Chapter 6

Short and
long
term (Bond)
Debt
-Characteristics
& Valuation
1

DEBT CHARACTERISTICS

• Debt is a loan to a firm, government, or

individual.
• Many types of debt instruments exists i.e. home
mortgages, commercial paper, term loans (short
or long terms, and bonds, among others.
• We identify debt by describing three of its
features: the principal amount that needs to be
 repaid, the interest payments, and the time to
maturity. For instance, a BDT 1,000, 10-year, 8
percent interest (coupon) bond.
2

Definition of Bond

• Bond is a debt instrument through which an

investor lends money to an entity
(corporates or government) that borrows the
funds for a definite period of time at a fixed
interest rate.
• Bonds are used by companies, municipalities and
governments to finance a variety of projects and
activities.
• Bonds are commonly referred to as fixed-income
 securities
• As a secured instrument, it is a promise to pay interest
and repay the principal at stipulated times.
3

Bond Issuing authority

Government :
The bond issued by the government is known as a treasury
bond. It is also called the risk-free bond. The maturity period
is five to ten years. It provides a lower yield in comparison to
other bonds.
Corporation or company
The bond issued by any company or corporation is known as a
corporate bond.
Foreign government or company
The bond issued by any foreign company or government is
known as a foreign bond.
Municipal Authority
The bond issued by any municipal authority is known as a
municipal bond. Such as: Bonds issued by Dhaka WASA, BRTC
etc.
4

DEBT/BOND CHARACTERISTICS (CONT’D)

• Principal Value, Face Value, Maturity

Value, and Par Value
– The principal value of debt represents the
amount owed to the lender, which must be repaid
at some point during the life of the debt. For much
of the debt issued by corporations, the principal
amount is repaid at maturity.
– The terms par value, face value, maturity value,
and principal value are used interchangeably to
designate the amount that must be repaid by the
borrower.
5

DEBT/BOND CHARACTERISTICS
(CONT’D)

• Par value: The par value is the amount of money that

is paid to the bondholders at maturity.
• Coupon Rate: The stated rate of interest on a bond is
referred to as the coupon rate. The coupon rate is fixed
and determines the periodic coupon or interest
payments. It is expressed as a percentage of the bond's
face value.
 • Coupon Payments: The coupon payments represent
the periodic interest payments from the bond issuer to
the bondholder. The annual coupon payment is
calculated by multiplying the coupon rate by the bond
face value.
(Coupon Payment = Face Value * Coupon Rate) 6

DEBT /BOND CHARACTERISTICS (CONT’D)

• Maturity Date--The maturity date represents the date on

which the principal amount of a debt is due. As long as
interest has been paid when due, once the principal
amount is repaid, the debt obligation has been satisfied.
• Priority to Assets and Earnings--Corporate debt holders
have priority over stockholders with regard to
 distribution of earnings and liquidation of assets. Interest
on debt is paid before stock dividends are distributed.
• Control of the Firm (Voting Rights)--Corporate debt
holders do not have voting rights, so they cannot attain
control of the firm.
7

DEBT /BOND CHARACTERISTICS (CONT’D)

Sinking Fund: A sinking fund is a type of fund that is

created and set up purposely for repaying debt. The
owner of the account sets aside a certain amount of
money regularly and uses it only for a specific purpose.
It is used by corporations for bonds and deposits
money to buy back issued bonds or parts of bonds
before the maturity date arrives.
 8

DEBT /BOND CHARACTERISTICS (CONT’D)

Bond Indenture: A bond indenture is a legal document or

contract between the bond issuer and the bondholder that
records the obligations of the bond issuer and benefits owed to
the bondholder. The bond indenture also includes the details of
the rights of ownership as well as the rights of the bondholder to
receive interest payments and principal payments in the future.
Bond indenture includes all the necessary particulars like call
options, details of the security, and restrictive covenants. It acts
as a guideline for the management of that bond.

