ICAN REVISION CLASS - BOND VALUATION (CAP-II)

Learning Objective of the Chapter:

1) Valuation approach.
2) Key terms relating to bond valuation.
3) Valuation of Normal bond, perpetual bond, zero coupon bond, deep
discount bond, semi-annual bond.
4) Premium bond and discount bond
5) Computation of returns on bonds: Current yield, YTM, YTC and
Capital gain and loss yield

Valuation Approach:

i) Book Value
= Net worth/ Nos of Shares
Net worth = Assets – Liabilities

ii) Liquidation Value

= (Amount Realised from sale of assets – Payments of Liabilities)/ Nos. of Shares

iii) Market Value

Refers to the price at which an asset can be sold in the market. For e.g. Price at which stock is
traded in the stock exchange.

iv) Replacement Value: The replacement value is the cost of acquiring a new asset of equal utility
and usefulness.

iv) Intrinsic Value

Present value of expected future cash flows discounted at appropriate required rate of return.

SECURITIES VALUATION BONDS (FIXED INCOME SECURITIES)

Bonds
Bonds is a long-term contract under which a borrower agrees to make payments of interest and
principal on specific dates to the holder of the bond

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Key Terms in relation to bonds

1) Par Value:
Par value is the stated face value of the bond. It is also known as principal.

2) Coupon Interest Rate/Coupon Rate:

The rate of interest; which are to be paid to bondholders on specific dates as per contract.
- Fixed Interest
- Floating interest rate (e.g. Treasury bill rate Plus 5%, LIBOR +2%, Base rate plus
3%)
Note: LIBOR=London Interbank Offered Rate
3) Coupon Payment/Interest amount:

4) Issue Price:

5) Maturity Date:
The specific date on which the principal amount (par value) is to be repaid, but some time bonds
may be issued without any maturity date.

6) Redemption Value/Maturity Value:

7) Call Provision:
The condition mentioned in the bond contract which will give the issuing company the right to
call the bonds for redemption before the maturity date.

8) Call Date:

9) Call Price:

10) Market Price:

Valuation Formula:
1) Normal Bonds
Vb= I1/(1+Kd)1+I2/(1+Kd)2………………………..+In/(1+Kd)n+ Pn/(1+Kd)n

2) Perpetual Bonds
Vb = I1/(1+Kd)1+I2/(1+Kd)2………………………..+Iα/(1+Kd)α

OR Vb =I/Kd

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3) Zero Coupon Bonds/Deep Discount Bonds

Vb = 0/(1+Kd)1+0/(1+Kd)2………………………..+Pn/(1+Kd)n

4) Bonds with semi- annual interest

Question No.1
Compute value of the following bonds assuming investors require 12 percent return.

a. 10 percent, Rs. 1000 par value bonds.

b. Rs. 1000 par, zero coupon bonds, which matures in 7-years.
c. 10-percent, 15-year, Rs. 1000 par value bond. Interest on such bond is paid annually.
d. 9-percent, 12-year, Rs. 1000 par value bond. Interest is payable semiannually.

Solution:
a) Vb=I/Kd =Rs. 1000*10%/12%=Rs. 100/0.12=Rs. 833.33

b) Vb=Pn/(1+Kd)n =Rs. 1,000/(1+0.12)7 =Rs. 1,000*0.452=Rs. 452

c) Vb= I X P.V. annuity factor @Kd for nth years + Pn X P.V. Single sum factor @ Kd for nth
Years

=Rs. 1000*10% X P.V. annuity factor @12% for 15 th years + Rs. 1,000 X P.V. Single Sum
factor @ 12% for 15th Years
=Rs. 100 X 6.811 + Rs. 1,000 X 0.183
=Rs. 681.10 + Rs. 183
=Rs. 864.10

d) Vb= I (Semi Annual) X P.V. annuity factor @Kd (Semi annual) for n th periods + Pn X P.V.
Single Sum factor @ Kd for nth Periods
= Rs. 1000*4.5% X P.V. annuity factor @ 6% for 24th periods + Rs. 1,000 X P.V. Single
Sum factor @ 6% for 24th Periods
=Rs. 45 X 12.550 + Rs. 1,000 X 0.247
=Rs. 564.75 + Rs. 247
=Rs. 811.75

Question No. 2
Suppose Narayani Textile Company sold an issue of bonds with a 10-year maturity, a Rs. 1000
par value; a 10 percent coupon rate, and semiannual interest payments.

