Financial Management

Bond Valuation
By: Prof. Trilochan Tripathy, XLRI

Lecture 04
Bond valuation

 Government of India is planning to issue a deep discount

Zero coupon bond. With the face value of Rs. 25000
payable at the end of 10 years. The planned yield for the
investor is 12%.
 What would be the issue price of the said bond?

 If the proposed issue price of the bond is Rs. 7500, what

yield would it offer to the subscriber of the bond if they
hold it till the redemption of the bond?
 Basics of Bond valuation

 If a bond has 5 years to maturity, an $80 annual

coupon, and a $1000 face value. How much is this
bond Value? Do you need any other information to
calculate bond value? [level of current market interest
rate- YTM]
 If the going rate on bonds like this one is 10%, then
this bond is worth $924.18.
 Why? [PV=Coupon(PVIFA)+FV(PVIF)]
= $80(3.791)+$1000(0.621)= $924.18
 Basics of Bond Valuation

TCS issued a bond with face value $1000 in the year April 1, 2005 and it
would mature in 15 years from now, the coupon amount is $150 and
the discount rate is 15%. Given this information calculate the present
value of the bond?
YTM: 15%,
Coupon: $150
Period: 15 years
FV: $1000
PV= $150(PVIFA15%,15Yr) +$1000(PVIF15%,15Yr)

= $150(5.8474) +$1000(0.1229)
=$1000.01
Bond valuation

 TCS issued a bond with face value $1000 in the year April 1, 2005
and it would mature in 14 years from now, the coupon amount is
$150 and the discount rate is 15%. Given this information calculate
the present value of the bond?
YTM: 15%,
Coupon: $150
Period: 14 years
FV: $1000
PV= $150(PVIFA15%,14Yr) +$1000(PVIF15%,14Yr)

= $150(5.724) +$1000(0.141)
=$999.98= Approx. $1000
Bond valuation

 TCS issued a bond with face value $1000 in the year April 1, 2005
and it would mature in 13 years from now, the coupon amount is
$150 and the discount rate is 15%. Given this information calculate
the present value of the bond?
YTM: 15%,
Coupon: $150
Period: 13 years
FV: $1000
PV= $150(PVIFA15%,13Yr) +$1000(PVIF15%,13Yr)

= $150(5.583) +$1000(0.163)
=$1000.45= Approx. $1000
TCS issued a bond with face value $1000 in the year April 1, 2005 and it would
mature in 15years from now, the coupon amount is $150 and the discount rate is
15%. Given this information calculate the present value of the bond for each year?

Year AMT FV PVIFA PVIF PV

1 150 1000 0.870 0.869565 1000.00
2 150 1000 1.626 0.756144 1000.00
3 150 1000 2.283 0.657516 1000.00
4 150 1000 2.855 0.571753 1000.00
5 150 1000 3.352 0.497177 1000.00
6 150 1000 3.784 0.432328 1000.00
7 150 1000 4.160 0.375937 1000.00
8 150 1000 4.487 0.326902 1000.00
9 150 1000 4.772 0.284262 1000.00
10 150 1000 5.019 0.247185 1000.00
11 150 1000 5.234 0.214943 1000.00
12 150 1000 5.421 0.186907 1000.00
13 150 1000 5.583 0.162528 1000.00
14 150 1000 5.724 0.141329 1000.00
15 150 1000 5.847 0.122894 1000.00
 Bond valuation

TCS issued a bond with face value $1000 in the year April 1, 2005 and it
would mature in 14 years from now, the coupon amount is $150 and
the discount rate is 10%. Given this information calculate the present
value of the bond?
YTM: 15%,
Coupon: $150
Period: 14 years
FV: $1000
PV= $150(PVIFA10%,14Yr) +$1000(PVIF10%,14Yr)

