Valuation of bonds and debentures

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<ul><li> SUBMITTED TO: SIR. SRINIVAS. FACULTY. DOS IN COMMERCE. MANASAGANGOTHRI. MYSORE. </li> <li> INTRODUCTION. MEANING AND DEFINITION. BONDS. DEBENTURES. DIFFERENCE BETWEEN THEM. VALUATION OF BONDS AND DEBENTURE VALUE. ILLUSTRATION. CONCLUSION. REFERENCE. </li> <li> Life is full of surprises, and even more so when it comes to finances. A person having a good income today may face financial crisis in future. To avoid these unforeseen financial crises everyone invests in different instruments that can fetch extra income. There are many options available in the market that can be classified as risky and non risky. It is very well understood that risky options yield higher gains but non risky ones can give very low returns. Debentures and bonds are two such options that can be taken for good returns on ones investment. Debenture is an instrument issued by a company that can be convertible or non convertible into equities. Bonds are issued by companies or by government and can be seen as a loan taken by them to meet their financial needs. These two instruments are basically loan taken from the investor but have very different repayment conditions. </li> <li> A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and central governments and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents. </li> <li> A type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are documented in an indenture. Debentures have no collateral. Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default on the repayment. An example of a government debenture would be any government- issued Treasury bond (T-bond) or Treasury bill (T-bill). T- bonds and T-bills are generally considered risk free because governments, at worst, can print off more money or raise taxes to pay these types of debts. </li> <li> Both bonds and debentures are instruments available to a company to raise money from the public. This is the similarity between the two, but on closer inspection, we find that there are many glaring differences between the two. Bonds are more secure than debentures. As a debenture holder, you provide unsecured loan to the company. It carries a higher rate of interest as the company does not give any collateral to you for your money. For this reason bond holders receive a lower rate of interest but are more secure. </li> <li> If there is any bankruptcy, bondholders are paid first and the liability towards debenture holders is less. Debenture holders get periodical interest on their money and upon completion of the term they get their principal amount back. Bond holders do not receive periodical payments. Rather, they get principal plus interest accrued upon the completion of the term. They are much more secure than debentures and are issued mostly by government firms. </li> <li> Bonds are more secure than debentures, but the rate of interest is lower Debentures are unsecured loans but carries a higher rate of interest In bankruptcy, bondholders are paid first, but liability towards debenture holders is less Debenture holders get periodical interest Bond holders receive accrued payment upon completion of the term Bonds are more secure as they are mostly issued by government firms </li> <li> 1. Determine the coupon rate of the bond. The coupon rate is the yield of the bond at par value. For example, a bond with a face value of $1000 and a coupon rate of 10% pays $100 interest annually. 2. Divide the annual interest amount by the number of times interest is paid per year, to arrive at I. For example, if the bond pays interest semi-annually, it pays I = $50 per period (6 months) </li> <li> 3. Determine the minimum rate of return required, or discount rate. How high a rate of return is acceptable to you to invest in the bond? Take into consideration the inflation rate (historically around 10- 12% per year), the quality of the bond (higher rate of return is required to compensate for more risky issues), the current market interest rate of issues of similar quality), and the rates of return offered by alternative investments. The discount rate takes the time value of money into account. Divide the discount rate required by the number of periods per year, to arrive at the required rate of return per period, k. For example, if I require a minimum rate of 12% return annually for the bond above paying interest semi-annually, k = 12%/2 = 6%. </li> <li> 4. Determine the number of periods interest is paid, n, by multiplying the number of years till maturity by the number of times interest is paid. For example, if the above bond matures in 10 years and pays interest semi-annually has n = 10*2 = 20 interest paying periods 5. Plug in I, k and n into the present value annuity formula PVA = I[1-(1+k)^-n]/k to arrive at the present value of interest payments. In my example, the present value of interest payments is $50[1- (1+0.06)^-20]/0.06 = $885.30. </li> <li> 6. Plug in k and n into the present value formula PV = FV/(1+k)^n to arrive at the present value of the principal of the bond (FV) of $1000 at maturity. For our example, PV = $1000/(1+0.025)^20 = $311.80. 7. Add the present value of interest to the present value of principal, to arrive at the present bond value. For our example, the bond value = $ 885.30 + $ 311.80 = $1197.10. A 100 par value bond bears a coupon rate of 14 per cent and matures after five years. Interest is payable semi- annually. Compute the value of the bond if the required rate of return is 16 per cent. [bond value= $475] </li> <li> The method we followed so far, for calculating the value of the bonds and debentures is general method. But practically to know the value of the bonds and debentures, we need to go with the other formulae according to the types of bonds and debentures. </li> <li> SUBMITTED BY: BHRGAVI.B. 1st YEAR MFM. DOS IN COMMERCE. MANASAGANGOTHRI. MYSORE. </li> </ul>


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