BOND VALUATION

Nur Atikah Binti Ishak Puspa Seri Binti Jalal Nor Shakirah Binti Shariffuddin 2012850864 2012691052 2012214718

What is bonds?

A long term-debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the bond holders

(RM) Coupon Interest (periodically)

Bond Firm A Capital Bond Holders Receive interest Payments until the terms ends

(RM) Par Value (at maturity date)

Bearer bonds Indexed bonds

Register ed bonds

Income bonds

Secured bonds

Categories of bond
Bonds with warrant Debentu res

Junk bonds

Zero coupon bonds

Converti ble bonds

Who Issues Bonds?

Treasury bonds Corporate bonds
Federal Government

Corporations

Municipal bonds
Foreign bonds

State government Local government

Foreign government Foreign Corporations

Key Characteristics of Bond

Par Value Coupon Interest Rate Maturity date Call Provisions Sinking Funds
The face value of bond

The stated annual interest rate on bond

A specified date on which the par value of a bond must be repaid

A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year

Other Characteristics
Convertible bond Warrant Putable bond Income bond Indexed bond
may be exchanged for common stock of the firm, at the holders option long-term option to buy a stated number of shares of common stock at a specified price allows holder to sell the bond back to the company prior to maturity pays interest only when interest is earned by the firm

interest rate paid is based upon the rate of inflation

Formula
Present Value of Bond = Present value annuity of interest payments + Present value of principal repayment

Present Value of Bond = I (PVA) + P (PV)

k%n k%n

Key Features of a Bond I Interest payment / coupon payment

K N P
Market interest rate / required rate of return

No. of years to maturity

Principal Payment / Par or maturity value

Present Value of Bond

o rd = the bonds market rate of interest or required rate of return; also called the yield to maturity (YTM); (can change many times over the bonds life). o N = the number of years before the bond matures. o M = the par, or maturity, value of the bond (usually $1,000). o INT = the dollar amount of interest the bond pays per year(INT = CIR x M). o CIR = the coupon interest rate (does not change over the bonds life).

(Calculator)

CPT

PV

INPUTS N I/Y PV PMT FV

OUTPUT

Example

Method 1

Method 2

INPUTS

30 N

10 I/YR PV
-811.46

80 PMT

1000 FV

OUTPUT

CPT = PV

Cont.
Assume that you purchased a bond with 15 years remaining to maturity with 15% coupon rate. The interest payment is paid annually and also assume that par value RM 1000.If the required rate of return on bonds of this risk and maturity is 15%, what will the bond sell for? What would be the bonds value after one year if the required rate of return were down to 10% or up to 20% respectively

Equation 1
Value of Bond = 150 (PVA) + 1000 (PV)
10%,14 10%,14

= 150 (7.367) + 1000 (0.263) = 1150.05 + 263

= RM 1413.05 (at premium)

Method 2

INPUTS

14 N

10 I/YR PV
-1368.33

150 PMT

1000 FV

OUTPUT

CPT = PV

Equation 2
Value of Bond = 150 (PVA) + 1000 (PV)
20%,14 10%,14

= 150 (4.611) + 1000 (0.078) = 691.65 + 78

= RM 769.65 (at discount)

Method 2

INPUTS

14 N

20 I/YR PV
-769.47

150 PMT

1000 FV

OUTPUT

CPT = PV

Self test..
A bond that matures in 8years has a par value of $1,000 and an annual coupon payment of $70; its market interest rate is 9%. What is its price? A bond that matures in 12 years has a par value of $1,000 and an annual coupon of 10%; the market interest rate is 8%. What is price? Which of those two bonds is a discount bond and which is premium bond?

Answer

INPUTS

8 N

9 I/YR PV
-889.30

70 PMT

1000 FV

OUTPUT

(at discount)

INPUTS OUTPUT

12 N

8 I/YR PV
-1,150.72

100 PMT

1000 FV

(at premium)

Interpretation
Sell at Par Value Whenever the required rate of is equal to the coupon rate I=K 10% = 10% PV Bond = RM1000 Sell at Premium Sell at Discount Whenever the Whenever the required rate of required rate of return is lower return than the than the coupon coupon return is rate higher rate I>K I<K 10% > 5% 10% < 15% PV Bond = RM PV Bond = RM

1,150.72

889.30

Yield - To - Maturity (YTM)

Another name:
Rate of return Internal rate of return Market interest rate Discount rate of return

It is the required yield expected by the investors How to calculate YTM: Trial & Error YTM formula Calculator

Using a financial calculator to solve for the YTM

What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887?

