Valuation of Debt and Equity

Bonds are debt securities issued by governments, municipalities, corporations, and other entities to
raise capital. When you invest in a bond, you are essentially lending money to the issuer in exchange
for regular interest payments (coupon payments) and the return of the principal amount at maturity.
Here are some key characteristics of bonds:
1. Principal or Face Value: This is the initial amount of money that the issuer borrows and
promises to repay to the bondholder at maturity.
2. Coupon Rate: The coupon rate is the fixed interest rate that the issuer agrees to pay the
bondholder annually or semi-annually as a percentage of the bond's face value. For example,
if a bond has a face value of $1,000 and a coupon rate of 5%, the bondholder would receive
$50 in coupon payments each year.
3. Maturity Date: This is the date on which the bond reaches its full term, and the issuer is
obligated to repay the principal amount to the bondholder.
4. Yield: The yield is the effective interest rate that an investor earns on a bond, taking into
account its purchase price and coupon payments. It represents the return an investor can
expect to receive from the bond.
Bonds are typically classified into different categories based on their issuers and characteristics. Some
common types of bonds include government bonds, corporate bonds, municipal bonds, and
convertible bonds. Each type has its own risk profile, yield, and market dynamics.
Bond valuation is the process of determining the fair value or worth of a bond. It involves calculating
the present value of future cash flows (coupon payments and principal repayment) discounted at an
appropriate interest rate (yield or required rate of return). By comparing the calculated present value
with the market price of the bond, investors can assess whether the bond is overvalued, undervalued,
or fairly priced.
Bond valuation methods, such as the discounted cash flow (DCF) approach, help investors analyze the
risk and return potential of bonds and make informed investment decisions.
Government bonds
Government bonds, also known as sovereign bonds or treasury bonds, are debt securities issued by
governments to raise funds for public spending or to manage budget deficits. These bonds are
considered relatively low-risk investments because they are backed by the full faith and credit of the
issuing government.
Here are some key features of government bonds:
1. Issuer: Government bonds are issued by national governments, such as the United States
Treasury bonds (T-bonds), United Kingdom gilts, German bunds, Japanese government bonds
(JGBs), etc.
2. Maturity: Government bonds have a fixed maturity date, which is the date on which the
principal amount is repaid to the bondholder. Maturities can range from short-term (less than
one year) to long-term (up to 30 years or more).
3. Coupon Payments: Government bonds typically pay periodic coupon payments to
bondholders, representing the interest earned on the bond. The coupon payments are usually
fixed and paid semi-annually or annually. Some government bonds, known as zero-coupon
 bonds, do not pay periodic coupon payments but are issued at a discount to their face value,
with the full face value repaid at maturity.
4. Credit Risk: Government bonds are generally considered low-risk investments because they
are backed by the taxing authority and the ability of the government to raise funds. However,
the creditworthiness of different governments can vary, and bonds issued by countries with
higher credit ratings are generally perceived as lower risk.
5. Liquidity: Government bonds are often highly liquid, meaning they can be easily bought or
sold in the market. This liquidity is due to the large volume of trading activity in government
bond markets and the presence of primary and secondary markets for these securities.
6. Yield and Interest Rate Sensitivity: The yield on government bonds depends on various
factors, including prevailing interest rates, inflation expectations, and the creditworthiness of
the issuing government. Government bonds are sensitive to changes in interest rates, with
bond prices moving inversely to interest rate fluctuations. When interest rates rise, bond
prices typically decline, and vice versa.
Government bonds play a significant role in financial markets as they are considered a benchmark for
risk-free rates. They are widely used by investors seeking stable income and capital preservation.
Government bond markets also serve as a reference point for pricing other fixed-income securities
and assessing the overall market conditions.
Corporate Bonds or Term Finance Certificates (TFCs)
Corporate bonds, also known as term finance certificates (TFCs) in some regions, are debt securities
issued by corporations or companies to raise capital for various purposes, such as financing projects,
acquisitions, or working capital needs. Unlike government bonds, which are issued by national
governments, corporate bonds are issued by private sector entities.
Here are some key features of corporate bonds or TFCs:
1. Issuer: Corporate bonds are issued by companies of varying sizes and across different
sectors, including finance, technology, utilities, manufacturing, and more. The issuing
companies can be publicly traded corporations or privately held companies.
2. Maturity: Corporate bonds have a fixed maturity date, indicating the period until the
principal amount is repaid to the bondholders. Maturities can range from short-term (typically
less than one year) to medium-term (1 to 10 years) or long-term (over 10 years).
3. Coupon Payments: Corporate bonds pay periodic coupon payments to bondholders, which
represent the interest earned on the bond. The coupon payments can be fixed or floating,
depending on the terms of the bond. Fixed-rate corporate bonds have a predetermined coupon
rate that remains constant throughout the bond's life. Floating-rate corporate bonds have a
coupon rate that adjusts periodically based on a benchmark interest rate.
4. Credit Risk: Corporate bonds carry credit risk, which refers to the risk of default by the
issuing company. The creditworthiness and default risk of corporate bonds can vary
depending on the financial strength, business prospects, and industry conditions of the issuing
company. Credit rating agencies assign ratings to corporate bonds based on their assessment
of the issuer's creditworthiness.
5. Yield and Risk-Reward Profile: The yield on corporate bonds is generally higher than
government bonds to compensate investors for the additional credit risk they bear. Investors
demand a higher yield for corporate bonds due to the potential default risk associated with
 private companies. The yield is influenced by factors such as prevailing interest rates, credit
rating, and market conditions.
6. Callability: Some corporate bonds may have a call provision that allows the issuer to redeem
the bond before the stated maturity date. This can occur if interest rates decline or the issuer
wants to refinance the debt at a lower cost. Callable bonds provide the issuer with flexibility
but may result in early repayment for bondholders.
Corporate bonds, including TFCs, provide a way for companies to access capital from investors in the
form of debt. They offer investors the opportunity to earn interest income and diversify their
investment portfolios. Corporate bond markets are active and provide liquidity through trading on
exchanges or over-the-counter markets.
Investors considering corporate bonds should assess the creditworthiness of the issuer, evaluate the
risk-reward profile, and analyze the company's financial health and future prospects. Credit ratings,
financial statements, and market conditions are essential factors to consider when investing in
corporate bonds or TFCs.
 Corporate Bond issued by companies and sold to investors, knows as TFCs in Pakistan

