VALUATION OF

CHAPTER FINANCIAL ASSETS:

3 BONDS
DISCUSSION POINTS:
Types of Bonds
Terminology and Characteristics of
Bonds
Definitions of Value
Determinants of Value
Valuation: The Basic Process
Bond Valuation
The Bondholder’s Expected Rate of
Return (Yield to Maturity)
 1. INTRODUCTION
 Valuation of assets is critical as Definitions of Value
well as a challenging task. The term value is often
 Understanding how to value used in different contexts,
financial securities is essential if depending on its application.
managers are to meet the Examples of different uses of
objective of maximizing the this term include book value,
value of the firm. liquidation value, market
 Specifically, managers need to value, and intrinsic value.
understand how bonds & stocks Book Value: is the value of
are valued in the marketplace; an asset as shown on the
otherwise, they cannot act in firm’s balance sheet. It
the best interest of the firm’s represents a historical
investors. rather than a current worth.
 INTRODUCTION… CONT’D
►For example, the book value for common stock is
the sum of the stock’s par value, the paid-in capital,
and the retained earnings.

Liquidation Value: is the amount that could be

realized if an asset were sold individually and not as
a part of a going concern.
For example, if a product line is discontinued, the
machinery used in its production might be sold. The
sale price would be its liquidation value and would
be determined independently of the firm’s value
 INTRODUCTION… CONT’D

Market Value: refers to Intrinsic Value of an asset:

the observed value of an ►is the present value of the
asset in the marketplace. asset’s expected future cash flows.
►This value is determined by ►This value is also called the fair
value as perceived by the investor,
supply & demand forces
given the amount, timing, and
working together in the riskiness of future cash flows.
marketplace, where buyers ►Once the investor has estimated
and sellers negotiate a the intrinsic value of the asset, this
mutually acceptable price for value can be compared with its
the asset. market value.
If the intrinsic value is greater than the market value, then the asset is
undervalued in the eyes of the investor. If the market value exceeds the
investor’s intrinsic value, then the security is overvalued.
 INTRODUCTION… CONT’D

Efficient Market: Is a market

in which the values of the
securities at any instant in time
fully reflect all available
information, which results in
the market value and the
intrinsic value being the
same.
This means that if the
securities market is working
efficiently, the market value
and the intrinsic value of a
security will be equal; and it is
extremely difficult for an
INTRODUCTION… CONT’D
 INTRODUCTION… CONT’D

►The first two factors are

characteristics of the asset; the
third one, the required rate of
return, is the minimum rate of
return necessary to attract an
investor to purchase or hold a
security, which is determined by
the rate of return available on
similar investments, or what is
called the opportunity cost of
funds.
►This rate must be high enough
to compensate the investor for
the risk perceived in the asset’s
future cash flows.
 2. TYPES OF BONDS

A bond is a type of debt or

long-term promissory note,
issued by the borrower,
promising to pay its holder a
predetermined and fixed
amount of interest per year.
There are different types of
bonds. Some of them are
briefly described in the
following paragraphs.
 TYPES OF BONDS…. CONT’D

1. Debentures
 The term debenture refers to any unsecured long-
term debt.
 Since these bonds are unsecured, the earning
ability of the issuing corporation is of great
concern to the bond holder.
 They are also viewed as being riskier than secured
bonds as a result must provide investors with a
high yield than secured bonds provide.
 For the issuing firm, the major advantage of
debentures is that no property has to be secured
by them. This allows the firm to issue debt and
still preserve some future borrowing power.
 TYPES OF BONDS…. CONT’D

2. Subordinated 3. Mortgage Bonds

Debentures A mortgage bond is a bond secured
►A debenture that is by a lien on real property. Typically, the
subordinated to value of the real property is greater
than that of the mortgage bonds
other debentures is
issued. This provides the bondholders
being paid in the
with a margin of safety in the event the
case of insolvency.
market value of the secured property
►The claims of the declines. In the event that the
subordinated proceeds from this sale do not cover
debentures are the bonds, the bondholders become
honored only after general creditors, for the unpaid
the claims of secured portion of the debt, similar to
debt and debenture bondholders.
unsubordinated
 3. TERMINOLOGY &
CHARACTERISTICS OF BONDS
 TERMINOLOGY…. CONT’D

