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Bonds, Bond Valuation,

and Risks

Corporate Finance
Session 7/8
PGP 2018-20
Kushankur Dey
Faculty, Finance & Accounting, IIM BG
Session plan (7/8)
• Key features of bonds
• Bond valuation
• Measuring yield
– Yield to maturity
• Assessing risks
– Default risk
– Market risk/interest rate risk

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Determinants of Intrinsic Value: The Cost of
Debt

Net operating Required investments



profit after taxes in operating capital

Free cash flow


=
(FCF)

FCF1 FCF2 ... + FCF∞


Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Firm’s debt/equity mix


Cost of debt
Market risk aversion Cost of equity Firm’s business risk

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What is bond?
• A bond is a long-term contract under which a
borrower (issuer) agrees to make payments
of either interest/coupon or principal or/and
both on specific dates to the bondholder
(investor).
• The interest payments or coupons to be paid
is based on the different frequency of time
period, say semi-annually, annually, quarterly,
monthly. And the principal amount is
generally paid in lump-sum amount at the end
of maturity of the bond.
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What is coupon rate
• Interest paid on a bond or other debt
instrument stated as a percentage of its face
value.
• Illustration: If a 10-year bond pays 7%
coupon semi-annually, what is the amount of
interest paid? If market interest rate (YTM)
is 8%, what will be the selling price/issue
price of the bond?
– There will be 20 semi-annual payments of INR 35
paid given the face value of the bond INR 1000.

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Types of bonds
• Government bond – bond issued by a state
body or federal/central or local government
such as municipality.
– G-bonds are called Treasury notes and T-bonds.
The nomenclature is based on the time to maturity.
• Corporate bonds are issued by businesses
called corporations.
• Mortgage bonds are backed by tangible
assets, i.e., immovable property. Frist-
mortgage bonds are senior in priority to the
second-mortgage bonds.
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Types of bonds…
• Debenture – a long-term bond that is not
secured by a mortgage on specific property.
• Income bond – a bond that pays interest
to the holder only if the interest is earned
by the firm
• Puttable bond – a bond that can be
redeemed at the bondholder’s option when
certain circumstances exist, say when the
firm is acquired or its outstanding debt
increases substantially.

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Types of bonds…
• Indexed (purchasing-power) bond – a bond that has
interest payments based on an inflation index to protect
the holder from loss of purchasing power.
– e.g. investing in CPI index fund.
• Floating-rate bond – a bond whose interest rate
fluctuates with the shift in the general level of market
interest rates.
• Zero-coupon bond – a bond that pays no annual
interest but sells at deep discount much below
par/redemption value, thus providing compensation to
investors in the form of capital gains/appreciation.
– Zero-coupon bonds are not susceptible to interest rate risk or
is immunised to market risk.

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Key Features of a Bond
• Par value: Face amount; paid at maturity.
Assume INR 1,000.
• Coupon interest rate: Stated interest rate.
Multiply by par value to get amount of interest.
Generally fixed.
• Maturity: Years until bond must be repaid.
Declines.
• Issue/settlement date: Date when bond was
issued.
• Default risk: Risk that issuer will not make
interest or principal payments.
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Properties of a bond
• Callable – The issuer has a right or
provision to call the bond before the maturity
if the interest rates tends to decline.
– So, in callable bond, there is put risk embedded.
• Puttable – The holder has a right or
provision to sell the bond before time to
maturity if interest rates tends to decline.
– So, in puttable bond, there is call risk embedded.
• Bond risk contained is written in
covenants/indenture

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Value of a 10-year, 10% coupon bond
if rd = 10%

0 1 2 10
10% ...
V=? 100 100 100 + 1,000

INR 100 INR 100 INR 1,000


VB = + . . . + +
(1 + rd) 1
(1 + rd) N
(1 + rd)N

= INR 90.91 + . . . + INR 38.55 + INR 385.54


= INR 1,000.
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The bond consists of a 10-year, 10% annuity of INR
100/year plus a INR 1,000 lumpsum at t = 10:

PV annuity = 614.46
PV maturity value = 385.54
Value of bond INR=1,000.00

INPUTS
10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1,000

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What would happen if expected
inflation rises by 3%, causing r moves
to 13%?

INPUTS
10 13 100 1000
N I/YR PV PMT FV
OUTPUT -837.21

When rd rises, above the coupon


rate, the bond’s value falls below
par, so it can be sold at a discount.
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What would happen if inflation falls,
and rd declines to 7%?

INPUTS
10 7 100 1000
N I/YR PV PMT FV
OUTPUT -1,210.71

If coupon rate > rd, price rises


above par, and hence, bond can be
sold at a premium.
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Exercise 1.0
• An infrastructure bond has maturity of 15
years. The interest on this bond is 12
percent. Determine the value of the bond
if the nominal yield to maturity is 14
percent per annum. The interest payment
on the bond is semi-annual and the face
value of the bond is INR 1000.
• Solution: FV = 1000, PMT= 60, r/YR =
0.07, NPER = 30, PV = INR 876, so the
bond is traded at discount
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Exercise 2.0
• The current two-year spot rate in
Indian market is, say, 7 percent. One
year at a forward rate offered for
any investment is 7.5 percent.
Calculate the current one year spot
rate prevailing in the market.
• Solution: (1+r1) = (1+r2)^2/
(1+f1,2) or r1 = 6.50%

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Exercise 3.0
• An investor has INR 20,00,000 that
he wishes to invest in the market at
the rate of 14 percent compounded
monthly. What will be the value of
his investment after 15 years?
Solution: FV (0.14/12, 180, 0,
-2000000)
= INR 1,61,35,013

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Exercise 4.0
• A person who is a risk averse
investor invests in 14 percent
coupon bond with a face value of
INR 100. The bond has five years to
maturity, the coupons are paid semi-
annually and the yield to maturity is
18 percent. What is the current
value of this bond?
• Solution: PV (0.18/2, 10, 0.14*100/2,
100,0)
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Exercise 5.0
• What would you prefer: a lump-sum of INR
48,00,000 or equal monthly installments of
INR 40,000 if the amount of investment
required is same? If the expected return is
14 percent per annum compounded monthly
make your choice as to what type of return
would you prefer.
– Solution: From the first investment, FV will be
₹ 1,93,07,859.08 (FV (0.14/12,120,0,-4800000,0)
From the second case, FV will be ₹
1,03,62,756.48 (FV (0.14/12,120,-40000,0,0)
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