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This document provides an overview of bond valuation and characteristics. It defines different types of bonds, discusses how bonds are valued, and outlines key relationships in bond valuation. The valuation process discounts a bond's expected cash flows to calculate its present value using the investor's required rate of return. A bond's market value depends on how its coupon rate compares to the required rate of return.

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20 views

Last of 7 Chapter

This document provides an overview of bond valuation and characteristics. It defines different types of bonds, discusses how bonds are valued, and outlines key relationships in bond valuation. The valuation process discounts a bond's expected cash flows to calculate its present value using the investor's required rate of return. A bond's market value depends on how its coupon rate compares to the required rate of return.

Uploaded by

muhammed shamaa
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 32

CHAPTER 7

VALUATION AND
CHARACTERISTICS OF BONDS

• Under supervision
• Dr/ Dina fadaly

• Perpared by :
• Mohamed ramadan
• Mirna morqos
• Mohamed shamaa
• Ahmed safwat
• Mohamed yaqoup
CHAPTER OBJECTIVES

• Different types of bonds


• Features of bonds
• Term “Value”
• Process for valuing assets
• Value of a bond
• Expected rate of return
• Relationships in bond valuation
BONDS

• Type of debt or long-term promissory note


issued by a borrower, promising to pay the
holder a fixed amount of interest per year.
TYPES OF BONDS

• Debentures
• Subordinated Debentures
• Mortgage Bonds
• Euro Bonds
• Zero Coupon Bonds
• Junk Bonds
DEBENTURES

• Any unsecured long-term debt


• Viewed as more risky than secured bonds and provide a
higher yield than secured bonds.
SUBORDINATED DEBENTURE

• Hierarchy of payout in case of bankruptcy


• The claims of subordinated debentures are honored only
after the claims of secured debt and unsubordinated
debentures have been satisfied
MORTGAGE BOND

• A bond secured by a lien on real property


• Typically, the value of the real property is
greater than that of the bonds issued
EURO BONDS

• Securities (bonds) issued in a country different from the one


in whose currency the bond is denominated
ZERO COUPON BONDS

• Do not make regular interest payments


• Issued at a significant discount
• Return comes from appreciation of the bond.
• Series EE government savings bonds—purchase
for $500, payback is $1,000
JUNK BONDS

• High risk debt with low ratings by Moody’s and Standard & Poor’s
• High yield—typically pay Three to Five percent more than AAA
grade long-term bonds
TERMINOLOGY

• Claims on Assets and Income: In the event of insolvency,


claims of debt , including bonds are honored before those of
common or preferred stock.

• Par Value: Face value of the bond, returned to the


bondholder at maturity.

• Coupon Interest Rate: The percentage of the par value


of the bond that will be paid out in the form of interest.
• Maturity: the length of time until the bond
issuer returns the par value to the bondholder and
terminates or redeems the bond.

• Indenture: the legal agreement between the


organization issuing the bond and the trustee who
represents the bondholders
TERMINOLOGY

• Current yield: the ratio of the interest payment to the bond’s


current market price.
• Calculated by dividing the annual interest payment by the market price of
the bond.
• A $1,000 bond with 10% coupon rate and market price of $700
Current yield = $100 / $700 = 14.286 % .
BOND RATINGS

Three agencies rate bonds:


• Moody’s
• Standard & Poor’s
• Fitch Investor Services

The lower the rating, the higher the return demanded in


the market
BOND RATINGS

• Bond ratings are favorably affected by:


• Greater reliance on equity as opposed to debt financing
• Profitable operations
• Low variability in past earnings
• Large firms' size
• Little use of subordinated debt
BOND RATINGS

• AAA is the highest rating assigned by Standard &


Poor’s.

• AAA indicates a strong capacity to pay principal


and interest.
VALUE

• Value is defined differently depending


on the context. But for us, value is the
present value of future cash flows
expected to be received from an
investment discounted at the investor's
required rate of return.
VALUE

• Book value: value of an asset as shown on a firm’s


balance sheet.

• Liquidation value: the dollar amount that could be


realized if an asset were sold individually and not as part of a
going concern.

• Market value: the observed value for the asset in the


marketplace.

• Intrinsic or economic value: also called fair value—the


present value of the asset’s expected future cash flows.
EFFICIENT MARKET

• The values of all securities at any instant fully


reflect all available public information, which
results in the market value and the intrinsic value
being the same
DETERMINANTS OF VALUE

• For our purposes: The value of an asset is its intrinsic


value or the present value of its expected future cash
flows, when these cash flows are discounted back to
the present using the investor’s required rate of return
• Determinants:
• Amount and timing of expected cash flows
• Riskiness of the cash flows
• Investor’s required rate of return for the investment
VALUATION

• The valuation process can be described as follows: It is


assigning value to an asset by calculating the present value
of its expected future cash flows using the investor's
required rate of return as the discount rate. The investor's
required rate of return, k, is determined by the level of the
risk-free rate of interest and the risk premium that the
investor feels is necessary to compensate for the risks
assumed in owning the asset. Therefore, a basic asset
valuation model can be defined mathematically as follows:
VALUATION

 (1 + k)
$Ct
V = t
t=1

• Ct = cash flow to be received at time t.

• k = the investor’s required rate of return.


• V = the intrinsic value of the asset.
BOND VALUATION

• The value of a bond is a combination of:


• The present value of the interest payments

Plus
• The present value of the par or face value.
BOND VALUATION

• Discount the bond’s cash flows at the


investor’s required rate of return.
• The coupon payment stream (an
annuity).
• The par value payment (a single sum).
BOND VALUATION


$It $M
Vb = +
t=1
(1 + k b)t
(1 + kb)n

Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)


PAR VALUE

• When the investor’s required rate of return is


equal to the coupon interest rate, the bond has a
market value of par or face value
DISCOUNT

• The market value of a bond will be below


the par or face when the investor’s
required rate is greater than the coupon
interest rate. The bond will sell at a
Discount or below face value.
PREMIUM

• The market value of a bond will be above the par


or face value when the investor’s required rate is
lower than the coupon interest rate. The bond
will sell at a Premium or above face value.
YIELD TO MATURITY

• To measure the bondholder's expected rate of return,


we find the discount rate that equates the present
value of the future cash flows (interest and maturity
value) with the current market price of the bond.
The expected rate of return for a bond is also the
rate of return the investor will earn if the bond is
held to maturity, or the yield to maturity.
YIELD TO MATURITY

• The expected rate of return on a bond.


• The rate of return investors earn on a bond if they
hold it to maturity.


$It $M
P0 = +
t=1 (1 + k b)t
(1 + kb)n
FIVE IMPORTANT RELATIONSHIPS

• 1. The value of a bond is inversely related to changes in the


investor’s present required rate of return (the current interest rate).
As interest rates increase, the value of the bond decreases.
• 2. The market value of a bond will be less than the par value if
the investor’s required rate of return is above the coupon interest
rate; the value will be above par value if the investor’s required rate
of return is below the coupon interest rate.
• 3. As the maturity date approaches, the market value of a bond
approaches its par value.
FIVE IMPORTANT
RELATIONSHIPS

• 4. Long-term bonds have greater interest rate risk


than do short-term bonds.
• 5. The sensitivity of a bond’s value to changing
interest rates depends not only on the length of time to
maturity’ but also on the pattern of cash flows provided
by the bond.

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