Claims on Assets & Income

☻In the case of
insolvency, claims on debt ☻If interest on
If interest on bonds is not
in general, including bonds is not
paid, the bond paid,
trustees can
bonds, are honored before the bond trustees
classify the firm as insolvent
and force it into bankruptcy.
those of both common can classify
If interest on bondsthe
is notfirm
stock and preferred stock. paid, the bond trustees can
as insolvent
classify and
the firm as insolvent
☻Bonds also have a claim and force it into bankruptcy.
force it into
on income that comes
ahead of common and bankruptcy.
preferred stock.
 TERMINOLOGY…. CONT’D

Par Value Example:

The par value of a bond is X Corp’s bond was
its face value that is returned recently quoted in the
to the bondholder at maturity. Wall Street Journal as
When bond prices are selling for 77.88.
quoted, either by financial Meaning that this bond
managers or in the financial is selling for 77.88
press, prices are generally percent of its par value
expressed as a percentage of of $1,000. MP = $778.80
the bond’s par value. & MV = $1,000
 TERMINOLOGY…. CONT’D

Regardless of what
Coupon Interest Rate happens to the price
Indicates the of a bond with a 10
percentage of the par percent coupon
value of the bond that interest rate and a
will be paid out annually $1,000 par value, it
in the form of interest. will pay out $100
annually in interest
until maturity.
 TERMINOLOGY…. CONT’D

Maturity
The maturity of a
bond indicates the
length of time until
the bond issuer
returns the par value
to the bondholder
and terminates or
redeems the bond.
 TERMINOLOGY…. CONT’D

Indenture ♥ The bond trustee,

♥ An indenture refers to the usually a banking
legal agreement between the institution or
firm issuing the bond & the bond trustee Co., is then
trustee who represents the
assigned the task
bondholders.
♥ The indenture provides the of overseeing the
specific terms of the loan r/n ship between
agreement, including a the bondholder &
description of the bonds, the the issuing firm,
rights of the bondholders, the protecting the
rights of the issuing firm, and the bondholder, and
responsibilities of the trustee. seeing that the
terms of the
 TERMINOLOGY…. CONT’D

►All of these restrictions have one thing in

common: They attempt to prohibit actions that
would improve the status of other securities at
the expense of bonds and to protect the status
of bonds from being weakened by any
managerial action.
 TERMINOLOGY…. CONT’D

Example:
If a firm has a bond with a
Current Yield 10 percent coupon interest
The current yield on a rate, a par value of $1,000,
bond refers to the ratio and a market price of
$778.80, what would be the
of the annual interest current yield on the bond?
payment to the bond’s Current Yield =
market price.
=
= 0.1284 = 12.84%
 TERMINOLOGY…. CONT’D

Bond Ratings Although they deal

John Moody first with expectations,
began to rate bonds several historical
in 1909. Since that factors seem to play a
time three rating vital role in their
determination.
agencies – Moody’s, Bond ratings are
Standard & Poor’s,
favorably affected by
and Fitch Investor
(1) a greater reliance on
Services – have
equity as opposed to
provided ratings on debt in financing the
corporate bonds. firm, (2) profitable
These ratings involve operations, (3) a low
a judgment about the variability in past
 TERMINOLOGY…. CONT’D

In turn, the

rating a bond
receives affects
the rate of return
demanded on the
bond by the
investors. The
poorer the bond
rating the higher
the rate of return
demanded in the
 TERMINOLOGY…. CONT’D

