Business valuation: Bond valuation

1. Explain the fundamental characteristics of a bond

issue

2. Describe how the valuation of a bond is based on

present value techniques

3. Explain the differences among various concepts of

yield such as yield to maturity, yield to call, and
anticipated realized yield

3. Describe the techniques for anticipating changes in

interest rates

12-2
 Fundamentals of the Bond Valuation Process

 Rates of Return

 The Movement of Interest Rates

 Investment Strategy: Interest Rate

Considerations

12-3
11-4
 Term Description
 Major provisions/ agreement
Bond  Over 100 pages long
indentur  Complicated legal document
e  Administered by a trustee
(usually a commercial bank)
 Face value of a bond
Par  Corporate: $1,000
value  Fed, state, & local: $5,000 or $10,000

11-5
 Term Description
Coupon  Actual interest on the bond
rate  Payable semiannually

Variable-  Coupon rate fixed for a short period

rate notes  Then varies with a stipulated short-
(floating- term rate (e.g. U.S. Treasury bills)
rate notes)

11-6
 Term Description
 Debt issued at values substantially
below maturity value
Zero-coupon
 No semiannual cash interest paid
bonds
 Investor receives return in the form
of capital appreciation
Date at which final payment is due at the
Maturity date stipulated par value
Perpetual Bonds that are never paid off (issued by
bonds Canadian and British governments)
Bonds paid off in installments over the life
Serial payment
of the issue (e.g. Municipal bonds)

11-7
 Term Description
Semiannual or annual contributions by the
Sinking-fund bond issuer into a fund run by a trustee for the
purposes of debt retirement
 Allows the corporation to call or force
in all of the debt issue prior to maturity
Call provision
 Price paid usually 3 to 5% above par
 Usually deferred 5 to 10 years
Enables the bondholder to sell a long-term
bond back to the corporation at par value
Put provision (useful when market interest rates have gone
up)

11-8
11-9
 The price of a bond represents the
present value of future interest
payments plus the present value of
the par value of the bond at maturity

12-10
 n
Ct Pn
V  
t 1 1  i  1  i  n

V= Market value or price of the bond

n= Number of periods
t= Each period
Ct = Coupon or interest payment for each period, t
Pn = Par or maturity value
i= Interest rate in the market

12-11
 Assume a bond pays 10% interest or $100 for 20 years and
has a par or maturity value of $1,000.
 The interest rate in the marketplace is assumed to be 12%.
 The present value of the bond, using annual compounding,
is:

12-12
 tn
Ct Pn
V  t 1

(1  i ) (1  i )
t n

 Present Value of Coupon Payments (Ct) Present value of Maturity Value (P n)


n = 20, i = 12 % n = 20, i = 12%

 $100 x 7.469 = $746.90 $1,000 x 0.104 = $104.00

 Present value of coupon payments = $746.90

 Present value of maturity value = $104.00
 Value of bond = $850.90

12-13
 Assume a bond pays 10% interest (5% semiannually, or $50
every six months) for 20 years and has a par or maturity value
of $1,000.
 The interest rate in the marketplace is assumed to be 12%.
 The present value of the bond, using semiannual
compounding, is:

12-14
 Current Yield
 Yield to Maturity
 Yield to Call

12-15
 Annual interest payment divided by price
of bond

 Example:
◦ 10% coupon rate $1,000 par value bond selling
at $950
$ 100
C urrent yield   10 . 53 %
$ 950
 Ignores capital gains or losses

12-16
 Measure of return that considers:

 The interest rate at which you can discount the

future coupon payments and maturity value to
arrive at quoted price of the bond

 Assumption: all coupons are reinvested at the same (YTM) rate.

12-17
Ytm = Approximate yield to maturity
V = Market value or price of the bond
n = Number of periods
Ct = Coupon or interest payment for each period,
Pn = Par or maturity value

12-18
 Assume the market price of the bond is $850.90, coupon or
interest payment is $100, maturity value is $1,000 and
number of periods is 20.
 What interest rate will force the future cash inflows to equal
$850.90?

12-19
 To the extent a debt instrument may be
called in before maturity, a separate
calculation for yield to call may be necessary
 Yield to call value is determined by:
◦ the coupon rate,
◦ the length of time to the call date,
◦ the call price, and
◦ the market price.

12-20
 20-year bond was initially issued at 11.5% interest rate,
and was callable at $1,090 five years after issue

 Two years later, the yield to maturity on the bond is

9.48%, and the bond is selling for $1,180

 An investor who buys the bond two years after issue can
have his bond called back after three more years at
$1,090

 To compute yield to call, determine the approximate

interest rate that will equate a $1,180 investment today
with $115 (11.5%) per year for the next three years plus a
payoff or call price value of $1,090 at the end of three
years

12-21
 Yield to call = 7.43%
◦ 205 basis points less than yield to maturity

12-22
Y = yield to maturity expressed in %
R = coupon rate (or i)
P = price of the bond.
M = the number of years to call date.

The relation is:

M
R 100
P 
i 1  Y  i 
 Y  M
1
  1





 100  
 100 

12-23
 Investors wishing to make substantial profit in bond
market must try to anticipate direction of interest
rates

 Short-term rates may not move in the same direction

as long-term rates

 Interest rates — coincident indicator

12-24
 Inflationary expectations
 Demand for funds by:
◦ Individuals
◦ Businesses
◦ Government
 Desire for savings
 Federal Reserve policy

12-25
 When an investor believes interest rates will
fall:
◦ Buy long-term bonds to maximize price movement
with rate change
 When an investor believes interest rates will
rise:
◦ Buy short-term bonds to minimize price movement
with the rate change

12-26
1. Bond prices and interest rates are inversely related

2. Prices of long-term bonds are more sensitive to change in

YTM than short-term bonds

3. Bond price sensitivity increases at a decreasing rate as

maturity increases

4. Bond prices are more sensitive to a decline in market YTM

than to a rise in market YTM

5. Prices of low-coupon bonds are more sensitive to a change in

YTM than high-coupon bonds

6. Bond prices are more sensitive when YTM is low than when
YTM is high

12-27
 Question

Compute the value for an IBM Bond with a

6.375% coupon that will mature in 5 years
given that you require an 8% return on your
investment.

What are the bond price($)?