A VALUATION MODEL

A Valuation Model

California Baptist University

BUS539-BE Financial Management

Dr. John Obradovich

May 24, 2020

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A VALUATION MODEL
Abstract

This is a hypothetical of a valuation model for a new issuance of $100 million-dollar corporate

bonds with a face value of par with numerical illustrations with tables. This hypothetical is

meant to show an understanding of bonds along with the formulas necessary to calculate present

and future value. Market determinants, market dependency on maturity, yield curve analysis,

bond characteristics that affect bond valuation, the concept of the time value of money, the

different type of annuities and a bond’s yield to maturity versus if it is called, and how to

calculate their values are also assessed.

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A VALUATION MODEL

A Valuation Model for a $100 Million Dollar Bond

A bond is a long-term debt instrument that allows a corporation to raise capital, by

agreeing to make payments of principal and interest, to the bond holders on specific dates.

In this valuation model, a new issuance of $100-million-dollar corporate bonds with a face

value of PAR is needed, to raise capital for future projects.

 The total number of bonds issued is 100,000.

 The value of each bond is $1,000.

 The coupon rate is 6%.

 The maturity date is in ten years.

 Payments will be made semi-annually.

 The company will begin to sell the bonds on June 1, 2020.

 The market rate is at 9%.

Since the coupon rate of 6% is lower than the current market rate of 9%, the bonds will

be issued at less than face value. This means, the bond price will be less than the face value of

the bond issue price of $1,000. In other words, the price of the bonds will be less than their par

value.

FV = $1000

Nper = 10 X 2 = 20

Pmt = FV X Coupon Rate/# of payments per year

Pmt = 1000 x .06/2

Pmt = 1000 x .03

Pmt = $30
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A VALUATION MODEL
Market Rate = 9%/2 = 4.5% = .045

The calculation is:

PV = 30( 1 − (1 + 0.045)-20 + $1000

4.5% (1+0.045)20

Calculating PV in Excel = (0.045,20,30,1000)

PV = $804.88

Therefore, the price per bond would be $804.88. Thus, lower than the $1,000 face value

of the bond itself. The model is important for the issuing process, since it helps determine the

issue price of the bond at the current interest rate, which will yield to the potential investor, a

value equal to the market rate of return. For the issuing company the model is important, as it

helps them determine at what price the bonds will be issued: at par, at a discount, or at a

premium value, so that the yield equal to the market return be offered to potential investors.

Possible Determinants

“In general, the quoted interest rate on a debt security, r, is composed of a real risk-free

rate, r*, plus several premiums that reflect inflation, the security’s risk, its liquidity (or

marketability), and the years to its maturity” (Brigham & Houston, 2018, p. 201).

Quoted interest rate = r = r* + IP + DRP + LP + MRP

r = quoted rate on a given security

r* = real risk-free rate of interest. This rate exists in a riskless security, in a world where there is

no expectation of inflation.

RRF = r* + IP. This would be the quoted rate for a U.S. Treasury bill, usually a risk-free security,

this is free of most risk and is very liquid.

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IP = Inflation premium is equal to the expected average rate of inflation over the life of the

security. IP is not necessarily equal to current inflation since the expected future inflation rate is

not necessarily the same as the current rate of inflation.

DRP = Default risk premium reflects the possibility that the issuer may default. This means that

the bond holder would not get paid the interest or principal that they were promised when they

purchased the bond.

LP = Liquidity premium charged by lenders to reflect that some securities can’t be converted to

cash quickly. Normally liquidity is low for Treasury securities and those securities issued by

large firms. Liquidity is high on security issued by small, privately held firms.

MRP = Maturity risk premium that happens with longer-term bonds that are exposed to a

significant risk of price declines due to increases in inflation and interest rates volitivity. MRP is

charged by lenders to adjust for this risk (Brigham & Houston, 2018).

With a term of ten years until maturity, this bond could possibly be impacted by MRP.

Although interest rates are at historic lows today, there is no guarantee that they will stay at

those levels. If inflation and interest rate rise, the value of the bond may suffer a price decline in

response.

Market Rate’s Dependency on Maturity – Yield Curve Analysis

To fully understand how the market rate will depend upon the maturity of the bond, a

yield curve is helpful for the analysis. A yield curve is a graph that shows the relationship

between maturities and bond yields. There are three different types of yield curves. First, a

normal yield curve which has an upward-sloping curve. Second, an inverted (abnormal) yield

curve which has a downward-sloping yield curve. Third, a humped yield curve where interest

rates on intermediate-term maturities are higher than rate on both short- and long-term
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A VALUATION MODEL
maturities (Brigham & Houston, 2018). Historically, short-term rates are below long-term rates

because of maturity risk premium. This is because short-term securities have less interest rate

risk than their longer-term security counterparts. Hence, short-term rates are generally less than

long-term rates.

