TOPIC 2

BASIC OF VALUATION AND

BOND VALUATION

BWFF 2043, Department of Finance, SEFB, UUM

1
Subtopics:
2.1 Valuation Concepts
2.2 Intrinsic Value
2.3 Characteristics of Bonds
2.4 Types of Bonds
2.5 Bond Valuation
2.6 Yield to Maturity
2.7 Important Factors in Bond Relationships

BWFF 2043, Department of Finance, SEFB, UUM 2

 2.1 Valuation Concepts
• Valuation is the process that links risk and return to determine the worth
of an asset.
• There are three key inputs to the valuation process:
1. Cash flows (returns)
2. Timing
3. A measure of risk, which determines the required return

Intrinsic value= RM1200. Bond market price RM1100

BWFF 2043, Department of Finance, SEFB, UUM 3

 Basic Valuation Model
• The value of any asset is the present value of all future cash flows it
is expected to provide over the relevant time period.
• The value of any asset at time zero, V0, can be expressed as

where. 100/(1+ 0..6)^1 + 100/(1=0.06)^2

v0 = Value of the asset at time zero
CFT = cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period

BWFF 2043, Department of Finance, SEFB, UUM 4

 2.2 Intrinsic Value
• Intrinsic value: economic or fair value of an
asset; the present value of the asset’s
expected future cash flows.
• If the intrinsic value > market value, then the
asset is undervalued in the eyes of the
investor. Should the market value > intrinsic
value, then the asset is overvalued.

BWFF 2043, Department of Finance, SEFB, UUM 5

2.3 Characteristics of Bonds
• The basic features of a bond include the following:
• Bond indenture
• Claims on assets and income
• Par or face value
• Coupon interest rate
• Maturity and repayment of principal
• Call provision and conversion features

BWFF 2043, Department of Finance, SEFB, UUM 6

Table 9.2 Bond Terminology (1 of 2)

Indenture The indenture is the legal agreement between the firm issuing the bonds and the bond trustee, who
represents the bondholders. It lists the specific terms of the loan agreement, including a description
of the bonds, the rights of the bondholders, the rights of the issuing firm, and the responsibilities of
the trustee.
Priority of In the case of insolvency, claims of debt in general, including bonds, are honored before those of
claims both common stock and preferred stock. In addition, interest payments hold priority over dividend
on assets and payments for common and preferred stock.
income
Par value The par value of a bond, also known as its face value, is the principal that must be repaid to the
bondholder at maturity. In general, corporate bonds are issued with par values in increments of
$1,000. Also, when bond prices are quoted in the financial press, prices are generally expressed as a
percentage of the bond’s par value.
Maturity and The maturity date refers to the date on which the bond issuer must repay the principal or par value
repayment of to the bondholder.
principal
Coupon interest The coupon rate on a bond indicates the percentage of the par value of the bond that will be paid
Rate out annually in the form of interest and is quoted as an APR.

BWFF 2043, Department of Finance, SEFB, UUM 7

Table 9.2 Bond Terminology (2 of 2)
Current yield The current yield on a bond refers to the ratio of the annual interest payment to the bond’s current
market price. If, for example, we have a bond with an 8% coupon interest rate, a par value of $1,000,
and a market price of $700, it has a current yield of 11.4%, calculated as follows:

, or 11

Coupon 6%, MP 1000 (9-1)

Call provision The call provision provides the issuer of the bond with the right to redeem or retire a bond before it
matures.
The call price is the stated price at which a bond may be repurchased, by use of a call feature,
prior to maturity.
The call premium is the amount by which a bond’s call price exceeds its par value
Conversion Some bonds have a conversion feature that allows bondholders to convert their bonds into a set
feature number of shares of common stock.

BWFF 2043, Department of Finance, SEFB, UUM 8

Bond Ratings and Default Risk
Bond ratings indicate the default risk i.e. the probability that the firm
will make the bond’s promised payments. Rating agencies use
borrower’s financial statements, financing mix, profitability, variability
of past profits, and make judgments about the quality of the firm’s
management in order to determine ratings.

