TOPIC 2

BASIC OF VALUATION AND

BOND VALUATION

1
 Value
 Book value: value of an asset as shown on
a firm’s balance sheet; historical cost.
 Liquidation value: amount that could be
received if an asset were sold individually.
 Market value: observed value of an asset
in the marketplace; determined by supply
and demand.
 Intrinsic value: economic or fair value of
an asset; the present value of the asset’s
expected future cash flows. 2
 Security Valuation
 In general, the intrinsic value of an
asset = the present value of the stream
of expected cash flows discounted at
an appropriate required rate of
return.

3
 Valuation

 (1 + k)
$Ct
V = t
t=1

 Ct = cash flow to be received at time t.

 k = the investor’s required rate of return.
 V = the intrinsic value of the asset. 4
 Bond Valuation

 Discount the bond’s cash flows at

the investor’s required rate of
return.
 The coupon payment stream (an
annuity).
 The par value payment (a single
sum).

5
 Bond Valuation


$It $M
Vb = +
t=1
(1 + k b)t
(1 + kb)n

Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)

6
 Characteristics of Bonds
 The basic features of a bond include the
following:
 Bond indenture
 Claims on assets and income
 Par or face value
 Coupon interest rate
 Maturity and repayment of principal
 Call provision and conversion features

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 Bond Terminology
Indenture The indenture is the legal agreement between the firm issuing the bonds
and the bond trustee, who represents the bondholders. It lists the specific
terms of the loan agreement, including a description of the bonds, the rights
of the bondholders, the rights of the issuing firm, and the responsibilities of
the trustee.
Priority of In the case of insolvency, claims of debt in general, including
claims bonds, are honored before those of both common stock and
on assets preferred stock. In addition, interest payments hold priority over
and
income
dividend payments for common and preferred stock.

Par value The par value of a bond, also known as its face value, is the principal that
must be repaid to the bondholder at maturity. In general, corporate bonds
are issued with par values in increments of $1,000. Also, when bond prices
are quoted in the financial press, prices are generally expressed as a
percentage of the bond’s par value.

Maturity The maturity date refers to the date on which the bond issuer must repay the
and principal or par value to the bondholder.
repayment
of
principal
Coupon The coupon rate on a bond indicates the percentage of the par value of the
interest bond that will be paid out annually in the form of interest and is quoted as 8
Rate an APR.
Bond Terminology

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 Characteristics of Bonds

 Bonds pay fixed coupon (interest)

payments at fixed intervals (usually
every six months) and pay the par
value at maturity.

$I $I $I $I $I $I+$M

0 1 2 ... n 10
 Example: AT&T 6 ½ 32
 Par value = $1,000
 Coupon = 6.5% or par value per year,
or $65 per year ($32.50 every six months).
 Maturity = 28 years (matures in 2032).
 Issued by AT&T.

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 Example: AT&T 6 ½ 32
 Par value = $1,000
 Coupon = 6.5% or par value per year,
or $65 per year ($32.50 every six months).
 Maturity = 28 years (matures in 2032).
 Issued by AT&T.
$32.50 $32.50 $32.50 $32.50 $32.50 $32.50+$1000

0 1 2 … 28 12
 Types of Bonds

 Debentures - unsecured bonds.

 Subordinated debentures - unsecured
“junior” debt.
 Mortgage bonds - secured bonds.
 Zeros - bonds that pay only par value at
maturity; no coupons.
 Junk bonds - speculative or below-
investment grade bonds; rated BB and
below. High-yield bonds.
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 Types of Bonds
 Eurobonds - bonds denominated in
one currency and sold in another
country. (Borrowing overseas).
 example - suppose Disney decides to sell
$1,000 bonds in France. These are U.S.
denominated bonds trading in a foreign
country. Why do this?
 If borrowing rates are lower in France.
 To avoid SEC regulations.
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 Bond Example

 Suppose our firm decides to issue 20-year

bonds with a par value of $1,000 and
annual coupon payments. The return on
other corporate bonds of similar risk is
currently 12%, so we decide to offer a 12%
coupon interest rate.
 What would be a fair price for these
bonds?
15
 Bond Valuation


$It $M
Vb = +
t=1
(1 + k b)t
(1 + kb)n

Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)

16
 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 120 1 - (1.12 )20 + 1000/ (1.12) 20 = $1000
17
.12
 1000
120 120 120 ... 120

0 1 2 3 ... 20

P/YR = 1
N = 20
I%YR = 12
FV = 1,000
PMT = 120
Solve PV = -$1,000

Note: If the coupon rate = discount

rate, the bond will sell for par value.
18
 Suppose interest rates fall
immediately after we issue the
bonds. The required return on
bonds of similar risk drops to 10%.

 What would happen to the bond’s

intrinsic value?

19
 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 120 1 - (1.10 )20 + 1000/ (1.10) 20 = $1,170.27
20
.10
 P/YR = 1
Mode = end
N = 20
I%YR = 10
PMT = 120
FV = 1000
Solve PV = -$1,170.27

Note: If the coupon rate > discount rate,

the bond will sell for a premium. 21
 Suppose interest rates rise
immediately after we issue the
bonds. The required return on
bonds of similar risk rises to 14%.

 What would happen to the bond’s

intrinsic value?

