BUSINESS
FINANCE
Aya Selim
Fall 2023
Bond Valuation
Bond Valuation
■ What is Interest Rates & Required rate of return?
■ Corporate Bonds
■ Bond Valuation
■ Bond Value behavior
– Required rate of return & Bond Value
– Yield to maturity (YTM) & Bond Value
– Semiannual interest & Bond value
– Time to maturity & Bond value
Interest Rates & Required rate of return
■ Required return Usually applied to equity instruments such as common stock; the
cost of funds obtained by selling an ownership interest.
■ Interest Rates Usually applied to debt instruments such as bank loans or bonds; the
compensation paid by the borrower of funds to the lender; from the borrower’s point of
view, the cost of borrowing funds.
– Real rate of interest: The rate that creates equilibrium between the supply of savings and
the demand for investment funds in a perfect world, without inflation, where suppliers and
demanders of funds have no liquidity preferences and there is no risk.
– Nominal interest rate: The actual rate of interest charged by the supplier of funds and paid
by the demander.
**The nominal rate of interest differs from the real rate of interest, r*, as a result of two
factors, inflation and risk.
r nominal= r* + IP + RPremium
RF
Interest Rates Cont’d
■ Term Structure of Interest rates The relationship between the time to maturity and the
yield to maturity of bonds with similar levels of risk.
– Time to maturity is the number of years of a bond until it matures
– Yield to maturity is the compound annual rate of return that an investor earns on the bond
assuming that the bond makes all promised payments and the investor holds the bond to
maturity
■ Yield Curve A graphic depiction of this relationship; the term structure of interest rates.
Inverted Yield Curve Blue: A downward-sloping yield
curve indicates that short-term interest rates are higher
than long-term interest rates.
Flat Yield Curve Green: A yield curve that indicates that
interest rates do not vary much at different maturities.
Normal Yield Curve Orange: An upward-sloping yield
curve indicates that long-term interest rates are higher
than short-term interest rates.
Corporate Bonds
■ Corporate Bonds A long-term debt instrument indicating that a corporation has
borrowed a certain amount of money and promises to repay it in the future under clearly
defined terms.
– Maturities: 3 to 30 years
– Bond Price: Par value, or face value, of $1,000.
– Bond Price is the current market price of the bond; although corporate bonds are issued with a
par value of $1,000, their market price throughout the life of the bond is different
– Coupon interest rate: The percentage of the bond’s par value that will be paid annually, typically
in two equal semiannual payments, as interest.
– Bond Yield is a measure of a bond’s cash return for the year
Bond Yield = (Par Value x Coupon Rate) ÷ Bond Price
– Bond Rating: Independent agencies such as Moody’s, Fitch, and Standard & Poor’s who assess
the riskiness of publicly traded bonds. They derive their ratings by using financial ratio and cash
flow analyses to assess the likely payment of bond interest and principal. For example: AAA for
prime quality Bonds a D for defaulting Bonds
Corporate Bonds Cont’d
■ Eurobonds
– Issued by an international borrower and sold to investors in countries with
currencies other than the currency in which the bond is denominated.
– Example is a dollar-denominated bond issued by a U.S. corporation and sold in
Switzerland.
– Companies can borrow at interest rates below of their country’s Treasury bonds.
■ Foreign bonds
– Issued by a foreign corporation and is denominated in the investor’s home currency
and sold in the investor’s home market.
– Example is a Swiss-franc–denominated bond issued in Switzerland by a U.S.
company
Bond Valuation
Bond Valuation is the process that links risk and return to determine the worth of a bond; The value of a bond is the
present value of the cash inflows discounted at the bond’s required rate of return
■ Key Inputs of bond valuation:
– Cashflows “Coupons and Par value”, Time “Timing of the cashflows”, Risk & Return “The level of risk
associated with a given cashflow”
B0 = C x []+ M x [ ]
Excel: B0 = PV(rate, nper, -coupon, -par value)
Where
B0 = value of the bond at time zero “purchase price”
C= coupon paid
M = par value
r = required return on the bond
Purchase Price
n = number Coupon
of years to maturity Coupon Coupon Coupon + Par Value
Cash Outflow Cash Inflow
Bond Valuation Cont’d
Bond Valuation Example:
■ Sara wishes to determine the current value of the Bond A. Assuming that interest on the
bond issue is paid annually and that the required return is equal to the bond’s coupon
interest rate, C = $100, r= 10%, M = $1,000, and n = 10 years.
B0 = C x []+ M x [ ]
B0 = [ + + + …. + ]+
B0 = $614 + $ 386 = $1,000
Excel: B0 = PV(0.1, 10, -100, -1,000)
** Note that the calculated bond value is equal to its par value; this will always be the
case when the required return is equal to the coupon interest rate.
Bond Value Behavior
■ Required rate of return & Bond Value: Whenever the required return on a bond
differs from the bond’s coupon interest rate, the bond’s value will differ from its par
value.
– When the required return > the coupon interest rate, B 0 < the par value, M. In this case, the
bond is said to sell at a discount, which will equal M - B0
– When the required return < the coupon interest rate, B 0 > the par value. In this situation,
the bond is said to sell at a premium, which will equal B0 - M.
Bond Value Behavior Cont’d
■ Yield to maturity (YTM) & Bond Value: The YTM is the compound annual rate of
return earned on a bond purchased on a given day and held to maturity; investors use it
to evaluate bonds.
– When B0 = M, YTM = Coupon interest rate
– When B0 ≠ M, YTM ≠ Coupon interest rate
■ Example:
Mohamed wishes to find the YTM on Mills Company’s bond. The bond currently sells for
$1,080, has a 10% coupon interest rate and $1,000 par value, pays interest annually, and has
10 years to maturity.
Excel: YTM = Rate(nper, pmt, -pv, fv, 0)
Excel: YTM = Rate(10, 100, -1,080, 1,000, 0) = 8.766%
Bond Value Behavior Cont’d
■ Semiannual interest & Bond value: It’s similar to that of compounding interest more frequently
than annually, except that here we need to find present value instead of future value. It involves
– Converting coupon to semiannual interest by dividing c by 2.
– Converting the number of years to maturity, n, to the number of 6-month periods to maturity
by multiplying n by 2.
– Converting the required annual return for similar-risk bonds that also pay semiannual
interest from an annual rate, r, to a semiannual rate by dividing r by 2.
+
Bond Value Behavior Cont’d
■ Semiannual interest & Bond value Example:
Sara wishes to determine the current value of the Bond A. Assuming that the bond pays interest
semiannually and that the required stated annual return, r, is 12% for similar-risk bonds that also
pay semiannual interest, C = $100, r= 12%, M = $1,000, and n = 10 years.
+
B0 = PV(0.06, 20, -50, -1000) = $885.30
**Comparing this result with the $887.00 value found earlier for annual compounding, we can see that the
bond’s value is lower when semiannual interest is paid. This will always occur when the bond sells at a
discount. For bonds selling at a premium, the value with semiannual interest will be greater than with
annual interest.
Bond Value Behavior Cont’d
■ Time to maturity & Bond value: Whenever the required return is different from the coupon
interest rate, the amount of time to maturity affects bond value.
Constant Required Returns When the
required return is different from the coupon
interest rate and is constant until maturity,
the value of the bond will approach its par
value as the passage of time moves the
bond’s value closer to maturity.
