Chapter

Valuation of Bond

Learning Goals
Describe the key inputs and basic model used in
the valuation process.
Review the basic bond valuation model.
Discuss bond value behavior, particularly the
impact that required return and time to maturity
have on bond value.
Explain yield to maturity and the procedure used
to value bonds that pay interest annually.
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Valuation Fundamentals

i)

Valuation = a process that links return and risk to

determine the worth of an asset.
Three key inputs:
Cash Flows (returns): value of asset depends on the cash

ii)

Timing the time period(s) in which the cash flows are

iii)

Risk and the Required Return: The level of risk associated

flow(s) it is expected to provide over the ownership period.

received, and

with a given cash flow can significantly affect its value. In general, the
greater the risk (or the less certain) a cash flow, the lower its value.
- Required return the interest rate used to discount the future cash
flows to a present value. The selection of the required return allows the
level of risk to be adjusted; the higher the risk, the higher the required
return (discount rate).

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Valuation Fundamentals
The (market) value of any investment asset is simply the present

value of expected cash flows.

The interest rate that these cash flows are discounted at is called
the assets required return.
The required return is a function of the expected rate of inflation and
the perceived risk of the asset.
Higher perceived risk results in a higher required return and lower
asset market values.
The valuation process applies to assets that provide any type of
cash flow (from annual to daily and even continuous time periods) or
even a single cash flow over the investment period. As can be seen
in the valuation equation in the next slide, the size, timing and
required return of cash flows all can be adjusted.
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Basic Valuation Model

V0 =

CF1
(1 + k)

CF2
(1 + k)

+...+

CFn
(1 + k)n

Where:
V0 = value of the asset at time zero
CFt = cash flow expected at the end of year t
k = appropriate required return
(discount rate)
n = relevant time period
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Basic Valuation Model

Using present value interest factor notation, PVIFk,n

V0 = [(CF1 x PVIFk,1)] + [CF2 x (PVIFk,2)] + + [CFn x (PVIFk,n)]

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Example
Nina Diaz, a financial analyst for King industries, a
diversified holding company, wishes to estimate the
value of three of its assets:
1. common stock in Unitech
2. an interest in an oil well, and
3. an original painting by a well-known artist.
Forecasted cash flows, required returns, and the
resulting present values are shown in Table 1 on the
following two slides.
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Basic Valuation Model

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Table 1 (Panel 1)

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Basic Valuation Model

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Table 1 (Panel 2)

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Bond Fundamentals
A bond is a long-term debt instrument that pays the

bondholder a specified amount of periodic interest over a

specified period of time.
Note: a bond is equal to long-term debt instruments used

by business and government to raise large sums of

money.
Most corporate bonds pay interest semiannually (every 6

months) at a stated coupon interest rate, have an initial

maturity of 10 to 30 years, and have a par value, or face
value, of $1,000 that must be repaid at maturity.
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Bond Fundamentals
Par value = the face value of a stock or bond.
Face value = the stated value of an asset. In the case of

a bond, the face value is usually $1,000.00

The bonds principal is the amount borrowed by the
company and the amount owed to the bondholder
on the maturity date.
The bonds maturity date is the time at which a bond
becomes due and the principal must be repaid.
The bonds coupon rate is the specified interest rate
(or dollar amount) that must be periodically paid.
The bonds current yield is the annual interest (income)
divided by the current price of the security.

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Bond Fundamentals
The bonds yield to maturity is the yield (expressed

as a compound rate of return) earned on a bond

from the time it is acquired until the maturity date
of the bond.
A yield curve graphically shows the relationship

between the time to maturity and yields for debt

in a given risk class.

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Bond Valuation Equation

B0 I

B0

t 1

1
1

n
(1 k d ) t
(1 k d )

= I x (PVIFA kd,n) + M x (PVIF kd,n)

The basic bond valuation equation for a bond that pays annual interest is:
where:
B0
=
value of a bond at time zero
I
n
M
kd

=
=
=
=

annual interest paid in dollars

number of years to maturity
par value of a bond in dollars
required return on a bond

To find the value of bonds paying interest semiannually, the basic bond valuation equation is
adjusted as follows to account for the more frequent payment of interest:
1. The annual interest must be converted to semiannual interest by dividing by 2
2. The number of years to maturity must be multiplied by 2; and
3. The required return must be converted to a semiannual rate by dividing it by 2

