Chapter 7A

BOND VALUATION
From: Basic Financial Management Seventh Edition Chapter 7

Terminology and Characteristics of Bonds

Bonds a type of debt or long-term promissory note, issued by the borrower, promising to pay its holder a predetermined and fixed amount of interest each year. Types of Bonds: Debenture- any unsecured long-term debt. Subordinated Debentures a debenture that is subordinated to other debentures in being paid in case of insolvency. Mortgage Bond a bond secured by a lien on real property.

Terminology and Characteristics of Bonds (Continued)

Zero and Very Low Coupon Bonds bonds issued at a substantial discount from their $1,000 face value that pay no or little interest. Junk or Low-Rated Bonds bonds rated BB or below. Eurobonds bonds issued in a country different from the one in whose currency the bond is denominated for instance, a bond issued in Europe or Asia by an American company that pays interest and principal in U.S. dollars.

Features or Characteristics of Bonds Claim on Assets and Income in case of insolvency, claims of debt in general, including bonds, are honored before those of the preferred and ordinary shares of stock. Bonds also have claim on income that comes ahead of common and preferred stocks. Par Value bonds face value that is returned to the bondholder at maturity, usually $1,000. Coupon Interest Rate indicates what percentage of the par value of the bond will be paid out annually in the form of interest.

Features or Characteristics of Bonds (Continued)

Indenture the legal agreement or contract between the firm issuing the bonds and the bond trustee who represents the bondholders. Current Yield the ratio of the interest payment to the bonds market price. Maturity the length of time until the bond issuer returns the par value to the bondholder and terminates the bond.

Definitions of Value
Valuation is an important issue if we are to manage a company effectively. And understanding of the concepts and how to compute the value of a security underlie much that we do in finance and in making correct decisions for the firm as a whole. Only if we know what matters to our investors can we maximize the firms value. Value is defined differently depending on the context. But for us, value is the present value of future cash flows expected to be received from an investment discounted at the investors required rate of return.

Definitions of Value (Continued)

Book Value the value of an asset as shown on a firms balance sheet. It represents the historical cost of the asset rather than its current market value or replacement cost. Liquidation Value the amount that could be realized if an asset were sold individually and not as a part of the going concern. Market Value the observed value for an asset in the market place.

Definitions of Value (Continued)

Intrinsic or Economic Value the present value of the assets expected future cash flows. This value is the amount the investor considers to be a fair value, given the amount, timing, and riskiness of future cash flows. Efficient Market a market in which the values of securities at any instant in time fully reflect all available information, which results in the market value and the

Valuation: Understanding the Process

Valuation process can be described as follows: It is assigning value to an asset by calculating the present value of its expected future cash flows using the investors required rate of return as the discount rate. The investors required rate of return, k, equals the risk-free rate of interest plus a risk premium to compensate the investor for assuming risk.

Valuation: Understanding the Process (Continued) Elements that affect the value of an asset: 1. The amount and timing of the assets expected cash flows; 2. The riskiness of these cash flows; and 3. The investors required rate of return for undertaking the investment.

*Bond Valuation*
The value of a BOND is the present value both of future interest to be received and the par or maturity value of the bond.

Bondholders Expected Rates of Return

Expected Rate of Return the discount rate that equates the present value of the future cash flows (interest and maturity value) with the current market price of the bond. It is the rate of return an investor will earn if a bond is held to maturity.

Yield to Maturity the same as the expected rate of return.

Bond Valuation: Five Important Relationships

1. A decrease in interest rates (required rates of return) will cause the value of the bond to increase; an interest rate increase will cause a decrease in value. The change in value caused by changing interest rates is called Interest Rate Risk.

Bond Valuation: (Continued) Five Important Relationships 2. If the bondholders required rate of return (current interest rate): a.) Equals the coupon interest rate, the bond will sell at par, or maturity value. b.) Exceeds the bonds coupon rate, the bond will sell below par value, or at a discount. c.) Is less than the bonds coupon rate, the bond will sell above par value, or at a premium.

Bond Valuation: (Continued) Five Important Relationships 3. As a bond approaches maturity, the market price of the bond approaches the par value. 4. A bondholder owning a long-term bond is exposed to greater interest rate risk than one owning a short-term bond.

Bond Valuation: (Continued) Five Important Relationships 5. The sensitivity of a bonds value to interest rate changes is not only affected by the time to maturity, but also by the time pattern of interim cash flows, or its duration.

Bond Valuation: Exercise Problems

Ex. #1- Wapoco bonds have a coupon rate of 8%, a par value of P 1,000, and will mature in 20 years. If you require a return of 7%, what price would you be willing to pay for the bond? What happens if you pay more for the bond? What happens if you pay less for the bond?

Bond Valuation: Solution to Exercise#1

Value (Vb) = +
20

$80
(1.07)
t

$1,000
(1.07)
20

t=1

Thus, Present value of interest: $80(10.594) Present value of par value: $1,000(0.258) Value of the Bond (Vb)

=$ 847.52 =$ 258.00 =$1,105.52 ========

If you pay more for the bond, your required rate of return will not be satisfied. In other words, by paying an amount for the bond that exceeds $1,105.52, the expected rate of return for the bond is less than the required rate of return. If you have the opportunity to pay less for the bond, the expected rate of return exceeds the 7% required rate of return.

Bond Valuation: Exercise Problems Ex. #2-Gandania Co.s bonds, maturing in 7 years , pay 8% on a $1,000 face value. However, interest is paid semiannually. If your required rate of return is 10%, what is the value of the bond? How would your answer change if the interest were paid annually?

Bond Valuation: Solution toExercise#2

If interest is paid semiannually: Value (Vb) =
14

t=1

$40 t (1+0.05)

$1,000 (1+0.05)
14

Thus, $40(9.899) = $ 395.96 $1,000(0.505) = $ 505.00 Value (Vb) = $ 900.96 ======= If interest is paid annually: Value (Vb) =

( 1.10)
t=1 t

$80

$1,000

( 1.10)

Value (Vb) = $80(4.868) + $1,000(0.513) Value (Vb) = $902.44 =======

Bond Valuation: Exercise Problems Ex. #3 (Expected Rate of Return) Ganansia Co.s bonds are selling in the market for $1,045. These 15-year bonds pay 7% interest annually on a $1,000 par value. If they are purchased at the market price, what is the expected rate of return?

Bond Valuation: Solution toExercise#3

$1,045 =
15

(1+k)
t=1

$70

$1,000
(1+k)
15

At 6%: $70(9.712) + $1,000(0.417)=$1,096.84 At 7%: Value must equal $1,000. Interpolation: Expected Rate of Return:
k

$51.84 = 6% + (1%) $96.84

= 6.54%

$1,096.84-$1,000 = $ 96.84 $1,096.84-$1,045 = $ 51.84