BPB23403

FINANCIAL AND
INVESTMENT
MANAGEMENT

VALUATION OF BONDS
Learning objectives:

1. Definition and types of Bonds

2. Terminology & Characteristics of Bonds
3. Concepts of Valuation
4. Bond Valuation
5. Bondholder’s Expected Rate of Return
(Yield to Maturity-YTM)
6. Bond Value: Three Important Relationships
 FUNDS

DEBT EQUITY
Bonds Common Stock
Preferred Stock
Example
 Definition of Bonds

A type of debt (long-term promissory

note) issued by the borrower,
promising to pay fixed coupon
(interest) payments at fixed intervals (6
months, 1 year etc ) and pay the par
value at maturity.
 Types of Bonds

• Debentures
• Subordinated debentures
• Mortgage bonds
• Eurobonds
• Zero and low coupon bonds
• Junk bonds
 Terminology & Characteristic of Bonds

a. Par Value (M) : the bond’s face value that is returned

to the bondholder at maturity, usually RM1000
b. Coupon Interest Rate ( I ) : percentage of the par
value of the bond will be paid out annually
c. Maturity ( n ) : The length of time until the bond
issuer returns the par value to the bondholder and
terminates the bond
e.g. Par Value : RM1000, Interest 5%(annually),
Maturity 4 years
RM1000
RM50 RM50 RM50 RM50

0 1 2 3 4
 Terminology & Characteristic of Bonds

d. Claims on Asset and Income : bonds have a claim on

Assets and Income that comes ahead of common stock
and preferred stock
e. Indenture : the legal agreement between the firm
issuing the bonds and the bond trustee who represents
the bondholders
f. Current Yield : the ratio of the annual interest payment
to the bond’s market price.

Current Yield = Annual interest payment

Market price of the bond
 Terminology & Characteristic of Bonds

g. Bond Ratings : the ratings involve a judgment

about the future risk potential of the bond. The
poorer the bond rating (BBB,CCC) the higher the
rate of return demanded in the capital markets.
They are affected by:
 a greater reliance on equity as opposed to
debt in financing the firm
 profitable operations
 a low variability in past earnings
 large firm size
 little use of subordinated debt
 Valuation: Basic process
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.
 Basic security valuation model can be defined as :
n

S
Ct
V = (1 + k) t
t=1
V = the intrinsic value of the asset.
Ct = cash flow to be received at time t.
k = the investor’s required rate of return.
 Bond Valuation
 The value of the bond is the present value of future
interest ( I ) and the par value (M) of the bond.
 3 essential elements in bond valuation
- the amount and timing of the cash flows ( I & M)
- the time to maturity of the bond (n)
- the investor’s required rate of return (kb)
 Discount the bond’s cash flows at the investor’s
required rate of return.
 the coupon interest rate (an annuity > use PVIFA).
 the par value payment (a single sum> use PVIF).
 n

S
It M
A) Vb = (1 + kb)t
+ (1 + kb)n
t=1
Vb : value of bond
I : interest payment
M : par value
Kb : investor’s required rate of return
n : time to maturity
or
B) Vb = RMIt (PVIFA kb, n) + RMM (PVIF kb, n)
 Bonds Valuation: Annual Interest Payment

 Example: Calculate the value of a bond that expects

to mature in 5 years and has a RM1000 face value.
The coupon interest rate is 8% and the investor’s
required rate of return is 12%

Thus ; I = RM80, M = RM1000, n = 5 years, kb =

12% 1000
80 80 80 80 80

0 1 2 3 4 5
Bonds Valuation: Annual Interest Payment

RM80 RM1000
+
 Vb = ∑ (1 + 0.12)t (1 + 0.12)5

(by using the table of PV)

RM80(PVIFA 12%,5) +RM1000(PVIF 12%,5)

= RM80(3.6048) + RM1000(0.5674)
= RM288.38 + RM567.40
= RM855.78
Bond Valuation – Semiannual Interest Payment

 Example : SEG Co. bonds mature in 3 years and pay

10% interest semiannually. Their par value is
RM1000. If your required rate of return is 8%, what
is the value of bond?
 Formula for semiannually interest payment:

Vb = (RMIt /2 )(PVIFA kb/2, 2n) + RMM (PVIF kb/2, 2n)

