So, continue with the topic of bond valuation.

We have already discussed what is the bond.

Now we're going to go on the other side of what is valuation.
So, valuation is simply whenever you're trying to determine the value of something.
And one way of determining the value is to determine the price of something.
So if something has a lot of value, it automatically has a lot of price.
Now the value of any financial asset, be it a stock, a bond, a lease, or even a
physical
asset, this is an apartment building or a piece of machinery, is the present value
of
the cash flows that asset is expected to produce.
For example, if you're going to purchase a car, you will get transportation out of
it.
So if you purchase a car, you'll get a real asset.
You can actually see and touch that car, it's tangible.
And you can use it for commuting purposes.
So that is utilization that you will take out from.
Similarly, if you buy a house, so you might buy the house to stay yourself in that
house.
So you will be utilizing it in that way, or you might be purchasing it for rent
purposes.
Now if you're purchasing it for rent purposes,
then how much are you willing to pay for that house will depend a lot on how much
do
you think the house is going to give you in the form of rent.
The higher you expect that you can charge for rent, the higher amount you would be
willing
to purchase that house automatically.
The similar is the case for financial assets as well.
So if you're purchasing a bond certificate, we're just going to get a certificate,
a piece
of paper from it.
So why are you purchasing that certificate because you are interested in the future
cash
flows that this certificate has to offer.
For example, I have saved 100,000 rupees.
Now this 100,000 rupees is idle cash with me.
It's not earning anything.
So I might decide, okay, let me just purchase a bond out of it.
If I purchase a bond, then I'll start to get the coupon payments.
Now the coupon payments can be monthly, it can be quarterly, they can be yearly.
But this money will start to earn something.
So now how much I'm ready to pay to purchase the bond will depend upon such
characteristics
as the coupon payments.
So if there are two bonds, one is offering a coupon payment of let's say 10% and
the other
is offering a coupon payment of 15% and other things, constant characteristics are
similar.
I would automatically be willing more to purchase for the pay more for the 15% bond
because that would mean I will get higher coupon payments compared to the 10% bond.
So this is the concept of bond valuation.
Now we're going to look at the steps of how to do so.
So if you want to calculate the price of any financial asset, there are some steps.
Step number one is that you need to estimate the cash flows.
Step number two is that you need to use an appropriate discount rate.
Now this discount rate is going to be the market interest rate on the bond.
It is not going to be the coupon rate.
This discount rate is not going to be the coupon rate.
It's going to be a different rate.
It is your market interest rate.
It is also called your YTM.
So you will use this rate for discounting your cash flows.
And third is to calculate the present value of these cash flows.
The present value of the cash flows will be the price, the value of the bond.
So let's look at an example to understand how are we going to go through these
steps.
Let me just clear all of this drawing.
Now this is our example.
So it says a three-year bond.
So let's make the data together, a three-year bond.
So our N is three over here with a coupon rate of 10%.
With a 10% coupon rate, so our coupon rate is 10%.
And 1,000 base value.
So this is our base value 1,000.
And has the yield to maturity of 8%.
So yield to maturity is the market interest rate.
We will discuss this rate in much more detail in the later coming on unit.
Right now this yield to maturity is the market interest rate.
It is the discount rate that will be used to calculate the present value of the
cash flows.
So this is your rate that you will use for discounting purposes.
It can be equal to your coupon rate as well and it can be different as well.
Now assuming annual coupon calculate the price of the bond.
So first step is that we need to estimate the cash flows.
We know that the face value is 1,000 and the coupon rate is 10%.
So first thing is that we should calculate what is the coupon payment.
Coupon payment is coupon rate multiplied by face value.
So you have taken on a loan of 1,000.
You have given a loan of 1,000 at an interest rate of 10%.
That means you will get a coupon payment of 100 each year because the coupon
payments are annual over here.
So let's make a timeline.
Since the bond is for three years will go till year three.
So you'll get the coupon payment of 100 at the end of the first year.
A coupon payment of 100 at the end of the second year and a coupon payment of 100
at the end of the third year.
Plus at the end of the third year because the bond is going to make sure you will
get your 1000 rupees.
Your loan that you had given to the corporation will be returned to you as well.
So now the bond has end.
They have returned to you the 1000 loan amount.
So the loan has ended.
Now these are your cash flows.
You need to find the present value of these cash flows.
You have already studied the topic of time value of money.
So this shouldn't be a problem for you.
So the how to calculate the present value.
