Valuation of Bonds

Financial Management

B 642

Outline

Meaning of a BondTypes of BondsFeatures/characteristics of a BondHow to Value a Bond

– Annual Coupon Paying Bonds– Semiannual Coupon Paying Bonds

Bond Yields– Nominal Yield– Current Yield– Yield to Maturity (Required Rate of Return)

Meaning of a Bond

Bond represents an agreement between a borrower (issuer) and lender (buyer) whereby – the borrower agrees to make regular interest payments and – to repay the principal at maturity of the loan

It is a debt instrument requiring the issuer also called the debtor or borrower – To pay interest over some specified period of time– to repay to the lender/investor the amount borrowed and

It is the legal obligation of the firm to meet the above two requirements

Features of a Bond

Face ValueMaturityCouponCallable/Non-callableSecured/Unsecured BondsRegistered/Bearer BondsProvisions for paying off bonds

Types of Bonds

Zero Coupon BondsFloating Rate BondsCallable BondsConvertiblesEurobonds

Valuation of Bonds

Process of determining the fair market value of a financial asset on the basis of present value of expected/anticipated cash flows

Three step process:– Estimate the expected cash flows– Determine the appropriate interest rate or interest rates

to discount the cash flows– Compute the present value of the expected cash flows

in step 1 by discounted them with interest rate (s) in step 2

Value of a Bond Today

Depends on the present value of expected cash flows from the bond

Need to estimate– Expected cash flows– The appropriate required yield/discount rate

What are the expected cash flows for a plain-vanilla bond?– Coupon Payment at regular intervals during the life of the bond– Repayment of principal at maturity of the bond

Par Bonds Discount Bonds Premium Bonds

Bond Yields

Nominal Yield• Coupon of a bond is the nominal yield of a bond

Current Yield• Annual coupon amount divided by the current

market price of the bond

Yield to Maturity– Rate of return promised to an investor if you

purchased the bond at the current market price given coupon and maturity of the bond