Thus = I : 10%/2, Kb : 8%/2, n : 3x2, M : RM1000

100
50 50 50 50 50 0 50

0 1 2 3 4 5 6
Bond Valuation – Semiannual Interest Payment

Vb = (RMIt /2 )(PVIFA kb/2, 2n) + RMM (PVIF kb/2, 2n)

= (RM100/2)(PVIFA 8%/2, 3 x 2) + RM1000 (PVIF 8%/2, 3 x 2)

= RM50(5.2421) + RM1000 (0.7903)

= RM262.11 + RM790.30
= RM1052.41
 Exercise : Bond Valuation (Vb)

1. You own a bond that pay RM100 in annual

interest, with a RM1000 par value. It matures in
15 years. Your required rate of return is 12%.
Calculate the value of the bond.
2. Telink Corporation bonds pay RM110 in annual
interest, with a RM1000 par value. The bond
mature in 20 years. Your required rate of return
is 9%. Calculate the value of the bond.
 Exercise: Bond Valuation (Vb)
3. Calculate the value of a bond that expects to mature
in 10 years and has a RM1000 face value. The
coupon interest rate is 9% that paid semiannually
and the investor’s required rate of return is 15%.
4. A bond have a 10% coupon rate. The interest is paid
semiannually and the bond mature in 11 years. Their
par value is RM1000. If your required rate of return
is 9%, what is the value of the bond?
 Bondholder’s Expected Rate of Return
(Yield to Maturity-YTM)

 YTM (bondholder’s expected rate of return) is the

discount rate that will equates the present value of
the future cash flows with the current market
price of the bond.
 Example: A bond’s market price is RM1100. It has
a RM1000 par value, will mature in 5 years and
pays interest 10% annually. What is your expected
rate of return (YTM)? 1000
100 100 100 100 100
1100

0 1 2 3 4 5
 I : Interest
M - MP
YTM : I+ n M : Par Value
MP : Market Price
M + MP n : year
2

YTM: 100 + (1000 -1100) / 5

= 7.6%
1000 + 1100 / 2
 Exercise YTM

1. The market price is RM900 for a 10 years bond

(RM1000 par value) that pay interest 8%
semiannually. What is the bond’s expected rate of
return?
2. Exxon 20 years bond pay 9% interest annually on a
RM1000 par value. If bonds sell at RM945, what is
the bond’s yield to maturity?
 Exercise YTM
3. A bond’s market price is RM950. It has a RM1000
par value, will mature in 8 years, and pay 9%
interest (4.5% semiannually). What is your expected
rate of return?
4. Zebner’s Corporation bonds mature in 14 years and
pay 7% annually. If you purchase the bonds for
RM1110, what is your expected rate of return?
 Bond Value: Three Important Relationship

1. 1st relationship: A decrease in interest rates (required rate of

return) will cause the value of a bond to increase; an interest
rate increase will cause decrease in value – interest rate risk.
2. 2nd relationship:
a. If the bondholder’s required rate of return (current
interest rate) equals the coupon interest rate, the bond will
sell at par, or maturity value.
b. If the current interest rate exceeds the bond’s coupon rate,
the bond will sell below par, or at a “discount”
c. If the current interest rate is less than the bond’s coupon
rate, the bond will sell above par, or at a “premium”
3. 3rd relationship: A bondholder owning a long-term bond is
exposed to greater interest rate risk than when owning a short-
term bonds.
 Types of Bonds

 Debentures - Unsecured long-term debt.

 Subordinated debentures – bonds that have a lower
claim on assets in the event of liquidation than do
other senior debt holders.
 Mortgage bonds – bonds secured by lien on a
specific assets of the firm, such as real estate.
 Eurobonds – bond issued in a country different from
the one in whose currency the bond is denominated;
for instance, a bond issued in Europe or Asia that
pays interest and principal in U.S. dollars.
 Types of Bonds

 Zero and low coupon bonds – allow the issuing firm

to issue bonds at a substantial discount from their
$1,000 face value with a zero or very low coupon.
 The disadvantages are, when the bond matures, the issuing
firm will face an extremely large non-deductible cash outflow
much greater than the cash inflow they experiences when the
bonds were first issued.
 Discount bonds are not callable and can only be retired only at
maturity.
 On the other hand, annual cash outflows associated with
interest payments do not occur with zero coupon bonds.
 Junk bonds – bonds rated BB or below.