Bond Valuation

Dr Deepika Upadhyay
 Security Valuation

Time value of money-Concept of present value. Debt instruments and valuations,

yield, Running yield, YTM And bond durations convexity (simple problems). Equity
instrument and valuations Earning valuations revenue valuations yield valuation
(simple problems)
 Security Valuation

Valuation is the process of estimating the market value of financial

assets or liability.

The security valuation models are based on time value of money.

Concept of Value

Book Value:

The value at which the assets and liabilities are recorded in the books of accounts of the entity

Market Value:

The price an asset would fetch in the marketplace, or the value that the investment community gives to a
particular equity or business.

Replacement Value:

A term referring to the amount of money a business must currently spend to replace an essential asset

Liquidation Value:

An estimation of the final value that will be received by the holder when an asset is sold

Going Concern Value:

A value that assumes the company will remain in business indefinitely and continue to be profitable.
 Time Value of Money

Money has time value

A rupee received now is worth more than a rupee to be received in future.

States that Earlier receipts are more worth than later receipts

Eg: We deposit Rs. 100 in an account that earns 10% per year. How much we would
receive at the end of the year?
110.
How much he would receive, if deposit for one more year?
121.
Purpose

● Knowing how to value stocks & bonds is important for investors

● It helps them to decide whether to buy, sell or hold securities at the
prices prevailing in the market.
•

Future Value factor

Mr A give to Mr. B Rs. 100. Mr. B take it to the bank. They will give him 10% interest per year for 2
year.
Discounting:
The process of finding present value based on future value, the interest rate and
the number of periods.

Eg: We want to know what amount to be deposited in the bank at 10% interest to get
Rs. 121 after 2 year.

Present Value Factor

Example:
What is the present value of Rs. 1000 to be received after 5 years if it is to be
invested at 6% PA.
 Debt Instruments and Valuation
Debt instruments are assets that require a fixed payment to the holder, usually with interest.
Bond Valuation

A bond is contract under which a borrower promises to pay interest and principal on specific
dates to the holders of the bond.

Bond Yields:
Sources of return on Bond Investments:
1. Periodic Coupon Payments
2. Reinvestment income earned on the periodic coupon receipts
3. Capital gain or loss on sale of bond before maturity.
Bond Returns:
Face value:
The amount of money promised to the bondholder upon the bond's maturity.
Face value is predetermined when the bond is sold.

Bonds market value: How much someone will pay for the bond on the free market.

Coupon Rate:
Nominal rate of interest fixed or printed on the bond certificate.
Calculated on the face value of the bond.
Payable by the issuing company to the bondholder.
Eg: The coupon rate on a bond of face value of Rs. 1000 is 12 per cent.
Rs. 120 is payable by the company annually till maturity.
Annual Interest.
1. BOND RETURN

The rate of return on a bond over the period in which it was held is called the
holding period return (HPR).

Holding Period Return

HPR = Price gain or loss during the holding period + coupon interest rate, if any /
price at the beginning of the holding period *100
 An investor purchases a bond at Rs. 900 with Rs. 100 as coupon payment and sells
it at Rs 1000.
1. What is his holding period return?
HPR = Price gain or loss during the holding period + coupon interest rate, if any /
price at the beginning of the holding period *100

= 100+100/900 *100
HPR = 22.22%

2. if the bond is sold for Rs750 after receiving Rs100 as coupon payment, what is
the HPR?

-150+100/900*100
= - 5.55%
2. Current Yield:
It is the coupon payment as a percentage of current market price.

Eg: Face value Rs. 1000

May be selling at a discount, at say Rs.
800, or selling at a premium at 1200

Represents the rate of return or cash flow from their investments every year.
An investment's annual income (annual interest receivable) divided by the current
market price.

Current Yield
Eg: If a bond of face value of Rs. 1000 and a coupon rate of 12%, is currently
selling for Rs. 800. What is the current yield of the bond.
Current Yield

Annual Interest = 1000*12% = 120

Current Market Price = 800

Bond Valuation

● A bond is contract under which a borrower promises to pay interest and principal
on specific dates to the holders of the bond.

