Chapter 7a- Bonds Valuation

8/2/2019 Chapter 7a- Bonds Valuation

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BOND VALUATION

From: Basic Financial Management

Seventh EditionChapter 7

Chapter

7A


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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 Bonda bond secured by a lien on real property.


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Terminology and Characteristics of Bonds

(Continued)

Zero and Very Low Coupon Bondsbonds 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 inEurope or Asia by an American company that

pays interest and principal in U.S. dollars.


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Features or Characteristics of Bonds

Claim on Assets and Income in case of

insolvency, claims of debt in general, includingbonds, are honored before those of the

preferred and ordinary shares of stock. Bonds also

have claim on income that comes ahead ofcommon and preferred stocks.

Par Value bonds face value that is returned to

the bondholder at maturity, usually $1,000.Coupon Interest Rateindicates what percentage

of the par value of the bond will be paid out

annually in the form of interest.


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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 thebond issuer returns the par value to the

bondholder and terminates the bond.


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Valuation is an important issue if we are to manage acompany effectively. And understanding of theconcepts and how to compute the value of asecurity underlie much that we do in finance andin making correct decisions for the firm as a

whole. Only if we know what matters to ourinvestors can we maximize the firms value.

Value is defined differently depending on the context.But for us, value is the present value of futurecash flows expected to be received from aninvestment discounted at the investors requiredrate of return.

Definitions of Value


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Definitions of Value (Continued)

Book Valuethe value of an asset as shown on a

firms balance sheet. It represents the historicalcost of the asset rather than its current market

value or replacement cost.

Liquidation Valuethe amount that could be

realized if an asset were sold individually and not

as a part of the going concern.

Market Valuethe observed value for an asset in

the market place.


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Intrinsic or Economic Valuethe present

value of the assets expected future cashflows. This value is the amount the

investor considers to be a fair value, given

the amount, timing, and riskiness of futurecash flows.

Efficient Marketa 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

Definitions of Value (Continued)


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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 ofreturn 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.


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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.

Valuation: Understanding the Process

(Continued)


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*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 thebond.


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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.


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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 causedby changing interest rates is calledInterest Rate

Risk.


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Bond Valuation: (Continued)


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.


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3. As a bond approaches maturity, the market

price of the bond approaches the par value.

4. A bondholder owning a long-term bond isexposed to greater interest rate risk than

one owning a short-term bond.




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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 ofinterim cash flows, or its duration.


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Bond Valuation:

Exercise Problems

Ex. #1- Wapoco bonds have a coupon rate of 8%, apar 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? Whathappens if you pay more for the bond? What

happens if you pay less for the bond?

B d V l ti


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Value (Vb) = +

Bond Valuation:

Solution to Exercise#1

20

t=1(1.07) t

$80 $1,000

20(1.07)

Thus,

Present value of interest: $80(10.594) =$ 847.52

Present value of par value: $1,000(0.258) =$ 258.00

Value of the Bond (Vb) =$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.

B d V l i


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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 thebond? How would your answer change if the

interest were paid annually?

Bond Valuation:

Exercise Problems


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Bond Valuation:

Solution toExercise#2

If interest is paid semiannually:

Value (Vb) =

Thus,

$40(9.899) = $ 395.96

$1,000(0.505) = $ 505.00

Value (Vb) = $ 900.96

=======

If interest is paid annually:

Value (Vb) =

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

Value (Vb) = $902.44

=======

14t=1

(1+0.05)

$40 $1,000

t (1+0.05)14

7

t=1

$80

( 1.10)

t

$1,000

( 1.10)

7

+

+


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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:

Exercise Problems

B d V l ti


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$1,045 =

At 6%: $70(9.712) + $1,000(0.417)=$1,096.84

At 7%: Value must equal $1,000.Interpolation:

Expected Rate of Return:

= 6% + (1%) = 6.54%

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

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

Bond Valuation:

Solution toExercise#3

15$70( 1+k )

$1,000t

t=1+

( 1+k )

15

$51.84

$96.84k

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Chapter 7a- Bonds Valuation