BOND CONTRACT FEATURES (CONT’D)

• Call provision: A provision in a bond contract that

gives the issuer the right to redeem (pay off) the
bonds under specified terms prior to the normal
maturity date.
• Conversion feature: Permits bondholders to
exchange their investments for a fixed number of
shares of common stock. Investors cannot convert
the stocks back to bonds.
 10

Various Kinds of Bond

•Coupon Bond: A coupon bond has a stated interest rate on the face
value of the bond. The interest is paid annually or semi-annually until
maturity. (1000/-, 12%, 5 years)
• Zero Coupon Bond: A zero coupon bond has not any stated interest
rate that is no periodic payments. These sorts of bonds are sold at a
deep discount than their face value. The holder of the bond will
receive full value at the date of maturity. (1000/-, 0%, 5 years)

• Perpetual Bond: Perpetual bond is just the opposite of zero coupon

bonds. Generally, a perpetual bond does not have any maturity date.
Instead, the bond will continue to provide periodic interest payments
for an indefinite future date.
11

Various Kinds of Bond

• Callable Bond: A callable bond can be called upon before maturity by the
intention of the issuer of the bond. Generally, the right to call is mentioned in
the bond indenture. In this, the call price is somewhat higher than the
maturity value.
• Put-able Bond: A bond containing an option that the bondholder can put
the bond in exchange for cash is defined as put able bond. This is just the
opposite of a callable bond. Here the put price is somewhat lower than the
maturity value.
Junk bond: Junk bonds are bonds that carry a higher risk of default than most
bonds issued by corporations and governments. Junk bonds are also called
high-yield bonds.
 12

The Basic Bond Valuation Model

Coupon-Bearing Bond: (n, coupon rate) Annually

�� −��
����+����
Here, ����)��
(�� + ���� = �� ×
����)�� (�� +

I = Coupon amount = Face value * coupon rate

Kd = YTM/ Yield to maturity/ Market interest rate/ Discount
rate etc.
MV = Maturity Value/ Face Value/1000.

13

The Basic Bond Valuation Model

Zero-Coupon Bond: ( I =0)

���� =����
(�� + ����)��
Perpetual Bond:

��
���� = ����
 14

YTM (Yield to Maturity)

Yield to maturity (YTM) is the total expected rate of return that

will have been earned by a bond when it makes all interest
payments and repays the original principal. Or,
YTM is the internal rate of return of an investment in a bond if
the bondholder holds the bond until maturity.

������ =�� +���� − ������

× ������ MV = Maturity Value
��
���� + ������
Here,
��
 NSV = Net sales value or, Net Market price
= Selling value or Market price – Flotation cost
15
• Flotation costs are incurred by a publicly-traded company when it
issues new securities and incurs expenses, such as underwriting
fees, legal fees, and registration fees. Companies must consider the
impact these fees will have on how much capital they can raise from
a new issue
• Value of Bond = Suitable Purchase price of Bond = How much money
you will spend to purchase the bond = Intrinsic value = Inherent
Value = Fair Price/Value of the Bond= What should be the
Maximum price of the bond
• YTM = Opportunity cost = Cost of Capital = Cost of Debt/Bond =
 Required rate of return = Rate of return = Expected rate of return
= Yield
16

Purchasing Decision

• If the calculated value of a bond is GREATER than the given market

price, the bond is currently UNDERVALUED and we can purchase
the bond.
• If the calculated value of a bond is LOWER than the given market
price, the bond is currently OVERVALUED and we should not
purchase the bond.
• If the calculated value of bond is equal to the given market price, the
bond is currently FAIRLY VALUED and we are indifferent in the
 decision but to avoid risk we should not purchase the bond.

17

Purchasing Decision

• If the Coupon rate is higher than YTM (Coupon rate > YTM), the
Value of Bond is greater than face value and the bond is
selling at a premium.
• If the Coupon rate is lower than YTM (Coupon rate < YTM), the
Value of Bond is lower than face value and the bond is selling
at a discount.
• If the Coupon rate is equal to YTM (Coupon rate = YTM), the
Value of the Bond is equal to face value and the bond is
 selling at par.18

Problem 1

Mr. Altaf is thinking to invest in bonds. There are two

prominent bonds in the market named. Surma Bond and
Tista Bond. The maturity period of the Surma bond is 10
years with face value Tk. 1,000 and the market value is Tk.
950. On the other hand, the maturity period of Tista bond
is 8 years with coupon rate 20%, face value Tk. 1,000 and
market value is Tk. 1, 100 Mr.Rony has decided to invest in
Tista bond. The expected rate of return is 12%.
(a) What is the intrinsic value of the Surma bond? (b)
Evaluate the rationality of the investment decision
taken by Mr. Rony.
 19

The Basic Bond Valuation Model

Zero-Coupon Bond: ( I =0)

�� ��������
(��+����) =
���� =���� ������.
� ����
(��+��.����)
���
=
Perpetual Bond:

��
���� = ����
 20

The Basic Bond Valuation Model

Coupon-Bearing Bond:

�� −��
����+����
���� = �� (�� + ����)��
× ����)��

(�� +
�� −��
 +
��. ���� ��������
���� = ������ ����)�� ��������.
(�� + ��. ���� ����.
× Here,
(�� + ��.
��
����) =

I = Coupon amount = Face value * coupon rate

= 1000*20% = 200/-
Kd = YTM/ Yield to maturity/ Market interest rate/ Discount rate etc. = 12%
MV = Maturity Value/ Face Value. = 1000/-
21

Problem 2

Mr. Zahid wants to invest his savings in the bond market.