● Types of bonds:
a. Treasury bonds – issued by central govt. for 3 to 20 years, pays interest
semi-annually
b. State Govt. bonds – issued by state govts. for 3 to 20 years, pays interest
semi-annually
c. PSU Bonds – Public sector undertakings, where govt. holds more than 50%
d. Private sector bonds – maturity from 1 – 15 years , interest paid semi-annually.
Bond Valuation Models:
Express the relationship between bond price and market interest changes.
Bonds are issued with a fixed rate of interest (Coupon rate)
At the time of issue Coupon rate = market interest rate.
Time passes market interest rate changes (either upwards or downwards)

1. Bond with a maturity period

2. Bonds Redeemable in Instalments
3. Bond values with semi annual interest
4. Bonds in perpetuity:
1. Bond with a maturity period.
When the bonds have a definite maturity period,
its valuation is determined by considering the
Annual Interest Payments + Maturity Value

Assumptions –
Fixed coupon rate for the term;
Coupon payments made annually;
Redeemable at par on maturity;
Non-callable (that cannot be prematurely retired)
•
Illustration 1:
An investor is considering the purchase of a 8% Rs. 1,000 bond redeemable after 5 years at par. The investor’s
required rate of return is 10%. What should he be willing to pay now to purchase the bond?
Bond with a maturity period R = 8%
N=5
M = 1000
kd = 10%
Annual coupon payments or Annual Interest = 80

=72.72 + 66.16 + 60.11 + 54.64 + 49.69 + 621.12

= 924.20

He should be willing to pay for Rs. 924.20

•
.
Practice Question:

Consider a 10-yr, 12% coupon bond with par value of 1,000. Required yield on this bond
is 13%. Calculate the present value of the bond.
R= 12% , N= 10 Years, M= 1000, kd= 13%
Annual coupon payments or Annual Interest = 120 Present Value Factor

.884 +.783+ .693 + .613 + .542 + .480 + .425 + .376 + .332 + .295
•
Illustration 2:
A company is proposing to issue a 5 year debenture of 1,000 redeemable in equal installments at 14
percent rate of interest per annum. If an investor has a minimum required rate of return of 12 per
cent, calculate the debenture’s present value for him. What should he be willing to pay now to
purchase the debenture?
Solution:
Face value of the bond =1000, Redeemable in equal instalments
n= 5 Year
Principal Value which you are going to get every year = 1000/5 = 200 per year
R = 14%
Kd = 12%
Year Amount Outstanding Interest ® Principal Payment Cashflows
1 1000 1000*14% = Rs. 140 200 340
2 (1000-200) = 800 800*14% = 112 200 312
3 (800-200) = 600 600*14% = 84 200 284
4 (600-200) = 400 400*14% = 56 200 256
5 (400-200) = 200 200*14% = 28 200 228
•

=303.62 + 284.66 + 202.21 + 162.82 + 129.28

= 1046.59
.
3. Bond values with semi annual interest
So far the valuation of debentures considering the annual interest payments.
Here unit period is 6 months

However, in most of the cases, interest is payable on semi-annual or half yearly basis.
The value of such bonds/debentures, the bond valuation equation has to be modified:
1. The annual interest amount, R, should be divided by 2 to find out the amount of
half-yearly interest. (R/2)
2. The maturity period, n, should be multiplied with 2 to get the number of half yearly
periods. (N*2)
3. The required rate of return, Kd, should be divided 2 to get an appropriate discount rate
applicable to half-yearly periods. (i/2)
Bond values with semi annual interest:

Illustration 1:
An investor holds a debenture of Rs. 100 carrying a coupon rate of 12% p.a. The interest is
payable half-yearly on 30th June and 31st December every year. The maturity period of the
debenture is 6 years and it is to be redeemed at a premium of 10%. The investor’s required
rate of return is 14% p.a. Compute the value of the debenture.

