WEEK 3

Valuation of
Bonds and Bills
DFN 2013-FINANCIAL MANAGEMENT
LEARNING OUTCOME

b. Objectives

List the advantages and disadvantages of

using bonds and bills

Identify the various factors affecting bond

value

Compute the intrinsic value of bonds based

on different features

Determine bond yields in assisting financial-

decision making
c. Outline
Section Topic
1 Overview
2 Bonds and Bills
2.1 Valuation Techniques
3 Factors Affecting Value of Bonds
3.1 Impact of Market Interest Rates
4 Measures of Bond Yields
5 Summary
6 Quiz
1. a. Overview

Bonds and bills have become very common financial

instruments in businesses, as investments as well as
sources of financing for companies. The valuation
of these instruments is critical in order to make the
right investment or financing decisions.

A bond is a long-term debt

instrument that pays the
bondholder a specified amount
of periodic interest over a
specified period of time
EXAMPLE OF BOND
CERTIFICATE=DEBT
 Bonds and bills

 Use of LT debt (bonds) has its advantages

and disadvantages:

Tax deductibility of interest, lower cost for

the company
Financial leverage can increase potential
EPS
 Ownership is not diluted through equity
issues

Financial risk is increased

Indenture provisions may restrict firm’s
flexibility (limitations on dividend,
minimum working capital, limitations on
additional debt)
Types of Bond
 Corporatebonds are issued by
companies.
 Municipal bonds are issued by states
and municipalities. Municipal bonds
can offer tax-free coupon income
for residents of those
municipalities.
 U.S. Treasury bonds (more than 10
years to maturity), notes (1-10
years maturity) and bills (less than
one year to maturity) are
collectively referred to as simply "
Treasuries.
 Zero-coupon bonds (NO COUPON
PAYMENT)do not pay out regular coupon
payments, and instead are issued at a
discount and their market price
eventually converges to face value upon
maturity
 Convertible bonds are debt instruments
with an embedded call option that allows
bondholders to convert their debt into
stock (equity).
 Some corporate bonds are callable,
meaning that the company can call back
the bonds from debtholders if interest
rates drop sufficiently.
 Key Features of a Bond
 Par value: face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate: stated interest rate
(generally fixed) paid by the issuer.
Multiply by par value to get dollar payment
of interest.
 Maturity date: years until the bond must
be repaid.
 Issue date: when the bond was issued.
 Yield to maturity: rate of return earned on
a bond held until maturity (also called the
“promised yield”).
Characteristics of Bonds
 Bonds pay fixed coupon
(interest) payments at fixed
intervals (usually every 6
months) and pay the par value
at maturity.
Example
 par value = $1000
 coupon = 8% of par value per year.=
$80 per year ($40 every 6 months).
 maturity = 10 years (matures in
2024).
 issued by ABC Company.
 Valuation of bonds and bills

 Determination of intrinsic value of

securities
 Importance of valuation:
To compare the intrinsic value to the
market value of securities; market
value is determined by DD and SS
Overpriced or under priced
Investment decision
 Valuation techniques

 Depends on standard features and common

optional features:
Payment procedures
Coupon rates
Original issue discount
Maturity period
Call feature
Convertible feature (linked to equity)
 Valuation of bonds
 Value is based on the expected cash flows generated over
the holding period
 Capitalization of cash flow method:

Value = Present value of stream of

future cash flows and principal
value repaid at maturity
discounted at an appropriate
required rate of return
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).
 Required rate of return is a function of
the asset’s risk as well as the risk-free
rate interest rate. If the asset’s
returns are known with certainty, then
there is no risk. The required rate of
return is the risk-free rate.
Capitalization-of-cash flow

  
Using Present value factors

 Sinceinterest payments are equal, the

value can also be calculated as

Vb = C (PVIFA i,n) + M (PVIF i,n)

 Valuation of bonds

 Example:
Find the value of a 6%-coupon bond that can be redeemed
at par when it matures in 10 years. Required rate of
return is 8%.

V = I (PVIFA k,n) + M (PVIF k,n)

= RM60 (6.7101) + RM1000 (0.4632)
= RM402.61 + RM463.20
= RM865.81
 Capitalization-of-cash flow

Bond that pay interest semi-annually

 Bons
 Using Present value factors

 since
interest payments paid semi-annually
are equal, the value can also be calculated
as

V = I/2 (PVIFA k/2,nx2) + M (PVIF k/2,nx2)

Capitalization-of-cash flow

  
Factors affecting value of bonds

 There is an inverse relationship

between a bond’s value and its
required rate of return (kd)
 An equal change in kd changes the
value of a long-term bond more
than the value of a short-term bond
(duration effect)
 Bonds are subject to interest rate
risk and reinvestment rate risk
Impact of market interest rates

Changes or fluctuations in market

interest rate result in changes in
bond value
Inverse relationship -- increase in
market interest rate will lead to
decrease in value of outstanding
bonds, and vice versa
PRICE RISK?
 Measures of bond yields
  
 Measures of bond yields

  
 Calculation of YTM
 Example:
AMP has issued zero-coupon bonds at RM705 that can be
redeemed at par at the end of 6 years. Value of the
bond is:

V = M (PVIF kd,6)
RM705 = 0.7050
RM1000
kd = 6%
5. Summary

 Valuation of debt securities enables the

firm to make comparisons and select the
method of financing which is most cost-
effective or the most viable investments
 Understanding of factors that can affect
the value of debt securities will help the
firm to decide whether issuing debt
securities is a better option compared to
other alternatives
 Quiz time

A corporate bond has an 11%

coupon rate, 20 years to
maturity and a par value of
RM1,000. Compute the value of
the bond:
a) at 10% required rate of
return (rate of interest)
b) at 12% required rate of
return (rate of interest)
Solution:
 PV
b = RM115 (PVIFA 10%,20) +
RM1,000 (PVIF 10%,20)
= RM1,127.70
 PV b = RM115 (PVIFA 12%,20) +
RM1,000 (PVIF 12%,20)
= RM962.70
As market interest rate increases, bond
value decreases. Inverse relationship.
 Quiz time

A zero coupon bond has a

principal value of RM1,000
and matures in 9 years. If
the bond is currently
priced at 45 percent of
par, compute the YTM on
the zero coupon bond.
Solution:


V = M (PVIF kd,n)
RM450 = PVIF kd,9
RM1,000
PVIF kd,9 = 0.4500
kd = 9.28%

Coupon interest is not taken into

consideration since it is a zero-
coupon bond.
 Points of discussion

 Bonds normally have

long maturity period
and are subject to
interest rate risk.
How can investors
protect these
investments against
the interest rate risk?