= $150(7.3667) +$1000(0.2663)
=$1368.31
TCS issued a bond with face value $1000 in the year April 1, 2005 and it would
mature in 15 years from now, the coupon amount is $150 and the discount rate is
10%. Given this information calculate the present value of the bond for each of the
year?
Year AMT FV PVIFA PVIF PV
1 150 1000 0.909 0.909091 1045.45
2 150 1000 1.736 0.826446 1086.78
3 150 1000 2.487 0.751315 1124.34
4 150 1000 3.170 0.683013 1158.49
5 150 1000 3.791 0.620921 1189.54
6 150 1000 4.355 0.564474 1217.76
7 150 1000 4.868 0.513158 1243.42
8 150 1000 5.335 0.466507 1266.75
9 150 1000 5.759 0.424098 1287.95
10 150 1000 6.145 0.385543 1307.23
11 150 1000 6.495 0.350494 1324.75
12 150 1000 6.814 0.318631 1340.68
13 150 1000 7.103 0.289664 1355.17
14 150 1000 7.367 0.263331 1368.33
15 150 1000 7.606 0.239392 1380.30
Bond Valuation

 TCS issued a bond with face value $1000 in the year April 1, 2005
and it would mature in 14 years from now, the coupon amount is
$150 and the discount rate is 20%. Given this information calculate
the present value of the bond for each of the year?
YTM: 20%,
Coupon: $150
Period: 14 years
FV: $1000
PV= $150(PVIFA20%,14Yr) +$1000(PVIF20%,14Yr)

= $150(4.6106) +$1000(0.0779)
=$769.49
 TCS issued a bond with face value $1000 in the year April 1, 2005
and it would mature in 15 years from now, the coupon amount is
$150 and the discount rate is 20%. Given this information calculate
the present value of the bond for each of the year?

Year AMT FV PVIFA PVIF PV

1 150 1000 0.833 0.833333 958.33
2 150 1000 1.528 0.694444 923.61
3 150 1000 2.106 0.578704 894.68
4 150 1000 2.589 0.482253 870.56
5 150 1000 2.991 0.401878 850.47
6 150 1000 3.326 0.334898 833.72
7 150 1000 3.605 0.279082 819.77
8 150 1000 3.837 0.232568 808.14
9 150 1000 4.031 0.193807 798.45
10 150 1000 4.192 0.161506 790.38
11 150 1000 4.327 0.134588 783.65
12 150 1000 4.439 0.112157 778.04
13 150 1000 4.533 0.093464 773.37
14 150 1000 4.611 0.077887 769.47
15 150 1000 4.675 0.064905 766.23
Calculate YTM

 Suppose you were offered a 14 year , 15% coupon , $1000

par value bond at a price of $1368.31. What rate of interest
would you earn on your investment if you bought the bond
and held upto maturity (calculate the yield to maturity)?
 PV= $150/(1+r)^1+ …….$150/(1+r)^14+$1000/(1+r)^14

 PV=$150(PVIFA)+$1000(PVIF)

 $1368.31=$150(PVIFA)+$1000(PVIF)

Trial and Error Method

At 12% for 14 Yrs : $150(6.6282)+$1000(0.2046)=$1198.83< $1368.31
At 10% for 14 Yrs: $150(7.3667)+$1000(0.2633)= $1368.31 = $1368.31

Hence YTM is 10%

Lets understand the discount and premium bonds

 Whenever the YTM=Coupon interest rate: bond is sold at par

value
 Whenever the YTM>Coupon interest rate: value: Bond is
sold at Discount
 Whenever the YTM<Coupon interest rate: Bond is sold at
Premium
 Thus increase in market interest rate will cause the decline
in value of an outstanding bond and vice versa
 Market value of bond=Par value on maturity

 Why so?? What is the rationale behind it?

 Basics of Bond Valuations

 Assume you have the following information.

Suppose XYZ company bond have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 10%
 1. Calculate the present value of the face value

= $1,000 [1/1.1020 ] = $1,000 .14864 = $148.64

 2. Calculate the present value of the coupon payments

= $100 [1 - (1/1.1020)]/.10 = $100 8.5136 = $851.36
 3. Bond Value = $148.64 + 851.36 = $1,000
Bond Rates and Yields

 Suppose a bond currently sells for $932.90. It pays an annual

coupon of $70, and it matures in 10 years. It has a face value of
$1000. What are its coupon rate, current yield, and yield to
maturity (YTM)?

