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Chapter 7

Bond valuation involves calculating the present value of a bond's future cash flows. This includes coupon payments made periodically until maturity plus the face value repaid at maturity. The discount rate used is the required rate of return or market rate. The value of a bond is affected by the relationship between the coupon rate and the market rate. If the coupon rate equals the market rate, the bond sells at par value. If the coupon rate is higher (lower), the bond sells at a premium (discount). As the market rate increases (decreases), the bond value decreases (increases). Other factors that influence bond valuation include payment frequency, yield-to-maturity, current yield, capital gains or losses,

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408 views11 pages

Chapter 7

Bond valuation involves calculating the present value of a bond's future cash flows. This includes coupon payments made periodically until maturity plus the face value repaid at maturity. The discount rate used is the required rate of return or market rate. The value of a bond is affected by the relationship between the coupon rate and the market rate. If the coupon rate equals the market rate, the bond sells at par value. If the coupon rate is higher (lower), the bond sells at a premium (discount). As the market rate increases (decreases), the bond value decreases (increases). Other factors that influence bond valuation include payment frequency, yield-to-maturity, current yield, capital gains or losses,

Uploaded by

Muhammad Waqas
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Bond Valuation

Valuing the cash flows

Chapter 7

(1) coupon payment (interest payment)


= (coupon rate * principal)

Bonds, Bond Valuation,


and Interest Rates

usually paid every 6 months

(2) maturity value


= principal or par value
= $1000

Example (coupon rate = rd)


Five year corp. bond pay coupons at 10% rate,
market rate (discount rate) (required rate of
return) is 10%

Example (coupon rate = rd)


Define Terms
C

rd = 10%
0
1
2
3
4
5

P0

$100

$100

$100

$100

$100
$1,000

F
n
rd
P0

= coupon payment = coupon rate x $1000


= 10% x $1,000 = $100
= face amount or maturity value = $1000
= payments to maturity = 5
= required rate of return = 10%
= bond value = ?

Example (coupon rate = rd)


P0

= PV of coupon annuity
+ PV of lump sum maturity value

PV of coupon annuity = $379.08


PV of lump sum maturity value = $620.92
P0

= $379.08 + $620.92 = $1,000.00

Solve with Calculator


PMT = C
FV = F
I/Y = rd
N
P0

PMT = C
FV = F
I/Y = rd
N

= 100
= 1000
= 10%
=5

= PV = 1,000

In this case coupon = rd so P0 = F


This Bonds sells at PAR

Example (coupon rate > rd)


Five year corp. bond pay coupons
at 10% rate, market rate is 8%

= 100
= 1000
= 10%
=5

Example (coupon rate > rd)


P0

= 399.27 + 680.58 = $1,079.85

Calculator:
PMT = C
FV = F
I/Y = rd
N
P0

= 100
= 1000
= 8%
=5

= PV = $1,079.85

Example (coupon rate > rd)


In this case coupon rate > rd so P0 > F, we
are getting more in coupon than we
demand through required rate of return.
Premium = $79.85

Example (coupon rate > rd)


P0

Calculator:
PMT = C
FV = F
I/Y = rd
N
P0

Example (coupon rate < rd)


Five year corp. bond pay coupons
at 10% rate, market rate is 12%
PMT = C
FV = F
I/Y = rd
N

= 100
= 1000
= 12%
=5

Example (coupon rate < rd)

360.47 + 567.43 = $927.90

= 100
= 1000
= 12%
=5

In this case coupon rate < rd so P0 < F, we


are getting less in coupon than we
demand through required rate of return.
Discount = $72.10

= PV = $927.90

Problem
A Harrahs Entertainment Inc 9 7/8 percent
bond matures in ten years. Assume that
the interest on these bonds is paid and
compounded annually. Determine the
value of a $1,000 denomination Harrahs
bond as of today if the required rate of
return is 7 percent.

Solution
PMT = 9.875% x $1,000 = 98.75
FV = 1000
I/Y = 7%
N
= 10
PV = $1,201.93

Problem
A Harrahs Entertainment Inc 9 7/8 percent
bond matures in ten years. Assume that
the interest on these bonds is paid and
compounded annually. Determine the
value of a $1,000 denomination Harrahs
bond as of today if the required rate of
return is 9 percent.

Solution
PMT = 9.875% x $1,000 = 98.75
FV = 1000
I/Y = 9%
N
= 10
PV = $1,056.15

Problem
A Harrahs Entertainment Inc 9 7/8 percent
bond matures in ten years. Assume that
the interest on these bonds is paid and
compounded annually. Determine the
value of a $1,000 denomination Harrahs
bond as of today if the required rate of
return is 11 percent.

Solution
PMT = 9.875% x $1,000 = 98.75
FV = 1000
I/Y = 11%
N
= 10
PV = $933.75

Problem

Problem (cont)

Assume you purchased a Stations Casino,


Inc. bond one year ago for $829.73 when
the market rate of interest was 10%. This
bond matures in 19 years and is
contracted to pay a annual coupons at the
rate of 8%. If the current market rate of
interest is 13%, what would be the
percentage change in bond value from the
time you purchased this bond until today?