First I'm going to use the single cash flow formula and then I'm going to apply
another formula that I'm sure you would have figured out on your own as well.
So first let's use the single cash flow formula for that purpose.
So this is the formula.
I'm going to write it over here.
Present value is equals to future value.
One plus r to the power n.
Now this is your single cash formula, which means each cash flow will be discounted
separately over here.
So the first 100 is going to come back one year.
This is 100.
Now they are very important that you're not supposed to use the coupon right over
here.
You are supposed to use your YTM, which is your market interest rate for this
purpose.
This is 0.08.
And then power will be one because you're bringing this cash for back one year.
So let's calculate the value of this.
Well, this is giving us a value of 92.59.
Similarly, we're going to do it for the second cash flow.
What is the present value of this 100?
You can just add it in the formula because that is what you're going to do in 100.
One plus the rate is going to be the same.
The only thing that is changing is your power because this is coming back two
years.
You're going to use power to over here.
And similarly, you're going to do it for the third cash flow.
But in the third cash flow, you have 100 and you have 1000.
Both of these cash flows are going to come back three years.
That means you have a total of 1100.
In the third cash flow. So one plus 0.08.
And we have power three.
So the second cash flow is giving us a value of 85.73.
85.73 and the last cash flow.
The last cash flow is giving us a 73.21.
So as you can see over here, we have discounted each and every cash flow.
We have not left anything out.
So we have discounted the first second and the third 100 and 1000 as well.
So you can sum all of these values up.
So this is the price of the strong ones.
You have sum it up and our answer is move to them.
105 1.55.
Add them up and you're going to get 105 1.55.
This is the price of the store. This is the value of the stock.
So one certificate will be selling for 1051.55 and the market.
Now I'm going to solve the same question using the simple formula,
which is your annuity formula. As you can see from here,
the cash flows, the payments themselves are like an annuity.
They are equal. The amount is not going to change. It's 100 every year.
They are coming every year. So they are equidistant and you know when the payment
is going to end,
it's going to end in three years. So all of the three characteristics of annuity
are present over here
and you can actually use the annuity formula. And I would prefer that you use that
formula.
So now that's all this question using that formula. I'm going to clear all of this.
Okay. So we're going to make the timeline once again.
So we had it for three years since our end was three.
And we had 100 each coupon payment.
And 1000 bar value over here.
So these are our cash flows and we need to find the present value of these cash
flows.
But for this purpose for the 100s over here,
because these values have the pattern of an annuity,
we're going to use the annuity formula because later on your one questions are
going to be very long.
So it's better if you start using the annuity formula over here.
This 1000 is not an equal cash flow. So you cannot use this in the annuity formula.
You can use it only for the 100 amount.
So let's write down the annuity formula.
The present value of annuity, the pieces of reporting.
PMT. So your PMT is over here are going to be coupon payments and you have one
minus one plus R.
This is your annuity formula. So the coupon payments are 100.
The interest rate that you will use is 0.08 and you are going to use an N over here
of three,
because there are three annuity payments and you're taking them back three years.
0.08.
So if you solve this, this is giving you two five,
seven point seven one. Now you really need to understand this that once you have
applied this formula,
you're actually getting the present value of all of these three cash flows
together.
So this is two five seven point seven one.
You do not have to calculate the present value of each cash flow separately as you
did it with the single cash flow formula
because the annuity formula gives you the present value of all three cash flows
together.
But you're less to left with this 1000. So for this 1000, you can apply the single
cash flow formula and bring it back three years.
So we're going to incorporate the single cash flow formula, which you already used,
which was right.
So we're going to incorporate this in the formula as well. So I'm going to add.
This formula over here so future value.
Your face value that is left to be discounted back is 1000. So this is plus sorry
1000.
And one plus 0.08 and you have power three, because you need to bring this back
three years. So if you saw this is coming seven.
So this is your bond valuation formula formula that I have written over here.
This is a formula that you will use.
So this is your bond valuation formula formula that I have written over here.
This is a formula that you will use every time to find out the bond value.
You don't have to do the single cash flow one that I did just for your explanation.
This is your bond valuation formula.
For formula.
You can actually write bond valuation over here instead of this.
Because this is your bond valuation formula.
Which you will use directly now in the later questions.
The PMT stands for payment, which is your coupon payment. The R over here will be
the discount rate your market interest rate also call your YTM yield to maturity.
And will be the maturity time and if we will be your face value your far value.