red frog bonds, except that old Chicago's
bonds mature in exactly 15 years. Now, assume that the markets
nominal annual required rate of return for both bond issues
suddenly fell from 9 percent to 8 percent.
a) Which Brewery's bonds would show the greatest price change ?
Why ?
b) At the market's new, lower required rate of return for these
bonds, determine the per bond price for each brewery's bonds.
Which bonds price fell the most, and by how much ?
 Types of bonds

• Mortgage bonds
• Debentures
• Subordinated debentures
• Investment-grade bonds
• Junk bonds
 Evaluating default risk:
Bond ratings

Investment Junk Bonds

Grade
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BB B CCC D
BBB