Assume you purchased a Stations Casino,


Inc. bond one year ago for $829.73 when
the market rate of interest was 10%. This
bond matures in 19 years and is
contracted to pay a annual coupons at the
rate of 8%. If the current market rate of
interest is 7%, what would be the
percentage change in bond value from the
time you purchased this bond until today?

Bond Rules
(1) coupon rate = rd, Bond sells for PAR
(2) coupon rate < rd, Bond sells for a discount
(3) coupon rate > rd, Bond sells for a premium
(4) rd increases, Value decreases

Semi-Annual Coupons
Example: What is the price of a 10 year
bond with a coupon rate of 10%, if it pays
coupons semiannually and the market rate
of interest is 8%?
P0 = ??

(5) rd decreases, Value increases

Semi-Annual Coupons
Answer:
PMT
N
FV
I/Y

= (coupon rate*Maturity Value) / m = $50


= years to maturity * m = 10 * 2 = 20
= $1,000
= rd / m = 8% / 2 = 4%

P0

= $1,135.90

Problem
A MGM-Mirage Corporation bond pays a
14.5% coupon on a semi-annual basis.
What is the value of this bond if it matures
in 16 years and the market rate is 11%?

Answer
PMT = (14.5% x $1,000) / 2 = $72.50
N
= 16 x 2 = 32
FV = $1,000
I/Y = 11% / 2 = 5.5%

Problem
What is the value of a Walt Disney
Incorporated 30 year zero coupon bond if
the required rate of return is 9% and a
similar AA-rated Paychex Incorporated
bond pays a 10% coupon?

= $1,260.82

P0

Answer

Yield -to-Maturity (YTM)


Calculating the return on a Bond.

PMT = (0.0% x $1,000) = $0.00


N
= 30
FV = $1,000
I/Y = 9%
P0

Consider a bond with a 10% annual coupon


rate, 15 years to maturity, and a par value
of $1,000. The current price is $928.09.
What is the YTM?

= $75.37

Yield -to-Maturity (YTM)

YTM = ( Coupon yield ) (%)P0)


Coupon Yield

N
PV
FV
PMT

= 15
= -928.09
= 1,000.00
= 100
YTM = i = 11%

Problem
A Microsoft, Incorporated bond has a
coupon rate of 8.5%, matures in 12 years,
and sells for $835.60 (assume coupons
are paid on a semi-annual basis). What is
the YTM for this Microsoft, Inc. Corporate
Bond?

= return from the coupon


= annual coupon / P0
= $100 / $928.09 = 10.77%

%)P0

= ( P1 - P0 ) / P0
= ( $930.18 - $928.09 ) / $928.09
= 0.23%

YTM

= 10.77% + 0.23% = 11.00%

Yield -to-Maturity (YTM)


N
PV
FV
PMT

= 12 x 2 = 24
= -$835.60
= $1,000.00
= (8.5% x $1,000) / 2 = $42.50
YTM = i = 5.5% x 2 = 11%

Problem
A Microsoft, Incorporated bond has a
coupon rate of 8.5%, matures in 12 years,
and sells for $835.60 (assume coupons
are paid on a semi-annual basis). What is
the current yield for the first year on this
bond?

Problem
A Microsoft, Incorporated bond has a
coupon rate of 8.5%, matures in 12 years,
and sells for $835.60 (assume coupons
are paid on a semi-annual basis). What is
the expected percentage capital gain or
loss for the first year on this bond?

Current Yield
Current or Coupon Yield is the return on a
bond from the coupon only
Current Yield = Annual Coupon / P0
Current Yield = $85 / $835.60
= 10.17%

Capital Gain or Loss


Expected Percentage Capital Gain or Loss
= %)P0 = ( P1 - P0 ) / P0
= (842.71 835.60) / 835.60
%)P0 0.85%

Capital Gain or Loss

Corporate Bond Quotes

YTM = ( Coupon yield ) (%)P0)


FINRA Investor Information
11.0% = 10.17% (%)P0)
11.0% = 10.17% + (%)P0)
%)P0 = 11.00% - 10.17%

Table 7-4 on page 221

%)P0 = 0.83%

Bond Ratings Investment Quality

Bond Ratings Speculative (Junk)

High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very strong

Low Grade
Moodys Ba, B, Caa and Ca; S&P BB, B, CCC, CC

Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more impact
on the firms ability to pay

Very Low Grade


Moodys C and S&P C income bonds with no interest
being paid
Moodys D and S&P D in default with principal and
interest in arrears

Considered speculative with respect to capacity to pay

10

Bond Evaluation
Use bond rating - yield comparisons
Also, consider maturity, liquidity, call
provision, convertibility feature, collateral,
other provisions
Major Credit Rating Companies - Moodys,
Standard and Poors (S&P), Fitch

11

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