Inflation will affect the slope of the yield curve. If inflation is expected to increase than

the yield curve will slope up, a normal yield curve. If inflation is expected to decrease, that will

result in an inverted yield curve that slopes downward.

Bond Characteristics Influence on Bond Valuation

Most bonds have similar characteristics in common, however certain bonds have

contractual features that allow the issuer to call the bond early. Call provisions, for example

allows the issuer to pay off the bond before the maturity date. A sinking fund provision is a

bond contract that mandates the bond issuer to retire a portion of the bond issue each year. For

example, this provision would “require the issuer to buy back a specified percentage of the issue

each year. A failure to meet the sinking fund requirement constitutes a default, which may

throw the company into bankruptcy. Therefore, a sinking fund is a mandatory payment”

(Brigham & Houston, 2018, p. 233). Call provisions and sinking funds are two contractual bond

characteristics that can influence bond valuation. Different contractual provisions can lead to

differences in a bond’s risks, expected returns and price. X

The Importance of the Time Value of Money in Finance

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A VALUATION MODEL
The single most important concept in finance is the time value of money. This is because

time value analysis has implications in planning for retirement, valuing stocks and bonds,

mortgages and other loan payment schedules along with corporate planning for future

investments. “A dollar in hand today is worth more than a dollar to be received in the future

because if you had it now, you could invest it, earn interest, and own more than a dollar in the

future” (Brigham & Houston, 2018, p. 151). This principle comes from the knowledge that

investors prefer to receive a return sooner, of if it is later, than it would garner a higher rate of

return because of the perceived risk.

This concept is significant in the banking industry. Since time value of money concept is

used to calculate the present value of annuities, annuities due of present investments for future

payment, cash flows, along with a known interest rate it can calculate the length of time for an

investment to grow, and perpetuity. Interest rates are also, set to the risk factors involved.

The Different Types of Annuities – Present Value v Future Value

An annuity is a series of equal payments at fixed intervals for a specified number of

periods. When payments occur at the end of each year, this is an ordinary or a deferred annuity.

When the payments are made at the beginning of each year, this is an annuity due.

The future value of an ordinary annuity can be calculated by solving for FVAN.

In where:

Which can be streamlined to:

FVAN
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“The present value of an annuity is the current value of all the income that will be

generated by that investment in the future” (Boyte-White, 2019, para. 10). In other words, it is

the amount of money that needs to be invested today to net a specific amount in the future. The

present value of an ordinary annuity can be calculated by solving for PVOrdinary Annuity.

PVOrdinary Annuity = Pmt X [1-(1+I)-n/I]

Now to calculate the future value of an annuity due, the formula is:

FVAnnuity Due = Pmt X [(1+I)n -1/I] X (1+I)

To calculate the present value of an annuity due, the formula is:

PVAnnuity Due = Pmt X [1-(1+I)-n/I] X (1+I)

Using Excel, the calculation is simplified by using the PMT function. Here the formula is:

PMT (rate, nper, pv, [fv],[type])

Rate = interest rate (entered as a decimal)

NPER = # of payments

PV = principal of the annuity (entered as a negative since it represents a payment made)

TYPE = is the type of annuity (ordinary = 0, due = 1)

A Bond’s Yield to Maturity vs Yield to Call and the True Yield

A bond’s yield to maturity (YTM) is the internal rate of return (IRR) that is required for

the present value (PV) of all the future cash flows (FCF) of the bond. At maturity, the value of

any bond must equal the par/face value of the bond. To calculate for the YTM:

Again, using Excel the RATE formula would solve for which states:

Rate(nper, pmt, pv, [fv], [type], [guess])

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A bond’s yield to maturity with a call would require solving for yield to call (YTC).

This refers to the return an investor will receive if they hold the security/bond until call date,

which is before the debt instrument reaches maturity.

“The bond is expected to be called if interest rates decrease below the coupon rate, but

the call price to be paid partially prevents this from happening. If the market price reaches this

limit, the issuer most likely will redeem bonds and reissue them at a lower interest rate. The key

problem is that nobody can know in advance whether this will happen or when. Thus, many

investors use the lowest yield to call and yield to maturity as the most realistic appraisal of the

expected rate of return” (Smirnov, n.d. para 11).

The true yield of a bond is the amount of return the bondholder will realize on the

investment instrument, calculated by dividing the par value/face value by the amount of interest

is pays. In Excel the # of periods would differ in calculating the YTM vs YTM.

References
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Boyte-White, C. (2019). Present Value Vs. Future Value in Annuities. Retrieved from:

https://www.investopedia.com/ask/answers/070915/what-difference-between-present-

value-annuity-and-future-value-annuity.asp

Brigham, E.F., & Houston, J.F. (2018). Fundamentals of Financial Management. Mason, OH.

Cengage Learning.

Smirnov, Y. (n.d.) Yield to Call, Ytc. Retrieved from:

http://financialmanagementpro.com/yield-to-call-ytc/