 Redeemable capital, for short and mid-term

 Exposed to default risk, unlike treasury bonds

 The higher the risk, the higher the interest rate

 Call Provisions

 issuer has the right to force the holder to sell the bond back, at a higher call price
usually, with a waiting period
 call option exercised depending upon the market interest rates

 when interest rates fall, the price of the bond rises, when the price rises above the call
price, the firm calls the bond
 Call provisions because of the sinking fund, or to alter capital structure, or because of
certain covenants restricting the firm from some activity of interest to stockholders
 Conversion

 bonds can be converted into shares of common stock

 the stock price rises, the bondholders will convert to stock at a relatively high price

 price is higher than the price of comparable nonconvertible bonds, and lower interest
rate

Types of Corporate Bonds

 Secured Bonds or Mortgage bonds
  with collateral attached, less risky than comparable unsecured bonds, and lower
interest rate
 Unsecured Bonds or Debentures

 long-term unsecured bonds that are backed only by the general creditworthiness of
the issuer
 lower priority than secured bonds if the firm defaults, a higher interest rate

 Subordinated debentures (even lower priority claim and lower credit worthiness) &
Variable-rate bonds
 Junk Bonds

 Bonds below the investment grade rating

Sukuk Bonds
 Islamic bonds, complying with Sharia law, i.e. no interest involved

 Investor gets partial ownership in the assets purchased with the bonds, receive a portion of
earnings
 The issuer must make a contractual promise to buy back the bond at a future date at par value.

Structuring Islamic bonds can be challenging, requires approval from recognized Sharia scholars

Finding the Value of Coupon Bonds

 Following three steps:

1. Identify the cash flows that result from owning the security.
2. Determine the discount rate required to compensate the investor for holding the security.
3. Find the present value of the cash flows estimated in step 1 using the discount rate
The value of a coupon bond, also known as the present value of a bond, can be determined by
calculating the present value of its future cash flows, including coupon payments and the
principal repayment at maturity. The present value is calculated by discounting the future
cash flows using an appropriate discount rate.
Here is the general formula to find the value of a coupon bond:
Value of Coupon Bond = (C / (1 + r)^1) + (C / (1 + r)^2) + ... + (C / (1 + r)^n) + (F / (1 +
r)^n)
Where:
 C is the coupon payment per period
 r is the discount rate or required rate of return
 n is the number of periods or the remaining time to maturity
  F is the face value or principal amount of the bond
Let's consider an example to illustrate the calculation:
Suppose you have a coupon bond with the following characteristics:
 Face value (F): $1,000
 Coupon rate: 5% (annual coupon payment)
 Remaining time to maturity: 5 years
 Discount rate (r): 6% (the rate of return required by the investor)
Step 1: Calculate the present value of each coupon payment: PV of each coupon payment =
(C / (1 + r)^t), where t is the period
For each year, the coupon payment is $1,000 * 5% = $50. Using the formula, the present
value of each coupon payment is as follows:
Year 1: PV1 = $50 / (1 + 6%)^1 = $47.17 Year 2: PV2 = $50 / (1 + 6%)^2 = $44.43 Year 3:
PV3 = $50 / (1 + 6%)^3 = $41.84 Year 4: PV4 = $50 / (1 + 6%)^4 = $39.38 Year 5: PV5 =
$50 / (1 + 6%)^5 = $37.03
Step 2: Calculate the present value of the principal repayment at maturity: PV of principal
repayment = F / (1 + r)^n = $1,000 / (1 + 6%)^5 = $747.26
Step 3: Sum up the present values of the coupon payments and principal repayment: Value of
Coupon Bond = PV1 + PV2 + PV3 + PV4 + PV5 + PV of principal repayment = $47.17 +
$44.43 + $41.84 + $39.38 + $37.03 + $747.26 = $957.11
Therefore, the value of the coupon bond in this example is approximately $957.11.
It's important to note that the discount rate used in the calculation should reflect the risk and
required rate of return for similar bonds. Additionally, the calculation assumes that coupon
payments are made at regular intervals, such as annually or semi-annually.