Thus, bond ratings

are extremely
important for the
financial manager.
They provide an
indicator of default
risk that in turn
affects the rate of
return that must be
paid on borrowed
funds.
 4. VALUATION: THE BASIC
PROCESS
►Valuation is the process of
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, r, 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
 VALUATION…. CONT’D
Bond Valuation
►The value of a bond is the
present value both of
future interest to be
received and the par or
maturity value of the
bond.
►The process of valuing a
bond requires knowing of
three essential elements:
(1) the amount & timing of
the cash flows to be
received by the investor,
(2) the time to maturity of
 VALUATION…. CONT’D

Example:
The amount of cash On November 5,
flows is dictated by 2017, Hussen Corp.
issued a 10% coupon
the periodic interest rate, 10 year
interest to be bond with Br.
received and the 1,000,000 par value
par value to be paid that pays interest
at maturity. Given annually.
these elements, we Case 1: Assume that
the investor requires
can compute the a 10% rate of return
intrinsic value of on this bond. What is
the bond. the value of the bond
 VALUATION…. CONT’D

Solution:
Periodic/ Annual interest on the bond = Br. 1,000,000 x 0.1 = Br. 100,000
Face /par Value of Bond = Br. 1,000,000.00
Investor’s Required Rate of Return = 10 percent
Term of the bond = 10 years

Present Value Discount Factor of Ordinary Annuity (PVDF-OA 10, 10%) = 6.1446
PV of 10 payments of Br. 100,000 at 10% interest (Br. 100,000 x 6.1446) = Br. 614, 460

Present Value Discount Factor of Single Sum for 10 periods, at 10%= 0.3855
PV of Br. 1,000,000 for 10 periods, at 10% (Br. 1,000,000 x 0.3855) = 385, 500
The value of the bond today is, therefore, Br. 1,000,000

NB: When the required rate of return on a bond is the same as its
coupon rate, the value of the bond is always equal to its par value.
 VALUATION…. CONT’D

Required Returns and Bond Values

►Whenever the required return on a bond differs from the
bond’s coupon interest rate, the bond’s value will differ
from its par or face value.
►The required return on the bond is likely to differ from
the coupon interest rate because of several reasons, for
example,
(1) Economic conditions have changed, causing a shift in
the basic cost of long-term funds, or
(2) The firm’s risk has changed.
 VALUATION…. CONT’D

◙ Regardless of the
Increases in the basic exact cause, when the
cost of long-term funds required rate of return
on a bond is greater
or risk will raise the
than its coupon
required return interest rate, the value
whereas decreases in of the bond will be less
the basic cost or risk than its par value. In
will lower the required this case the bond is
return. said to sell at a
discount. The discount
is equal to the
difference between the
 VALUATION…. CONT’D

On the other hand, Case 2: Assume

when the required that another
rate of return falls investor viewed
below the coupon the bond of
interest rate, the Hussen Corp. to
bond value will be be riskier and thus
greater than its requires 12% rate
par value. In this of return on this
case, the bond is bond.
said to sell at a Determine its
premium. value?
 VALUATION…. CONT’D

Solution:
Periodic/ Annual interest on the bond = Br. 1,000,000 x 0.1 = Br. 100,000
Face /par Value of Bond = Br. 1,000,000.00
Investor’s Required Rate of Return = 12 percent
Term of the bond = 10 years

Present Value Discount Factor of Ordinary Annuity (PVDF-OA 10, 12%) = 5.650
PV of 10 payments of Br. 100,000 at 12% interest (Br. 100,000 x 5.650) = Br. 565,000

Present Value Discount Factor of Single Sum for 10 periods, at 12% = 0.322
PV of Br. 1,000,000 for 10 periods, at 12% (Br. 1,000,000 x 0.322) = 322,000
The value of the bond today is, therefore, Br. 887,000

Note: When the required rate of return on the bond is greater than the
coupon rate, the bond is said to be issued at a discount and the intrinsic
value of the bond is less than the par value.
VALUATION…. CONT’D

Case 3: Further
assume that an
investor
requires 8%
return on this
bond.
Determine its
value?
 VALUATION…. CONT’D