BWFF 2043, Department of Finance, SEFB, UUM 9

Table 9.3 Interpreting Bond Ratings
Bond Rating Category Standard & Moody’s Description
Poor’s
Investment Grade: Blank Blank Blank

Prime or AAA Aaa Highest quality; extremely strong capacity to pay

highest strong
High quality AA Aa Very strong capacity to pay

Upper medium A A-1, A Upper medium quality; strong capacity to pay

Medium BBB Baa-1, Baa Lower medium quality; changing circumstances could
impact the firm’s ability to pay
Not Investment Grade: Blank Blank Blank

Speculative BB Ba Speculative elements; faces uncertainties

Highly speculative B, CCC, CC B, Caa, Ca Extremely speculative and highly vulnerable to

nonpayment
Default D C Income bond; doesn’t pay interest

BWFF 2043, Department of Finance, SEFB, UUM 10

2.4 Types of Bonds
Table 9.7 contains a list of the major types of corporate bonds. The
differences among the various types of bonds are a function of how
each of the following bond attributes are defined:
• Secured versus unsecured
• Priority of claims
• Initial offering market
• Abnormal risk
• Coupon level
• Amortizing or non-amortizing
• Convertibility

BWFF 2043, Department of Finance, SEFB, UUM 11

Table 9.7 Types of Corporate Bonds (1 of 3)
Debentures A debenture is any unsecured debt instrument. Because they are unsecured, the earning ability of
the issuing corporation is of great concern to the bondholder. They are riskier than secured bonds
and as a result must provide investors with a higher yield than secured bonds provide. Often the
issuing firm attempts to provide some protection to the holder of the bond by committing not to
issue more secured long-term debt that would further tie up the firm’s assets and leave the
bondholders less protected. To the issuing firm, the major advantage of debentures is that no
property has to be committed to secure them. This allows the firm to issue debt and still preserve
some future borrowing power.

Subordinated The claims of subordinated debentures are honored only after the claims of secured debt and
debentures unsubordinated debentures have been satisfied.

Mortgage bonds A mortgage bond is secured by a lien on real property. Typically, the value of the real property is
greater than that of the bonds issued. This provides the mortgage bondholders with a margin of
safety in the event the market value of the secured property declines. In the case of foreclosure,
the bondholders get the proceeds from the sale of the secured property. If the proceeds from this
sale do not cover the bonds, the bondholders become general creditors, similar to debenture
bondholders, for the unpaid portion of the debt.

BWFF 2043, Department of Finance, SEFB, UUM 12

Table 9.7 Types of Corporate Bonds (2 of 3)
Eurobonds Eurobonds are bonds issued in a country different from the one in whose currency the bonds are
denominated. For example, a bond that is issued in Europe or Asia by an American company and
(considered as that pays interest and principal to the lender in U.S. dollars is considered a Eurobond. Thus, a
international Eurobond does not have to be issued in Europe; it merely needs to be issued in a country
issuance of bond) different from the one in whose currency it is denominated to be considered a Eurobond.

Zero-coupon and These bonds require either no coupon interest payments (these are called zeroes) or very low
very-low-coupon coupon interest payments. Consequently, bondholders receive all or most of their return at
bonds maturity. Because these bonds pay little or no interest, they must sell at a deep discount. For the
investor, a zero-coupon bond is like a U.S. savings bond. The obvious appeal of zero-coupon
bonds is to those investors who need a lump sum of money at some future date but don’t want to
be concerned about reinvesting interest payments. Today, zero-coupon bonds are infrequently
issued by corporations. The dominant player in this market is the U.S. government, with the
government’s zero-coupon bonds called STRIPS.

BWFF 2043, Department of Finance, SEFB, UUM 13

Table 9.7 Types of Corporate Bonds (3 of 3)
Junk (high-yield) Junk bonds are high-risk debt that has a below-investment-grade bond rating (see the earlier
bonds discussion of bond ratings). They are also called high-yield bonds because they pay interest
rates that are 3 to 5% higher than those of the highest-rated bonds.

Floating-rate bonds A floating- or variable-rate bond is simply one whose coupon rate fluctuates according to the
level of current market interest rates. These bonds are quite popular with municipalities and
foreign governments but are far less common among corporations.

Convertible bonds Convertible bonds are debt securities that can be converted to a firm’s stock at a prespecified
price.

BWFF 2043, Department of Finance, SEFB, UUM 14

 Corporate Bonds:
International Bond Issues
• Companies and governments borrow internationally by issuing bonds in two
principal financial markets:
– A Eurobond is a bond issued by an international borrower and sold to investors in countries with
currencies other than the currency in which the bond is denominated.
– In contrast, a foreign bond is a bond issued in a host country’s financial market, in the host
country’s currency, by a foreign borrower.
• Both markets give borrowers the opportunity to obtain large amounts of long-term
debt financing quickly, in the currency of their choice and with flexible repayment
terms.