He is interested to invest in Incepta or Keya Company's
bonds. The coupon rate of Keya company's bonds is 12%,
market value is Tk. 2,500 and expires in 7 years. On the
other hand, Incepta Company's bonds' coupon rate is 9%
paid semi-annually with a maturity period of 7 years
and the market value is Tk 1,700. The face value of both
bonds is Tk. 2,000.
Mr. Zahid's expected rate of return is 10%.
On the basis of intrinsic value of the bonds, recommend
the better investment decision for Mr.Zahid.
22

The Basic Bond Valuation Model

Keya Bond:

�� −��
 ����+����
���� = �� (�� + ����)��
× ����)��

(�� +
�� −��

+
��. ���� ��������
���� = ������ ����)�� ��������.
(�� + ��. ���� ����.
× Here,
(�� + ��.
��
����) =

I = Coupon amount = Face value * coupon rate

= 2000*12% = 240/-
Kd = YTM/ Yield to maturity/ Market interest rate/ Discount rate etc. = 10%
MV = Maturity Value/ Face Value. = 2000/-
23
Incepta Bond:
�� −��

��.
���� = �� ×
����/��+��������
(�� + ��. ����/��)��∗��
(�� + ��. ����/��)��∗��
= ��������. ����
�� −�� ����.
����+���� Here,
���� = ������/�� ×
(�� + ����)��
(�� + ����)��

I = Coupon amount = Face value * coupon rate

= 2000*9% = 180/-
Kd = YTM/ Yield to maturity/ Market interest rate/ Discount rate etc. = 10%
MV = Maturity Value/ Face Value. = 2000/-
 24

Problem 3

In which bond you should invest in?

Bond Face Coupon Rate Maturity/Year Market YTM
Value Value
(BDT) (BDT)

A 1000 10% 15 950 12%

B 1000 14% 1000 12%

C 1000 12 950 12%

25

Problem 4
Mr. Toufiq Omar is thinking to invest a portion of his business profit
in the bond market. He always invests in famous companies’ bond.
Here are some particulars about two bonds issued by ACI and
Square Company-
• ACI Company has issued 12-year bond at Tk. 2,000 par value. The
coupon rate and required rate of return is 15% and 12%
respectively. The present market value of the bond is Tk. 2,400. •
Square Company has issued 8 year zero coupon bond at Tk. 1,500
par value. The present market value of the bond is Tk. 600.
Required rate of return is 13%.

Keeping present value in mind, logically explain whether Mr. Toufiq

Omar should invest in any of these two bonds.
26

Problem 5
 Based on Given Data, Which Bond You will
purchase based on intrinsic value?
Particulars ACI SQUARE
Face Value TK. 2000 TK. 2000
Coupon Rate 12% 14%
Period 20 Years 20 Years
Market Value TK. 1600 TK. 1900
Rate of Return 15% 15%
Maturity Value At 5% premium At 5% Discount
27

The Basic Bond Valuation Model

ACI Bond:

�� −��
����+����
��
���� = �� × �� )
�� −��
��

(�� +
(�� + ����)��

+
��. ���� ��������
���� = ������ ����)���� ��������.
(�� + ��. ���� ����.
× Here,
(�� + ��.
����
����) =
I = Coupon amount = Face value * coupon rate
= 2000*12% = 240/-
Kd = YTM/ Yield to maturity/ Market interest rate/ Discount rate etc. = 15%
MV = Maturity Value/ Face Value. = 2000+(2000*5%) =2100 28

The Basic Bond Valuation Model

Square Bond:

�� −��
����+����
��
���� = �� × �� )
�� −��
��

(�� +
(�� + ����)��
 +
��. ���� ��������
���� = ������ ����)���� ��������.
(�� + ��. ���� ����.
× Here,
(�� + ��.
����
����) =

I = Coupon amount = Face value * coupon rate

= 2000*14% = 280/-
Kd = YTM/ Yield to maturity/ Market interest rate/ Discount rate etc. = 15%
MV = Maturity Value/ Face Value. = 2000 - (2000*5%) =1900 29