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Required Returns and Bond Values

Whenever the required return on a bond differs from the bonds coupon

interest rate, the bonds value will differ from its par value.
A bond sells at a discount when the required return exceeds the coupon rate
(M B0). It sells at a premium when the required return is less than the coupon
rate. It sells at par value when the required return equals the coupon rate (B0
M).
The coupon rate is generally a fixed rate of interest, whereas the required
return fluctuates with shifts in the cost of long-term funds due to economic
conditions and/or risk of the issuing firm. The disparity between the required
rate and the coupon rate will cause the bond to be sold at a discount or
premium.
If the required return on a bond is constant until maturity and different from the
coupon interest rate, the bonds value approaches its $1,000 par value as the
time to maturity declines.
To protect against the impact of rising interest rates, a risk-averse investor
would prefer bonds with shorter periods until maturity. The responsiveness of
the bonds market value (price) to interest rate fluctuations is an increasing
function of the time to maturity.

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Bonds with Maturity Dates

Annual Compounding

B0 =

I1
(1 + i)

I2
(1 + i)

+...+

(In + Pn)
(1 + i)n

For example, find the price of a 10% coupon bond

with three years to maturity if market interest rates
are currently 10%.

B0 =

100
(1 + .10)1

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100
(1 + i)2

(100 + 1,000)
(1 + .10)3
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Coupon Effects
on Price Volatility
The amount of bond price volatility depends on three basic factors:
Length of time to maturity
Risk
Amount of coupon interest paid by the bond

First, we already have seen that the longer the term to maturity,

the greater is a bonds volatility.

Second, the riskier a bond, the more variable the required return

will be, resulting in greater price volatility.

Finally, the amount of coupon interest also impacts a bonds

price volatility.
Specifically, the lower the coupon rate, the greater will be the bonds

volatility, because it will be longer before the investor receives

a significant portion (the par value) of the cash flow from his
or her investment.
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Coupon Effects
on Price Volatility

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Price Converges
on Par at Maturity
It is also important to note that a bonds price will

approach par value as it approaches the maturity date,

regardless of the interest rate and regardless of the
coupon rate.

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Price Converges
on Par at Maturity
It is also important to note that a bonds price will approach par

value as it approaches the maturity date, regardless of the interest

rate and regardless of the coupon rate.

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Yields
The current yield measures the annual return

to an investor based on the current price.

Current yield =

Annual coupon interest

Current market price

For example, a 10% coupon bond which is currently

selling at $1,150 would have a current yield of:

Current yield =

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$100
$1,150

= 8.7%

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Yields
The yield to maturity measures the compound annual

return to an investor and considers all bond cash flows.

It is essentially the bonds IRR based on the current price.
PV =

I1
(1 + i)1

I2
(1 + i)2

+...+

(In + Pn)
(1 + i)n

Notice that this is the same equation we saw earlier when

we solved for price. The only difference then was that we

were solving for a different unknown. In this case, we
know the market price but are solving for return.
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Yield to Maturity (YTM)

The yield to maturity (YTM) on a bond is the rate investors earn if they buy the bond at a specific price and hold it until

maturity.
The yield to maturity measures the compound annual return to an investor and considers all bond cash flows.

It is essentially the bonds IRR based on the current price.

Note that the yield to maturity will only be equal to the current yield if the bond is selling for its face value ($1,000).
And that rate will also be the same as the bonds coupon rate.
For premium bonds, the current yield > YTM.
For discount bonds, the current yield < YTM.

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Example

Northern Company, a large defense contractor, on January 1, 2002, issued

a 10% coupon interest rate, 10-year bond with a $1,000 par value that
pays interest semiannually. Investors who buy this bond receive the
contractual right to two cash flows:
(1) $100 annual interest (10% coupon interest rate X $1,000 par value)
distributed as $50 (1/2 x $100) at the end of each 6 months, and
(2) the $1,000 par value at the end of the tenth year

Required:
1) Assuming that interest on the Northern Company bond issue is paid
annually and that the required return is equal to the bonds coupon interest
rate, I = $100, kd = 10%, M = $1,000 and n = 10 years, calculate the bond
value.
2) Assuming that the Northern Company bond pays interest semiannually and
that the required return, kd, is 12% for similar-risk bonds that also pay
semiannual interest, calculate the bond value.
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