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Bond valuation is the determination of the fair price of a bond

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- 1. Corporate Finance Bond Valuation – Session 2
- 2. Bonds – Fixed Income Securities “ Fixed income securities, promises to pay a stream of semiannual or annual payments for a given number of years and then repay the loan amount at the maturity date.”
- 3. Types of Financial Instruments Treasury Bonds Corporate Bonds or TFC Treasury Bills
- 4. Key Characteristics of Bonds Par Value Coupon payment Coupon interest rate Floating Rate Bond Zero coupon bond Original issue discount / premium bonds Maturity Date
- 5. Bond Indenture The bond indenture is the contract between the issuer and the holder. It specifies: Details regarding payment terms Collateral Positive & negative covenants Par or face value (usually increments of $1,000) Bond pricing – usually shown as the price per $100 of par value, which is equal to the percentage of the bond’s face value
- 6. Security & Protective Provisions Covenants Positive covenants – things the firm agrees to do Supply periodic financial statements Maintain certain ratios Negative covenants – things the firm agrees not to do Restrictions on the amount of debt the firm can take on Prevents the firm from acquiring or disposing of assets
- 7. Bond Valuation Kd = The bond market rate of interest. Discount to use to calculate the present value of bond. N = The number of years before the bond matures. INT = Rupee amount of interest paid annually or semiannually. M or FV = the or maturity value of the bond.
- 8. Bond Valuation Bond Value = VB = INT + INT + … + INT + M (1+Kd) ⁿ (1+Kd) ⁿ (1+Kd)¹ (1+Kd)² [ or ] 1 PV = C 1 − r (1+ r ) n + (1FV) n r +r
- 9. Bond Valuation N=3 Kd = 12% INT = 10 M or FV = 100 Find out Bond value. Semi annual coupon.
- 10. Current Yield It is the yield based on bond’s annual coupon payment. It does not reflect the total return on bond. It does not reflect the capital gain or loss on bond.
- 11. Current Yield Current Yield = Annual Coupon Payment Current Price of Bond Example: A semi annual bond with a FV = 100, market price Rs.98 and coupon rate of 9.50%. Compute current yield.
- 12. Yield to Maturity The rate of return earned on a bond if it is held till maturity. It is the total rate of return on a bond. YTM equals the expected rate of return only if: 1. The probability of default is ZERO. 2. The bond cannot be called.
- 13. Yield to Maturity YTM approx. = Annual Cpn + (FV – PV ) / N (FV + PV ) / 2 E.g. N = 10, annual coupon 10%, FV = Rs.100, PV = Rs.105. Find out YTM.
- 14. Yield to Call The rate of return earned on a bond if it is called before its maturity. Can be called if interest rates falls below the bond coupon rate.
- 15. Yield to Call YTC = Annual Cpn + (Call price – PV ) / N (Call price + PV ) / 2 E.g. N = 10, FV = 100, PV = 105, Coupon rate = 10%, Call price = 108, Kd = 5%. The bond can be called after 5 Years.
- 16. Factors Affecting Bond Prices There are three factors that affect the price volatility of a bond Yield to maturity Time to maturity Size of coupon
- 17. Coupon Rate Relationship to Yield-toMaturity The relationship between the coupon rate and the bond’s yieldto-maturity (YTM) determines if the bond will sell at a premium, at a discount or at par If Then Bond Sells at a: Coupon < YTM Market < Face Discount Coupon = YTM Market = Face Par Coupon > YTM Market > Face Premium 6 - 17 CHAPTER 6 – Bond Valuation and Interest Rates
- 18. Other Types of Bonds/Debt Instruments
- 19. Treasury Bills Short-term obligations of government with an initial term to maturity of one year or less Issued at a discount & mature at face value The difference between the issue price and the face value is treated as interest income To calculate the price of a T bill, use the following formula: P Bill T 6 - 19 Where: P = market price of the T Bill F = F = face value of the T Bill n BEY = the bond equivalent yield 1 + BEY ÷ n = the number of days until maturity B B = the annual basis (365 days in Pakistan) CHAPTER 6 – Bond Valuation and Interest Rates
- 20. Solving for Yield on a T Bill To solve for the yield on a T bill, rearrange the previous formula and solve for BEY. Example: What is the yield on a Rs.100 T-bill with 180 days to maturity and a market price of Rs.98.20? 6 - 20 CHAPTER 6 – Bond Valuation and Interest Rates
- 21. Zero Coupon Bonds A zero coupon bond is a bond issued at a discount that matures at par or face value A zero coupon bond has no reinvestment rate risk, since there are no coupons to be reinvested To calculate the price of a zero coupon bond, solve for the PV of the face amount 6 - 21 CHAPTER 6 – Bond Valuation and Interest
- 22. Zero Coupon Bonds Example: What is the market price of a Rs.100 zero coupon bond with 25 years to maturity that is currently yielding 14%? 6 - 22 CHAPTER 6 – Bond Valuation and Interest Rates

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