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a. Two years after the bonds were issued, the going rate of interest on such bonds fell to 6 percent.
At what price would the bonds sell?

b. Suppose that, 2 years after the initial offering, the going interest rate had risen to 12 percent. At
what price would the bonds sell?

c. Suppose that the conditions in part 'a' existed – that is, interest rates fell to 6 percent 2 years after
the issue date. Suppose further that the interest rate remained at 6 percent for the next 8 years.
What would happen to the price of the company's bonds over time?

Solution:

a) Vb= I (Semi Annual) X P.V. annuity factor @Kd (Semi annual) for n th periods + Pn X P.V.
Single Sum factor @ Kd for nth Periods
= Rs. 1000*5% X P.V. annuity factor @ 3% for 16th periods + Rs. 1,000 X P.V. Single
Sum factor @ 3% for 16th Periods
=Rs. 50 X 12.561 +Rs. 1,000 X 0.623
=628 +623
= Rs. 1251 (Premium Bond)

b) Vb= I (Semi Annual) X P.V. annuity factor @Kd (Semi annual) for n th periods + Pn X P.V.
Single Sum factor @ Kd for nth Periods
= Rs. 1000*5% X P.V. annuity factor @ 6% for 16th periods + Rs. 1,000 X P.V. Single
Sum factor @ 6% for 16th Periods
=Rs. 50 X 10.106 +Rs. 1,000 X 0.394
=505 +394
= Rs. 899 (Discount Bond)
c)
Premium Bond = Rs. 1251

Par Value =Rs. 1,000 Maturity Value (Par value)

8 years remaining

Discount Bond

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Note: Bond Valuation Fundamentals

(a) When the required rate of return equals the coupon rate, the bond sells at par value.
(b) When the required rate of return exceeds the coupon rate, the bond sells at a discount. The
discount declines as maturity approaches.
(c) When the required rate of return is less than the coupon rate, the bond sells at a premium. The
premium declines as maturity approaches

Question No 3
The Dhaulagiri Company has two bond issues outstanding. Both bonds pays Rs. 80 annual interest
plus Rs. 1000 at maturity. Bond A has a maturity of 15 years and bond B a maturity of 1 year.

a. What will be the value of each these bonds when the going rate of interest is (1) 4 percent, (2) 8
percent, and (3) 12 percent? Assume that there is only one more interest payments to be made on
bond B.

b. Which bond fluctuate more with the change in going rate of interest? The long-term (15 year)
bond or the shorter-term bond (1 year).

Note: Bond Valuation Fundamentals [Addition to point (c)]

(d) The longer the maturity of a bond, the greater is its price change with a given change in the
required rate of return.

Question No. 4
ABC Ltd. issued 9%, 5 year bonds of Rs. 1,000/- each having a maturity of 3 years. The present
rate of interest is 12% for one year tenure. It is expected that Forward date of interest for one year
tenure is going to fall by 75 basis points and further by 50 basis points for every next year in further
for the same tenure.
Calculate: Intrinsic value of bond
Answer
(i) Intrinsic value of Bond = PV of interest + PV of Maturity Value of Bond
Forward rate of interests
1st Year 12%
2nd Year 11.25%
3rd Year 10.75%

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. . .
PV of interest = +( )(
+( )( )(
( . ) . . ) . . . )

= Rs. 217.81
.
PV of Maturity Value of Bond = ( )( )(
= Rs. 724.67
. . . )

Intrinsic value of Bond = Rs. 217.81 + Rs. 724.67 = Rs. 942.48

(Past Exam Questions relating to Valuation of Bonds)

Question No. 5
Mathura Corporation has two different bonds currently outstanding. Bond M has a face value of
Rs. 20,000 and matures in 20 years. The bond makes no payments for the first six years, then pays
Rs. 1,200 every six months over the subsequent eight years, and finally pays Rs. 1,500 every six
months over the last six years. Bond N also has a face value of Rs. 20,000 and a maturity of 20
years; it makes no coupon payments over the life of the bond. The required return on both of these
bonds is 10 percent compounded semiannually.
Required:
(5 Marks)
What is the current price of Bond M and Bond N?
You can use the following statistical figures:
PVIFA5%, 12 Years =8.8633 PVIFA5%, 28 Years =14.8981
PVIFA5%, 40 Years =17.1591 PVIFA5%, 40th Years=0.1420
[December 2017]

