Bond Valuation

Corporate Finance
Dr. A. DeMaskey

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 Learning Objectives

 Questions to be answered:
 What is a bond?
 Who issues bonds?
 What are the key characteristics of bonds?
 How are bonds valued?
 What is the rate of return on a bond?
 What types of risk are bondholders exposed to?

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 Types of Bonds

 Treasury Bonds
 Corporate Bonds
 Municipal Bonds
 Foreign Bonds

3
 Basic Terminology

 Bond
 Par Value
 Coupon Interest Payment
 Coupon Interest Rate
 Maturity Date
 Bond’s Market Rate of Interest, kd

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 Financial Asset Valuation

0 1 2 n
k
...
Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + + ... + .
1+ k 1
1 + k2
1+ k n

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 Required Rate of Return

 The discount rate (ki) is the opportunity cost

of capital, i.e., the rate that could be earned
on alternative investments of equal risk.

ki = k* + IP + LP + MRP + DRP

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 Default Risk

 Risk that issuer will not make interest

or principal payments.
 Increases required rate of return
 Bond ratings provide one measure of
default risk
 Defaulting on bonds may result in
bankruptcy and/or reorganization

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 Value of Bond
0 1 2 10
10% ...
V=? 100 100 100 + 1,000

$100 $100 $1,000

VB  + . . . + +
1 + k d  1 + k d  1+ k d 
1 10 10

= $90.91 + . . . + $38.55 + $385.54

= $1,000.

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 Annual Coupon Bonds

N
INT M
VB   
t 1 1  k d  1  k d 
t N

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 Semiannual Coupon Bonds

 Multiply years by 2 to get periods = 2n.

 Divide nominal rate by 2 to get periodic
rate = kd/2.
 Divide annual INT by 2 to get PMT = INT/2.
2N
INT / 2 M
VB   
t 1 1  k d / 2  1  k d / 2 
t 2N

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 General Observations About
Bond Values
 If coupon rate < kd, bond sells at a discount.
 If coupon rate > kd, bond sells at a premium.
 If coupon rate = kd, bond sells at its par
value.
 If kd rises, price falls; if kd falls, price rises.
 At maturity, the value of a bond equals par.

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 Changes in Bond Values Over
Time
 At maturity, the value of any bond must equal
its par value.
 The value of a premium bond would decrease
to $1,000.
 The value of a discount bond would increase
to $1,000.
 A par bond stays at $1,000 if kd remains
constant.

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 Time Path of Bond Value

Bond Value ($)

1,372 kd = 7%.
1,211

kd = 10%. M
1,000

837 kd = 13%.
775

30 25 20 15 10 5 0

Years remaining to Maturity

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 Bond Yields

 Yield-to-Maturity (YTM)
 Effective Annual Return on Bond
 Yield-to-Call
 Current Yield

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 Yield-to-Maturity

 YTM is the rate of return earned on a bond

held to maturity, also called “promised
yield.”
 It is the discount rate that equates the present
value of the interest and principal payments
to the price of the bond.
 Annualized YTM = 2 x six-month yield
 Effective YTM = (1 + six-month yield)2 - 1

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 Total Return or Yield on Bond

 The effective annual return on a bond is

equal to its current yield and capital gains
yield.
 Current yield
 Capital gains yield
 YTM = Current yield + Capital gains yield
 Effective annual yield
 (1 + semiannual return)2 -1

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 Yield-to-Call

 Call Provision
 Callable bonds
 Call premium
 Refunding operation
 YTC is the average annual return an investor
will receive if the bond is held until its
expected call date.

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 Current Yield

 Annual interest payment/Current value of

bond
 Provides information about cash income on
bond.
 Does not provide accurate measure of total
expected return on bond.

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 Interest Rate Risk
 Rising interest rates have an adverse effect on bond
values.
 The longer the maturity of a bond, the greater the
exposure to interest rate risk.
kd 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,000 4.8% 1,000 38.6%

15% 956 4.4% 749 25.1%

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 Interest Rate Risk
Value
1,500 10-year

1,000 1-year

500

0 kd
0% 5% 10% 15%

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 Reinvestment Rate Risk

 The risk that CFs will have to be

reinvested in the future at lower rates,
reducing income.
 The shorter the maturity of the bond,
the greater the risk of a decrease in
interest rates.

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