INPUTS OUTPUT

10 N I/YR 10.91

- 887 PV

90 PMT

1000 FV

Find YTM, if the bond price is $1,134.20

Solving for I/YR, the YTM of this bond is 7.08%. This bond sells at a premium, because YTM < coupon rate.
10 N I/YR
-1134.2

INPUTS

90 PMT

1000 FV

PV

OUTPUT

7.08

Yield to call
Is a measure of the yield of a bond if you were to hold it until the call date. How It Works/Example:
the price of a bond is equal to the present value of its future cash flows, as calculated by the following formula:

Bond values over time

At maturity, the value of any bond must equal its par value. If rd remains constant:
The value of a premium bond would decrease over time, until it reached $1,000. The value of a discount bond would increase over time, until it reached $1,000. A value of a par bond stays at $1,000.

The same company also has 10-year bonds outstanding with the same risk but a 13% annual coupon rate
This bond has an annual coupon payment of $130. Since the risk is the same the bond has the same yield to maturity as the previous bond (10%). In this case the bond sells at a premium because the coupon rate exceeds the yield to maturity.
INPUTS OUTPUT 10 N 10 I/YR PV
-1184.34

130 PMT

1000 FV

The same company also has 10-year bonds outstanding with the same risk but a 7% annual coupon rate
This bond has an annual coupon payment of $70. Since the risk is the same the bond has the same yield to maturity as the previous bonds (10%). In this case, the bond sells at a discount because the coupon rate is less than the yield to maturity.
INPUTS OUTPUT 10 N 10 I/YR PV
-815.66

70 PMT

1000 FV

Changes in Bond Value over Time

What would happen to the value of these three bonds if its required rate of return remained at 10%:
VB

1,184 1,000 816

10 5 10% coupon rate.

13% coupon rate

7% coupon rate Years to Maturity

Semiannual bonds
1.
2. 3.

Multiply years by 2 : number of periods = 2N. Divide nominal rate by 2 : periodic rate (I/YR) = rd / 2. Divide annual coupon by 2 : PMT = ann cpn / 2.

INPUTS OUTPUT

2N N

rd / 2 I/YR

OK PV

cpn / 2 PMT

OK FV

What is the value of a 10-year, 10% semiannual coupon bond, if rd = 13%?

1.
2. 3.

Multiply years by 2 : N = 2 * 10 = 20. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS OUTPUT

20 N

6.5 I/YR PV - 834.72

50 PMT

1000 FV

Assessing a Bonds Riskiness

Interest Rate Risk-The risk of loss due to a change in interest rates. Interest rate risk is also important to bonds; if interest rates rise, the prices of bonds fall. Example, if one purchases a bond with a 3% interest rate and the prevailing rate rises to 5%, it becomes difficult or impossible to resell the bond at aprofit. Finally, interest rate risk is important to project finance. If interest rates rise, funding may not be available for a new loan for a project that has already started.

Cont..
Reinvestment rate risk is the concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income. EXAMPLE: Suppose you just won $500,000 playing the lottery. You intend to invest the money and live off the interest.

Reinvestment rate risk example

You may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1year bonds currently yield 10%. If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000.

If you choose the 10-year bond strategy:

You can lock in a 10% interest rate, and $50,000 annual income.

Conclusions about interest rate and reinvestment rate risk

Short-term AND/OR Long-term AND/OR High coupon bonds Low coupon bonds
Interest rate risk Reinvestment rate risk Low High High Low

CONCLUSION: Nothing is riskless!

Default Risk
If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. Influenced by the issuers financial strength and the terms of the bond contract.

Types of bonds
Mortgage bonds Debentures Subordinated debentures Investment-grade bonds Junk bonds

Factors affecting default risk and bond ratings

Financial performance
Debt ratio TIE ratio Current ratio

Bond contract provisions

Secured vs. Unsecured debt Senior vs. subordinated debt Guarantee and sinking fund provisions Debt maturity

Other factors affecting default risk

Earnings stability Regulatory environment Potential antitrust or product liabilities Pension liabilities Potential labor problems Accounting policies

Bankruptcy
Two main chapters of the Federal Bankruptcy Act: Chapter 11, Reorganization Chapter 7, Liquidation Typically, a company wants reorganization, while creditors may prefer liquidation.

Bankruptcy
If company cant meet its obligations
It files under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the business and it has 120 days to file a reorganization plan. Court appoints a trustee to supervise reorganization. Management usually stays in control.

Company must demonstrate in its reorganization plan that it is worth more alive than dead.
If not, judge will order liquidation.

Priority of claims in liquidation

1.
2. 3. 4. 5. 6. 7. 8.

Secured creditors from sales of secured assets. Trustees costs Wages, subject to limits Taxes Unfunded pension liabilities Unsecured creditors Preferred stock Common stock

Reorganization
In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back. Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company emerges from bankruptcy with lower debts, reduced interest charges, and a chance for success.