= 6 (7.943) + 110 (.444) = 47.658 + 48.840

Rs. 96.498 or say Rs. 96.50

.935+0.873+0.816+0.763+0.713+0.666+0.623+0.582+0.544+0.508+0.475+0.444
Practice Question:
Consider an 8 year, 12 percent coupon bond with par value of Rs.100 on which
interest is payable semi-annually. The required rate of return on this bond is 14
percent.

= 6(9.447) + 100(0.338)
= 56.682 + 33.8 =
= 90.55
4. Bonds in perpetuity:
Perpetuity bonds are the bonds which never mature or have infinitive maturity period.
Value.
The discounted value of infinite streams of interest (cash) flows.

Bonds that never mature

No maturity value only perpetual interest cash flows.
Value of bond = annual interest / required rate of return.

where, Vd = Value or bond or debt

kd = Required rate of return
R = Annual Interest (as interest is constant)
Illustration 1:
Mr. A has a perpetual bond of the face value of Rs. 1,000. He receives an interest of
Rs. 60 annually. What would be its value if the required rate of return is 10%?

Vd = R/kd
= 60/.10
= Rs. 600
 Bonds have an inverse relationship to interest rates.

Bond Value will it have any changes based on these changes

1.Coupon rate and Required rate of return is same
2.Required rate of return is higher than Coupon Rate
3.Required rate of return is less than coupon Rate

Face value of a debenture = Rs.1000

Coupon rate of Debenture = 12%
Maturity period = 5 years

What is the value of the debenture, If

a. Required rate of return is 12%
b. Required rate of return is 15%
c. Required rate of return is 10%
Condition 1: Coupon rate and Required rate of return is same

Condition No:1 when the required rate of return is 12%

Vd= (R) x (ADFi,n )+ (M) x (DFi,n)

Vd = (120) x (ADF12,5)+ (100) x (DF12,5)

= 120(3.605) + 1000(.567)
= 432.60 + 567
= 999.6 = 1000
Annual interest rate of Debenture = 12%
Required rate of return is 12%
There is no change in the bond value
Condition 2: Required rate of return is higher than Coupon Rate
When the required rate of return is 15%
Vd= (R) x (ADFi,n )+ (M) x (DFi,n)

Vd = (120) x (ADF15,5)+ (1000) x (DF15,5)

= (120)(3.352)+1000(.497)
= 402.24+497 = 899.24

Coupon rate of Debenture = 12%

Required rate of return is 15%
The Bond value is LOW
Condition 3: Required rate of return is less than coupon Rate
When the required rate of return is 10%
Vd= (R) x (ADFi,n )+ (M) x (DFi,n)

Vd = (120) x (ADF10,5)+ (100) x (DF10,5)

= 120 (3.791) + 1000 (.621)

= 454.92 +621
= 1075.92 = 1076
Annual interest rate of Debenture = 12%
Required rate of return is 10%
The Bond value is HIGHER
Yield to Maturity – YTM

Most widely used measure of return on bonds

Reflects the yield an investor receives for holding a bond until it matures.

YTM is the discount rate that makes the present value of cash inflows from the bond equal to the cash
outflow for purchasing the bond.

Trial and Error Method: The value of YTM equates the two sides of the equation may be determined.

Vd or MPd= R1/(1+ytm)1+ R2/(1+ytm)2 + R3/(1+ytm)3....Rn/(1+ytm)n + MVn / (1+ytm)n

Or

Vd or MPd = (R) x (ADFi,n )+ (MV) x (DFi,n)

MP = Current Market price of the bond

R = Cash Inflow
MV or TV = Terminal Value
Question 1:
Face Value :1000, Coupon Rate :15%, MPd 900, N= 5 years, YTM= ?
Find out YTM using TE Method and also using the Direct Formula

Trial and Error Method:

Vd or MPd = (R) x (ADFi,n )+ (MV) x (DFi,n)
900 = (150) x (ADFi,5 )+ (1000) x (DFi,5)