 1. The coupon rate (or just “coupon”) is the annual

dollar coupon expressed as a percentage of the face
value:
Coupon rate = $70 /$_____ = ___%

 2. The current yield is the annual coupon divided by

the current market price of the bond:
Current yield = $___ /_____ = 7.5%
Under what conditions will the coupon rate and current yield be
the same?
Bond Rates and Yields (concluded)

 3. The yield to maturity (or “YTM”) is the rate that makes the
price of the bond just equal to the present value of its future
cash flows. It is the unknown r in:
$932.90 = $70 [1 - 1/(1 + r)10]/r + $1000 /(1 + r)10

The only way to find the YTM is trial and error:

a. Try 10%: $70 [(1 - 1/(1.10)10]/.10 + $1000/(1.10)10 = $816
=$70*((1-1/(1.1)^10)/0.1)+1000*(1/(1.1)^10)
b. Try 9%: $70 [1 - 1/(1.09)10]/.09 + $1000/(1.09)10 = $872
c. Try 8%: $70 [1 - 1/(1.08)10]/.08 + $1000/(1.08)10 = $933
( ) The yield to maturity is 8%
Example: A Discount Bond

 Assume you have the following information.

XYZ company has a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 12%

 1. Calculate the present value of the face value

= $1,000 [1/1.1220 ] = $1,000 .10366 = $103.66

 2. Calculate the present value of the coupon payments

= $100 [1 - (1/1.1020)]/.10 = $100 7.4694 = $746.94

 3. The value of each bond = $103.66 + 746.94 = $850.60

Example: A Premium Bond
 Assume you have the following information.
XYZ bond has a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 8%

 1. Calculate the present value of the face value

= $1,000 [1/1.0820 ] = $1,000 .21455 = $214.55

 2. Calculate the present value of the coupon payments
= $100 [1 - (1/1.0820)]/.08 = $100 9.8181 = $981.81

 3. The value of each bond = $214.55 + 981.81 = $1,196.36

 Why do the bonds in this and the preceding example have prices
that are different from par?
Bond Price Sensitivity to YTM

Bond price

$1,800
Coupon = $100
20 years to maturity
$1,600
$1,000 face value

$1,400 Notice: bond prices and YTMs are

inversely related.
$1,200

$1,000

$ 800

$ 600 Yields to maturity, YTM

4% 6% 8% 10% 12% 14% 16%
Inflation and Returns (continued)

 Real versus nominal returns:

Your nominal return is the percentage change in

the amount of money you have.
Your real return is the percentage change in the
amount of stuff you can actually buy.
Inflation and Returns (concluded)

 The relationship between real and nominal returns is described by

the Fisher Effect. Let:
R = the nominal return
r = the real return
h = the inflation rate

 According to the Fisher Effect:

1 + R = (1 + r) x (1 + h)

 From the example, the real return is 4.76%; the nominal return is
10%, and the inflation rate is 5%:

(1 + R) = 1.10

(1 + r) x (1 + h) = 1.0476 x 1.05 = 1.10

Solution to Problem

 Bond J has a 4% coupon and Bond K a 10% coupon. Both

have 10 years to maturity, make semiannual payments, and
have 9% YTMs. If market rates rise by 2%, what is the
percentage price change of these bonds? If rates fall by 2%?
What does this say about the risk of lower-coupon bonds?
Current Prices:
Bond J:
PV = $20 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $______
Bond K:
PV = $50 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $1065.04
Solution to Problem (continued)

Prices if market rates rise by 2%:

Bond J:
PV = $20 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $581.74

Bond K:
PV = $50 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $______
Solution to Problem (continued)

Prices if market rates fall by 2%:

Bond J:
PV = $20 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20
= $786.82

Bond K:
PV = $50 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20
= $1213.19
Solution to Problem (concluded)

 Percentage Changes in Bond Prices

Bond Prices and Market Rates

7% 9% 11%
_________________________________
Bond J $786.81 $674.80 $581.74
% chg. (+16.60%) (___%)
Bond K $1,213.19 $1,065.04 $940.25
% chg. (___%) (-11.72%)
_________________________________
The results above demonstrate that, all else equal, the
price of the lower-coupon bond changes more (in
percentage terms) than the price of the higher-coupon
bond when market rates change.