Solution:
Periodic/ Annual interest on the bond = Br. 1,000,000 x 0.1 = Br. 100,000
Face /par Value of Bond = Br. 1,000,000.00
Investor’s Required Rate of Return = 8 percent
Term of the bond = 10 years

Present Value Discount Factor of Ordinary Annuity (PVDF-OA 10, 8%) = 6.710
PV of 10 payments of Br. 100,000 at 12% interest (Br. 100,000 x 6.710) = Br.
671,000

Present Value Discount Factor of Single Sum for 10 periods, at 8% = 0.463

PV of Br. 1,000,000 for 10 periods, at 8% (Br. 1,000,000 x 0.463) = 463,000
The value of the bond today is, therefore, Br.1,134,000

Note: When the required rate of return on the bond is less than the
coupon rate, the bond is said to be issued at a premium and the
intrinsic value of the bond is greater than the par value.
 VALUATION…. CONT’D

Semiannual Interest Payments

Most bonds pay interest
Thus Vb = [(I/2*ADF2n,r/2) + (FVB*DF2n,r/2)]
semiannually. In this case, we
need to adjust the size of the Where,
interest payment as the coupon
interest amount is to be paid in Vb = Value of bond
two semiannual installments ADF = Annuity Discounting Factor
rather than a one time annual FVB = Face Value of the bond
SDF = Single Sum Discounting
payment. Besides, the Factor
discounting factors should be
adjusted accordingly to comply
with the payments.
 VALUATION…. CONT’D

Exercise 1:
Assume that Hi-Tech Co. has issued a 9%,
Birr 100,000, 6-year bond that pays
interest semi-annually. The investor’s
required rate of return is 8%.

Required: Determine the value of the

bond?
 VALUATION…. CONT’D

Solution:
Periodic/ Semiannual interest on the bond = Br. 100,000 x 9% * 0.5 = Br.
4,500
Face /par Value of Bond = Br. 100,000.00
Investor’s Required Rate of Return = 8 percent
Term of the bond = 6 years or 12 periods

Present Value Discount Factor of Ordinary Annuity (PVDF-OA12, 4%) = 9.3851

PV of 12 payments of Br. 4,500 at 4% interest (Br. 4,500 x 9.3851) = Br.
42,232.95

Present Value Discount Factor of Single Sum for 12 periods, at 4% = 0.6246

PV of Br. 100,000 for 12 periods, at 4% (Br. 100,000 x 0.6246) = 62,460.00
The value of the bond today is, therefore, Br.104,692.95
 VALUATION…. CONT’D

Review Questions:
1) Sunn Company’s bonds, maturing in 7 years, pays 8 percent
on a Birr 1,000 face value. However, interest is paid
semiannually. If your required rate of return is 10 percent, what
is the value of the bond? How would your answer change if the
interest were paid annually?
2) Tulip Corporation bonds pay Birr 110 in annual interest, with a
Birr 1,000 par value. The bonds mature in 20 years. Your
required rate of return is 9 percent.
Required:
(a) Calculate the value of the bond
(b) How does the value change if (i) your required rate of return
increases to 12 percent or (ii) decreases to 6 percent?
(c) Interpret your finding in parts (a) and (b).
 VALUATION…. CONT’D

Yield to Maturity (YTM) ☻YTM is computed as

☻YTM is the rate of follows:
return investors earn if
they buy the bond at a YTM =
specific price, Bo, and
Where,
hold it until maturity.
☻The measure assumes YTM = Yield to Maturity
that the issuer makes all I = Interest on
bonds
scheduled interest and M = Par/Face value of
principal payments as bonds
promised. Bo = Current value of
bonds
n = No. of years to
 VALUATION…. CONT’D

Example
Shark Company bond which currently
sells for Birr 1,080, has a 10% coupon
interest rate and Birr 1,000 par value,
pays interest annually, and has 10
years to maturity.
Find its Yield to Maturity (YTM).
YTM =

YTM =

YTM = 8.85 Percent