Semi-annual Bonds
Semi-annual bonds, also known as semi-annual coupon bonds, are a type of bond where the
coupon payments are made twice a year instead of annually. The presence of semi-annual
coupon payments affects the calculation of the bond's value by adjusting the coupon payment
amount and the number of periods.
To find the value of a semi-annual coupon bond, the formula for present value needs to be
modified accordingly. The general formula for the value of a semi-annual coupon bond is as
follows:
Value of Semi-annual Coupon Bond = (C / 2 / (1 + r/2)^1) + (C / 2 / (1 + r/2)^2) + ... + (C /
2 / (1 + r/2)^n) + (F / (1 + r/2)^n)
Where:
 C is the annual coupon payment
 r is the discount rate or required rate of return
 n is the number of periods or the remaining time to maturity (in semi-annual periods)
 F is the face value or principal amount of the bond
The modifications in the formula are dividing the coupon payment by 2 since the coupon is
paid semi-annually, and dividing the discount rate (r) by 2 to reflect the semi-annual
compounding.
Let's consider an example:
Suppose you have a semi-annual coupon bond with the following characteristics:
 Face value (F): $1,000
 Annual coupon rate: 6%
 Remaining time to maturity: 4 years
 Discount rate (r): 5% (annual rate)
Step 1: Adjust the annual coupon payment to a semi-annual coupon payment: Semi-annual
coupon payment = C / 2 = $1,000 * 6% / 2 = $30
Step 2: Adjust the discount rate to reflect semi-annual compounding: Semi-annual discount
rate = r / 2 = 5% / 2 = 2.5%
Step 3: Calculate the present value of each semi-annual coupon payment and the principal
repayment: PV of each semi-annual coupon payment = (C / 2 / (1 + r/2)^t), where t is the
period
Using the formula, the present value of each semi-annual coupon payment is as follows:
Period 1: PV1 = $30 / (1 + 2.5%)^1 = $29.27 Period 2: PV2 = $30 / (1 + 2.5%)^2 = $28.60
Period 3: PV3 = $30 / (1 + 2.5%)^3 = $27.96 Period 4: PV4 = $30 / (1 + 2.5%)^4 = $27.35
PV of principal repayment = F / (1 + r/2)^n = $1,000 / (1 + 2.5%)^8 = $843.48
Step 4: Sum up the present values of the semi-annual coupon payments and principal
repayment: Value of Semi-annual Coupon Bond = PV1 + PV2 + PV3 + PV4 + PV of
principal repayment = $29.27 + $28.60 + $27.96 + $27.35 + $843.48 = $956.66
Therefore, the value of the semi-annual coupon bond in this example is approximately
$956.66.
When working with semi-annual coupon bonds, it's important to adjust the coupon payment,
discount rate, and the number of periods accordingly to reflect the semi-annual payment and
compounding schedule.

NOTE
 an increase in the market interest rate will cause the price of an
outstanding bond to fall  discount bond
 a decrease in market interest rates will cause the outstanding bond’s price
to rise  premium bond
Rate of Return (Yield) Calculation
 The percentage rate of return consists of:
 the rate of return due to the interest payment (called the current
yield), and
 the rate of return due to the price change (called the capital gains
yield)
 The total rate of return is also called the bond yield, and it is calculated as
follows:
 Int/bond price + capital gain/bond price = Total rate of return
(yield)

 Yield to Maturity: the yield if the bond is held till maturity

 Yield to Call: when the bond is called back at a certain price

 when the bond price equals the par value of the bond, the yield to maturity is equal to the
coupon rate
 when the bond price is at par, the current yield equals the yield to maturity

 the current yield as well as the yield to maturity is negatively related to the price of the bond
 i.e. the current yield and the yield to maturity always move together