Answer:
Bond M is redeemable bond and the value of redeemable bond is discounted present value of
Interest and Principal amount over the life of the bond. Therefore the value of Bond M may be
calculated as below:
Value of Bond M = PV of Interest for First 6 Years + PV of Interest for next 8 Years + PV of
Interest for last 6 Years + PV of Redemption Value of Principal

= 0+ 1,200× [PVIFA 5%, 28 Years –PVIFA 5%, 12 Years] + 1,500× [PVIFA 5%, 40
Years –PVIFA 5%, 28 Years] + 20,000× [PVIF 5%, 40th Year]
= 0 + 1,200× [14.8981-8.8633] + 1,500× [17.1591- 14.8981]
+20000×0.1420
= 7,241.76 + 3,391.50 + 2,840
= Rs. 13,473.26

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Bond N is Zero Coupon Bond and the value of Zero Coupon bond is discounted present value of
Principal amount redeemed over the life of the bond. Therefore the value of Bond N may be
calculated as below:

Value of Bond N = PV of Redemption Value of Principal

= 20,000 × [PVIF5%, 40Years]
= 20,000 × 0.1420
= Rs. 2,840

Question No. 6
The XYZ limited is contemplating a debenture issue on the following terms:
Face value = Rs. 100 per debenture
Term of maturity= 7 years
Coupon rate of Interest:
Years 1-2=8% p.a.
3-4=12% p.a.
5-7=15% p.a.

The Current market rate of interest on similar debenture is 15%p.a.The company proposes to price
the issue so as to yield a (compounded) return of 16% p.a. to the investor. Determine the issue
price. Assume the redemption on debenture at a premium of 5% (Note: The present value interest
factors at 16% p.a. for years 1 to 7 are .862, .743, .641, .552, .476, .410, and .354 respectively).
(4 Marks)

[June 2014]

Answer:
The interest payments over the life of the debentures and their present values are given in the
following table:

Year Interest(Rs.) PVF@16% Present Value(Rs.)

1 8 .862 6.896
2 8 .743 5.944
3 12 .641 7.692
4 12 .552 6.624
5 15 .476 7.14
6 15 .410 6.15
7 15 .354 5.31
Total 45.756

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The present value of the redemption amount of Rs. 105 (Rs.100+Rs.5)@16% p.a. is Rs.
105*.354=Rs. 37.17
Therefore, the present value of the debenture is Rs. 45.76+Rs. 37.17=Rs. 82.93. The company
should issue the debenture at this value in order to yield a return of 16% to the investors.

Computation of Bond Return

The return on the bond can be measured as:
I
i) Current Yield =
P0
ii) Yield to Maturity (YTM)
Assumption
- held to maturity
- no call provision
- coupon interest will be re-invested@YTM
iii) Yield to Call (YTC)
iv) Capital Gain (or Loss) Yield
= YTM - current yield

Effective YTM = (1 + semi-annual YTM)2 - 1

Question No: 7
A 10-year, 12% semi-annual coupon bond, with a par value of Rs. 1,000 may be called in 4 years
at a call price of Rs. 1,060. The bond sells for Rs. 1,100. Assume that the bond has just been issued.
Required:
(4+1+1+4=10 Marks)
i) What is the bond’s effective annual yield to maturity?
ii) What is the bond’s annual current yield?
iii) What is the bond’s capital gain or loss?
iv) What is the bond’s effective annual yield to call?
[December 2011]

Answer:
Given,

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Par value (M) = Rs. 1,000

Coupon rate = 12%
Annual coupon (I) = 12% of Rs 1,000 = Rs 120
Maturity period (n) = 10 years
Call period = 4 years
Call price = Rs. 1,060
Selling price = Rs 1,100
Semi-annual compounding.

i. Calculation of bond’s effective annual yield to maturity (YTM)

Vb = I (PVIFAkd%, n) + M (PVIFkd%, n)

So, for semiannual bond,

Rs 1,100 = I/2 X PV annuity factor @ YTM for n x 2 periods + Pn X PV single factor @ YTM
for n x 2 periods ………………..(1)

Approximate semiannual YTM =

=
.

=
.

= 5.16%
Now, trying at 5%,

PV = Rs 60(PVIFA5%, 20) + 1,000(PVIF5%, 20)

= 60 x 12.4622 + 1,000 x 0.3769 = Rs 1,124.63 > Rs 11,00
Trying at 6%,

PV = Rs 60(PVIFA6%, 20) + 1,000(PVIF6%, 20)

= 60 x 11.4699 + 1,000 x 0.3118 = Rs 999.99 < Rs 1,100

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By interpolating,

( % %)
Semiannual YTM = 5% + x (1124.63 − 1100) = 5.2%
( . . )

Rs. 1125.63 5%

Rs. 1100 ?