1.Coupon rate and Required rate of return is same – No change in bond value
If ytm is 17%
If ytm is 18% 2.Required rate of return is higher than Coupon Rate – Bond value is low
If ytm is 19% 3.Required rate of return is less than coupon Rate – Bond value is higher
The market price is lower than the face value, it indicates that
If ytm is 20%
YTM should be higher than the coupon rate
If ytm is 17% = 935.85
Since the calculated value is higher than the
= (150) x (ADF17,5 )+ (1000) x (DF17,5)
market value, assume a higher YTM
= 150(3.199) + 1000(.456)
= 479.85 +456 = 935.85

If ytm is 18% = 906.05

= (150) x (ADF18,5 )+ (1000) x (DF18,5)
= 150(3.127) + 1000(.437)
= 469.06 + 437 = 906.05

If ytm is 19% = 877.70

= (150) x (ADF19,5 )+ (1000) x (DF19,5)
= 150(3.058) + 1000(.419)
= 458.7 + 419 = 877.7
Interpolation Method:

CMP = Cost or Current market price of the bond

= 18 + .21 = 18.21
Direct Formula Method: (Approximate YTM, not actual YTM)

I= Amount of Annual Interest

FV or MV = Face Value or Maturity Value of the bond
CMP = Cost or Current market price of the bond
n= Maturity Period
Practice Question: Prem is considering the purchase of a bond
currently selling at Rs 878.50 The bond has four years to
maturity., with a face value of Rs1000 and 8% coupon rate.
Calculate YTM of the bond?
FV= 1000
CMP=878.50
n=4 years
Coupon Rate = 8% Coupon Amount = 80
Yield To Call – YTC
Some bonds may be redeemable before their full maturity period either
at the option of the issuer or of the investor.

If the option is exercised, the bond would be called for redemption at

the specified call price on the specified call date.

Ex: a company may issue 15 years bond which can be redeemed at the
end of 5 years
Trial and Error Method

Vd or MPd= R1/(1+ytc)1+ R2/(1+ytc)2 + R3/(1+ytc)3....Rn/(1+ytc)n + CVn / (1+ytc)n

Or

Vd or MPd = (R) x (ADFi,n )+ (CV) x (DFi,n)

MP = Current Market price of the bond

R = Cash Inflow
CV = Callable Value
ABC Ltd. has a 14% debentures with a face value of Rs. 100 that matures at par in 15
years. The debenture is callable in 5 years at Rs. 114. It currently sells for Rs. 105.
Calculate Yield to Call (YTC).
Face value = 100
Callable Value = 114
Coupon rate = 14%
Callable period = 5
Market Price = 105.
Vd or MPd = (R) x (ADF i,n ) + (CV) x (DF i,n)
105 = (14) x (ADFi, 5 )+ (114) x (DFi, 5)

Identify whether YTC should be a higher or lower value than coupon rate.
The market price is lower than the callable value, it indicates that YTC should be higher
than the coupon rate i.e. 15%
 YTC at 15%

Vd or MPd = (R) x (ADFi,n )+ (CV) x (DFi,n)

105 = (14) x (ADF15%, 5 )+ (114) x (DF15%, 5)
105 = (14) x (3.352 )+ (114) x (.497)
= 46.928 + 56. 67 = 103. 61

Since the calculated value is lower than the market value, assume a lower YTC
YTC @ 14%

105 = (14) x (ADF14%, 5 )+ (114) x (DF14%, 5)

105 = (14) x (3.433 )+ (114) x (.519)
= 48.062 + 59. 166 = 107. 23.

YTC @ 15% = 103. 61

YTC @ 14 % = 107. 23.
Interpolation Method:

CMP = Cost or Current market price of the bond

= 14 + .62 = 14.62
If YTC is higher than the YTM, it would be advantageous to the
investor to exercise the redemption option at the call date.
On the other hand if YTM is higher, it would be better to hold the bond
till final maturity.
FV– Face Value
PV – Current Market Price
Spot Interest Rate:
Used to find the yield from a Zero Coupon Bond.

Spot interest rate is the discount rate that makes the PV of the single cash inflow to
the investor equal to the cost of the bond.
Question: A 2 year bond of FV Rs. 100 issued at a discount of Rs. 79.719. What is
the sport interest rate?

Face value = 100

PV = 79.719
PV =FV/(1+r)