Module 3:

Bond Valuation
Reference: Financial Management Fundamentals by E. Brigham, 12 th edition (Chapter 10)
Summary notes:

Bond - A long-term debt instrument in which a borrower agrees to make payments of

principal and interest, on specific dates, to the holders of the bond
I. Features of a Common Share
a. Par value: face amount of the bond, which is paid at maturity (assume
1,000 denomination)
b. Coupon interest rate: stated interest rate (generally fixed) paid by the
issuer. Multiply by par value to get dollar payment of interest.
c. Maturity date: years until the bond must be repaid.
d. Issue date: when the bond was issued.
e. Yield to maturity: rate of return earned on a bond held until maturity (also
called the “promised yield”).
f. Convertible bond: may be exchanged for common stock of the firm, at the
holder’s option.
g. Warrant: long-term option to buy a stated number of shares of common
stock at a specified price.
h. Putable bond: allows holder to sell the bond back to the company prior to
maturity.
i. Income bond: pays interest only when interest is earned by the firm.
j. Indexed bond: interest rate paid is based upon the rate of inflation
k. At maturity, the value of any bond must equal its par value.

ISSUER = SELLER = DEBTOR

BONDHOLDER = BUYER = CREDITOR

II. Call Provision

a. Allows issuer to refund the bond issue if rates decline (helps the issuer, but
hurts the investor).
b. Bond investors require higher yields on callable bonds.
c. In many cases, callable bonds include a deferred call provision and a
declining call premiumStock Price versus Intrinsic Value
III. Bond Markets
a. Primarily traded in the over-the-counter (OTC) market.
b. Most bonds are owned by and traded among large financial institutions.
c. Secondary markets through brokers and investment institutions

IV. Sinking Fund

a. Provision to pay off a loan over its life rather than all at maturity.
b. Similar to amortization on a term loan.
c. Reduces risk to investor, shortens average maturity.
d. But not good for investors if rates decline after issuance.
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V. Valuation Techniques
a. Discounted Cash Flow Methods
i. PV of all Future Cash flows

In general, cash flows of the bond include the Maturity Price or

Principal amount and all interests due.

Bond Value = PV of interest + PV of principal

NOTE: Use PV of 1 for unequal cash flows while PV of Ordinary

Annuity of 1 for series of equal cash flows (first payment one
period after

There is an INVERSE relationship between required rate of return

and price of the bond. If the rate increases, bond price decreases
while if the rate decrease, bond price increases. (Effective and
Nominal Interest Concept).

ii. Yield to Maturity or Yield to call

1. Using Financial Calculator.
Unfortunately, we are not allowed to use this in class or in
the licensure exam for that matter.
2. Trial and Error
Most effective but very time consuming

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 3. Estimation

4. Other relevant formula:

TOTAL YIELD = Current Yield + Capital Gains Yield

CURRENT YIELD = Annual Int. Paid / Bond’s Current Price
CAPITAL GAINS YIELD = (P1 – Po) / Po

VI. Risk associated with Bonds

a. Interest rate risk
i. The concern that rising cost of debt will cause the value of a bond to
fall.

b. Reinvestment rate risk

i. The concern that cost of debt will fall, and future cash flows will have
to be reinvested at lower rates, hence reducing income

c. Default risk
i. If an issuer defaults, investors receive less than the promised return.
ii. influenced by the issuer’s financial strength and the terms of the bond
contract.

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