Rs. 999.99 6%

Therefore, nominal (Annual) YTM = 5.2% x 2 = 10.4%

The effective annual YTM = (1 + 0.052)2 – 1 = 1.1067 – 1 = 0.1067 = 10.67%

ii. Calculation of bond’s current yield

= Coupon payments / Price of the Bond
= 120/1,100 = 0.1091
= 10.91%

iii. Calculation of bond’s Capital gain or loss

We have,
YTM = Current Yield + Capital Gain or Loss Yield
10.67% = 10.91% + Capital Gain or Loss Yield
Capital Gain or Loss Yield = 10.67% - 10.91% = (0.24%)
So, Capital loss is 0.24%

iv. Calculation Bond’s Yield to Call (YTC)

We have,

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Rs 1,100 = I x PV annuity factor @YTC for Call period + Rs Call price x PV single sum
factor @ YTC for call period
Or. Rs. 1,100 = Rs. 60 x PV annuity factor @YTC for 8 periods + Rs 1060 x PV single
sum factor @ YTC for call period

Approximate semiannual YTC =

=
-
=
.

= 5.061%

Now, trying at 5%,

PV = Rs 60(PVIFA5%, 8) + 1,060(PVIF5%, 8)
= 60 x 6.4632 + 1,060 x 0.6768
= Rs 1,105.20 > Rs 1,100

Trying at 6%,

PV = Rs 60(PVIFA6%, 8) + 1,060(PVIF6%, 8)
= 60 x 16.2098 + 1,060 x 0.6274
= Rs 1037.63 < Rs 1,100

By interpolating,

.
Semiannual YTC = 5% + x (6% − 5%) = 5.08%
( . . )

Therefore, nominal YTC = 5.08% x 2 = 10.16%

The effective annual YTC = (1 + 0.0508)2 – 1 = 1.1042 – 1 = 0.1042 = 10.42%

Question No: 8
The bonds of Express Ltd. are currently selling at Rs. 130. They have 9 percent coupon rate of
interest and Rs. 100 par value. The interest is paid annually and the bonds have 20 years to maturity.

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You are required to:

(4+2=6 Marks)
i) Compute the Yield to Maturity (YTM) of the bond.
ii) Explain the difference between YTM and coupon rate of interest of the bond.
(December 2010)

Answer:
We have,

Vb = I x (PVIFAkd n) + M x (PVIF kd n)

Where,
Vb = Value of the Bond
I = Annual Interest Paid
n = Number of Years to Maturity
M = Par/Maturity Value
kd = Required Return on the Bond

Information given in the problem are:

Vb = Rs. 130
I (Annual Interest Paid) = Rs. 100 X 0.09 = Rs. 9
M (Par/Maturity Value) = Rs. 100
n = 20

App. YTM= 6.52 % (By using CO+CI/2)

Let us try a lower rate of 7 per cent in the formula:

B = I x (PVIFAkd, n) + M x (PVIF kd, n) = Rs. 9 x (PVIFA 7, 20) + Rs. 100 x (PVIF 7, 20)
= (Rs. 9 x 10.594) + Rs. 100 x 0.258) = Rs, 95.35 + Rs. 25.80 = Rs. 121.15.

Since Rs. 121.15 < Rs. 135, let us try still a lower rate of 6 per cent.
B = I x (PVIFAkd n) + M x (PVIF kd n) = Rs. 9 x (PVIFA 6, 20) + Rs. 100 x (PVIF 6, 20)
= (Rs. 9 x 11.470) + Rs. 100 x 0.312) = Rs, 103.23 + Rs. 31.20 = Rs. 134.43.

By interpolation,

YTM = 6% + (7% – 6%) X (134.43-130) = 6% + (4.43/13.28)% = (6+0.33) %

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(134.43– 121.15)
= 6.33% approximately.

Note: The YTM (6.33%) is below the coupon interest rate (9%) of the bond since its market value
(Rs. 130) is above its par value (Rs. 100).

ii) Explanation Regarding the difference between YTM and Coupon Rate

Yield to maturity (YTM) is the expected rate of return on a bond if bought at its current market
price and held to maturity. It is also called the bond’s internal rate of return (IRR).
The underlying feature of bond price is that YTM < coupon rate when a bond sells at a premium
and vice versa. Similarly, YTM = coupon rate when a bond sells at par.
In the present case, the bond is selling at a premium of Rs. 30 as compared to the par value of Rs.
100. This is the reason for the YTM (6.33%) being lower than the coupon interest rate of 9%.

