Bonds and Their Valuation Part II

z
BOND
VALUATION
Fundamentals of Financial Management 15ed by Houston and Brigham
z

Bond Valuation

Value of any Financial Asset —a stock, a bond, a lease, or even a

physical asset such as an apartment building or a piece of
machinery—is the present value of the cash flows the asset is
expected to produce.

Cash flows for a standard coupon bearing bond:

✓ Interest payments during the bond’s life

✓ Principal borrowed (generally the par value) when the bond

matures
 Example: On the beginning of the
year 2018, Allied issued 15-year
z
bonds with a coupon interest rate
of 10% annually.

Annual Interest Payment:

=Php 1000* 10% = Php 100

Total Interest payments for 15yrs:

= Php 100*15yrs = Php 1500

z Total Payments:
= Principal + Interest Payments
= Php 1000 + Php 1500
 z

TIMELINE
WHERE:
Rd = the market rate of interest on the bond. This is the discount rate
used to calculate the present value of the cash flows, which is also the
bond price. Note that it is not the coupon interest rate. However, it will
be equal to the coupon rate at times, especially the day the bond is
issued; when the two rates are equal, the bond sells at par.
 z

TIMELINE
WHERE:
N =the number of years before the bond matures. N declines over time
after the bond has been issued, so a bond that had a maturity of 15
years when it was issued (original maturity = 15) will have N = 14 after
1 year and so on.
 z

TIMELINE
WHERE:
INT = Interest paid each year. Coupon rate * Par Value
 z

TIMELINE
WHERE:
M = The par, or maturity, value of the bond. This
amount must be paid at maturity.
Rd = 10% Example: On the beginning of the
year 2018, Allied issued 15-year
z 1000 * 10% = Php 100
INT = Php bonds with a coupon interest rate
M = Php 1000 of 10% annually.
N = 15 years
Annual Interest Payment:
=Php 1000* 10% = Php 100

Total Interest payments for 15yrs:

= Php 100*15yrs = Php 1500

z Total Payments:
= Principal + Interest Payments
= Php 1000 + Php 1500
 z
BOND VALUATION: EQUATION

Present Value of Interest Payments

Present Value of Principal Payment

 z
BOND VALUATION: EQUATION

Present Value of Interest Payments

Present Value of Principal Payment Principal

Payment OR Principal Payment x
1
z
MOVEMENT IN MARKET INTEREST RATE

Whenever the bond’s market, or going, rate, Rd, is equal to

its coupon rate, a fixed-rate bond will sell at its par value. Normally,
the coupon rate is set at the going rate in the market the day a bond
is issued, causing it to sell at par initially.

The coupon rate remains fixed after the bond is issued, but interest
rates in the market move up and down. An increase in the market
interest rate (Rd) causes the price of an outstanding bond to fall,
whereas a decrease in the rate causes the bond’s price to rise.
BONDS ARE SELLING @ PAR
Rd = 10%
z
BOND VALUATION: EQUATION
INT = Php 1000 * 10% = Php 100
M = Php 1000
N = 15 years

Bond Price = Php 1000

Rd > Coupon Rate

Rd = 15%
INT = Php 1000 * 10% = Php 100
M = Php 1000
N = 15 years

Bond Price = Php 707.63

Present Value of Interest Payments
Rd < Coupon Rate
Rd = 5%
INT = Php 1000 * 10% = Php 100
M = Php 1000
N = 15 years
Present Value of Principal Payment Principal
Payment OR Principal Payment x
1
Bond Price = Php 1,518.98
z
Present Value
(Single Payment)

Principal Payment x
1

1. (1+Rd )

2. Press (÷) two (2) times

3. Press (=) N times

z
Present Value
(Ordinary Annuity)

1. (1+Rd )

2. Press (÷) two (2) times

3. Press (=) N times

4. Press +- to make the value negative

5. Plus 1

6. Divide by Rd
z
Discount Bond
A bond that sells below its par
value; occurs whenever the
going rate of interest (or market
rate of interest) is above the
coupon rate.
Premium Bond
A bond that sells above its par
value; occurs whenever the
going rate of interest is below
the coupon rate.
z
ACTIVITY

1. A bond that matures in 8 years has a par value of Php1,000

and an annual coupon payment of Php 70; its market interest
rate is 9%. What is its price?

2. A bond that matures in 12 years has a par value of Php1,000

and an annual coupon rate of 10%; the market interest rate is
8%. What is its price?

3. Which of those two bonds is a discount bond, and which is a

premium bond? Explain.