22
 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = 120 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 120 1 - (1.14 )20 + 1000/ (1.14) 20 = $867.54
23
.14
 P/YR = 1
Mode = end
N = 20
I%YR = 14
PMT = 120
FV = 1000
Solve PV = -$867.54

Note: If the coupon rate < discount rate,

the bond will sell for a discount. 24
Suppose coupons are semi-annual

P/YR = 2
Mode = end
N = 40
I%YR = 14
PMT = 60
FV = 1000
Solve PV = -$866.68
25
 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = 60 (PVIFA .07, 40 ) + 1000 (PVIF .07, 40 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 60 1 - (1.07 )40 + 1000 / (1.07) 40 = $866.68
26
.07
 Yield To Maturity

 The expected rate of return on a

bond.
 The rate of return investors earn on a
bond if they hold it to maturity.

27
 Yield To Maturity

 The expected rate of return on a

bond.
 The rate of return investors earn on a
bond if they hold it to maturity.


$It $M
P0 = +
t=1 (1 + kb)t
(1 + kb)n
28
 YTM Example

 Suppose we paid $898.90 for a

$1,000 par 10% coupon bond
with 8 years to maturity and
semi-annual coupon payments.

 What is our yield to maturity?

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 YTM Example

P/YR = 2
Mode = end
N = 16
PV = -898.90
PMT = 50
FV = 1000
Solve I%YR = 12%
30
 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF k, 16 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
898.90 = 50 1 - (1 + i )16 + 1000 / (1 + i) 16
i solve using trial and error 31
2) YTM: Approximation method
For annual coupon payment:

32
 Zero Coupon Bonds

 No coupon interest payments.

 The bond holder’s return is
determined entirely by the
price discount.

33
 Zero Example

 Suppose you pay $508 for a zero

coupon bond that has 10 years
left to maturity.
 What is your yield to maturity?

-$508 $1000

0 10 34
Zero Example

P/YR = 1
Mode = End
N = 10
PV = -508
FV = 1000
Solve: I%YR = 7%
35
 Zero Example
PV = -508 FV = 1000

0 10
Mathematical Solution:
PV = FV (PVIF i, n )
508 = 1000 (PVIF i, 10 )
.508 = (PVIF i, 10 ) [use PVIF table]

PV = FV /(1 + i) 10
508 = 1000 /(1 + i)10
1.9685 = (1 + i)10
i = 7% 36
 Important Factors in Bond
Relationships
 First Relationship The value of bond is inversely related
to changes in the market’s required yield to maturity.

Blank YTM = 12% YTM rises to 15%

Par value $1,000 $1,000

Coupon rate 12% 12%

Maturity date 5 years 5 years

Bond Value $1,000 $899

Bond
Value
Drops

37
Bond Value and the Market’s Required Yield to Maturity (5—Year Bond, 12% Coupon
Rate)

38
 Relationship 2
The market value of a bond will be less than the
par value (discount bond) if the market’s
required yield to maturity is above the coupon
interest rate and will be more than the par valued
if the market’s required yield to maturity is
below the coupon interest rate.

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 Relationship 3
As the maturity date approaches, the market
value of a bond approaches its par value.
The value of a bond, whether a premium or a
discount bond, approaches its par value as the
maturity date becomes closer in time.

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 Bond Prices Relative to Maturity Date

Blank Blank Blank Years to Blank Blank Blank Blank

Maturity

Blank 12% Coupon Bond 5 4 3 2 1 0

Blank 12% yield scenario $1,000.00 $1,000.00 $1,000.0 $1,000.0 $1,000. $1,000.0
0 0 00 0

Discount 15% yield scenario $ 899.44 $ 914.35 $ 931.50 $ 951.23 $ $1,000.0

bond 973.91 0

Premium 9% yield scenario $1,116.69 $1,097.19 $1,075.9 $1,052.7 $1,027. $1,000.0

bond 4 7 52 0
Value of a 12% Coupon Bond during the Life of the Bond

42
 Relationships 4
• Long term bonds have greater interest-rate risk
than short-term bonds.
 While all bonds are affected by a change in
interest rates, the prices of longer-term bonds
fluctuate more when interest rates change than
do the prices of shorter-term bonds

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 Bond Price Fluctuations for Bonds with Different Maturities

Blank Blank Blank Years to Blank Blank Blank

Maturity

Blank 5 10 15 20 25 30

15% (increased yield) $899.44 $849.44 $824.58 $812.22 $806.08 $803.02

% price decrease −10.1% −15.1% −17.5% −18.8% −19.4% −19.7%

% price decrease $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00

% price increase 11.7% 19.3% 24.2% 27.4% 29.5% 30.8%

9% (decreased yield) $1,116.69 $1,192.53 $1,241.82 $1,273.86 $1,294.68 $1,308.21

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 Bond Ratings and Default Risk
Bond ratings indicate the default risk i.e. the
probability that the firm will make the bond’s
promised payments. Rating agencies use
borrower’s financial statements, financing mix,
profitability, variability of past profits, and make
judgments about the quality of the firm’s
management in order to determine ratings.

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 Table 9.3 Interpreting Bond Ratings

Bond Rating Category Standard & Moody’s Description

Poor’s
Investment Grade: Blank Blank Blank
Prime or AAA Aaa Highest quality; extremely strong capacity to pay
highest strong
High quality AA Aa Very strong capacity to pay
Upper medium A A-1, A Upper medium quality; strong capacity to pay
Medium BBB Baa-1, Baa Lower medium quality; changing circumstances
could impact the firm’s ability to pay
Not Investment Grade: Blank Blank Blank
Speculative BB Ba Speculative elements; faces uncertainties

Highly speculative B, CCC, CC B, Caa, Ca Extremely speculative and highly vulnerable to

nonpayment
Default D C Income bond; doesn’t pay interest

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