Question No: 9
Based on the credit rating of the bonds, an investor has decided to apply the following discount
rate for valuing the bonds.

Credit rating Discount rate

AAA 364-day Treasury-bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread

The investor is considering investing in an AA rated, Rs. 1,000 face value bond currently selling
at Rs. 1,010. The bond has five years to maturity and the coupon rate on the bond is 15% per
annum payable annually. The next interest payment is due one year from today and the bond is
redeemable at par. (Assume 364-day Treasury bill rate to be 9%)
You are required to calculate:
(5+3=8Marks)

i) Intrinsic value of the bond for the investor. Should the investor invest in the bond?
ii) Current yield (CY) and the yield to maturity (YTM) of the bond.
[June 2011]
Answer:
AA rated face value of bond = Rs. 1,000

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Current selling price = Rs 1,010

Maturity period of bond = 5 years
Coupon rate of the bond = 15% per annum payable annually
Bond redeemable at par at the end of 5th year.
Net interest payment is due on year from today.
Discount rate for AA rated bond = 9% + 3% + 2% = 14%

Calculation of Present Value of Cash Inflow from Bond

(Rs.
__________________________________________________________________
Year-end Cash Inflow PV Factor at 14% Pre. Values
__________________________________________________________________
1 150 0.8772 131.58
2 150 0.7695 115.43
3 150 0.6750 101.25
4 150 0.5921 88.82
5 1,150 0.5194 597.31
Present value of total Cash Inflow: 1,034.40
______________________________________________________________________________
______________________________________________________________________________
Thus, the intrinsic value of bond is Rs. 1,034.40. Since the intrinsic value of bond (Rs. 1,034.40)
is more than its current market value (Rs. 1,010), it is suggested to purchase the bond.

Current yield = Annual Bond Interest x 100 = 150 x 100 = 14.85%

Market price 1,010
Yield to Maturity (YTM)

P = Rs. 150 x PVIFA @ 15% for 4 years + Rs. 1,150 x PVIF at 15% for 5 th year
= (150 x 2.855) + (1,150 x 0.4972 = 428 + 571.78 = 1,000.03

Present value at 14% = Rs. 1,034.40

Present value at 15% = 1,000.03
By interpolation,

YTM = 14 + 1,034.40 – 1,010 x 1 = 14% + (24.40 / 34.37) = 14.71%

1,034.40 – 1,000.03

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Question No 10
In February 2016 the NEC issued a series of 3.4 percent, 30-year bonds. Interest rates rose
substantially in the years following the issue, and as they did, the price of the bonds declined. In
February 2029, 13 years later, the price of the bonds had dropped from Rs. 1000 to Rs. 650. In
answering the following questions, assume that the bond calls for annual interest payments.
a. Each bond originally sold at its Rs. 1000 par value. What was the yield to maturity of these
bonds at their time of issue?
b. Calculate the yield to maturity in February 2029.
c. Assume that interest rates stabilized at the 2029 level and stayed there for the remainder of the
life of the bonds. What would have been the bonds price in February 2041, when they had 5 years
remaining to maturity?
d. What would the price of the bonds have been the day before they matured in 2046? (Disregard
the last interest payment)

Question No. 11
Valuation of compulsorily convertible debenture [June 2012] (2.5 Marks)

Answer:
The debenture-holders of a Compulsorily Convertible Debenture (CCD) receives interest at a
specified rate for a pre-determined period after which a part or full value of the CCD is converted
into specific number of equity shares. The cash flows resulting in the case of valuation of CCD
are;
- Periodic interest receivable from the company.
- Expected market price of the share received on conversion.
- Redemption amount, if any.
The value of a CCD is then found out by using the following formula:
n
B0 (CCD) = ∑ Ii + mPt + RV
i
i=1 (1 + kd) (1+ke)t (1+kd)n

where, B0 (CCD) = Value of a CCD

I = Interest amount receivable per year
ke = Required rate of return on equity component
m = Number of shares received on conversion
Pt = Share price at the time of conversion
RV = Redemption value, if any
n = Life of the debentures

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kd = Rate of discount of debt.

In the case of partially convertible debentures, the annual interest before conversion and after
conversion would be different whereas in the case of fully convertible debentures, there will not
be any RV.

*****

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