BWFF 2043, Department of Finance, SEFB, UUM 15

2.5 Bond Valuation
The value of corporate debt is equal to the present value of the
contractually promised principal and interest payments (the cash flows)
discounted back to the present using the market’s required yield to
maturity on bonds of similar risk.

BWFF 2043, Department of Finance, SEFB, UUM 16

 Bond Valuation: Basic Bond Valuation
The basic model for the value, B0, of a bond is given by the following
equation:

Where
B0 = value of the bond at time zero
I= annual interest paid in dollars
n= number of years to maturity
M= par value in dollars
rd = required return on a bond

BWFF 2043, Department of Finance, SEFB, UUM 17

 Bond Valuation

S
$It $M
Vb = +
t=1
(1 + k b) t
(1 + kb)n

Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)

BWFF 2043, Department of Finance, SEFB, UUM 18

 Bond Example

• Suppose our firm decides to issue 20-year

bonds with a par value of RM1,000 and
annual coupon payments. The return on
other corporate bonds of similar risk is
currently 12%, so we decide to offer a 12%
coupon interest rate.
• What would be a fair price for these bonds?

BWFF 2043, Department of Finance, SEFB, UUM 19

 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = RM120 (PVIFA .12, 20 ) + RM1000 (PVIF .12, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 120 1 - (1.12 )20 + 1000/ (1.12) 20 = $1000
.12
BWFF 2043, Department of Finance, SEFB, UUM 20
 1000
120 120 120 ... 120

0 1 2 3 ... 20

P/YR = 1
N = 20
I%YR = 12
FV = 1,000
PMT = 120
Solve PV = -RM1,000

Note: If the coupon rate = discount

rate, the bond will sell for par value.
BWFF 2043, Department of Finance, SEFB, UUM 21
• Suppose interest rates fall
immediately after we issue the
bonds. The required return on bonds
of similar risk drops to 10%.

• What would happen to the bond’s

intrinsic value?

BWFF 2043, Department of Finance, SEFB, UUM 22

 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 120 1 - (1.10 )20 + 1000/ (1.10) 20 = $1,170.27
.10
BWFF 2043, Department of Finance, SEFB, UUM 23
 P/YR = 1
Mode = end
N = 20
I%YR = 10
PMT = 120
FV = 1000
Solve PV = -RM1,170.27

Note: If the coupon rate > discount rate,

the bond will sell for a premium.
BWFF 2043, Department of Finance, SEFB, UUM 24
• Suppose interest rates rise
immediately after we issue the
bonds. The required return on bonds
of similar risk rises to 14%.

• What would happen to the bond’s

intrinsic value?

BWFF 2043, Department of Finance, SEFB, UUM 25

 Bond Example
Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = RM120 (PVIFA .14, 20 ) + RM1000 (PVIF .14, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 120 1 - (1.14 )20 + 1000/ (1.14) 20 = RM867.54
.14
BWFF 2043, Department of Finance, SEFB, UUM 26
 P/YR = 1
Mode = end
N = 20
I%YR = 14
PMT = 120
FV = 1000
Solve PV = RM867.54

Note: If the coupon rate < discount rate,

the bond will sell for a discount.
BWFF 2043, Department of Finance, SEFB, UUM 27
 Suppose coupons are semi-annual

Mathematical Solution:

PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV =RM60 (PVIFA .14, 20 ) + RM1000 (PVIF .14, 20 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
PV = 60 1 - (1.07 )40 + 1000 / (1.07) 40 = RM866.68
.07
BWFF 2043, Department of Finance, SEFB, UUM 28
 2.6 Yield To Maturity

• The expected rate of return on a

bond.
• The rate of return investors earn on a
bond if they hold it to maturity.

BWFF 2043, Department of Finance, SEFB, UUM 29

 Yield To Maturity

• The expected rate of return on a bond.

• The rate of return investors earn on a
bond if they hold it to maturity.

S
$It $M
P0 = +
t=1 (1 + k b) t
(1 + kb)n
BWFF 2043, Department of Finance, SEFB, UUM 30
 YTM Example

• Suppose we paid RM898.90 for a

RM1,000 par 10% coupon bond
with 8 years to maturity and
semi-annual coupon payments.

• What is our yield to maturity?

BWFF 2043, Department of Finance, SEFB, UUM 31

 Bond Example
1) Trial and Error Method (YTM)
Mathematical Solution:

BV = PMT (PVIFA k, n ) + FV (PVIF k, n )

898.90 = RM50 (PVIFA k, 16 ) + RM1000 (PVIF k, 16 )
1
PV = PMT 1 - (1 + i)n + FV / (1 + i)n
i

1
898.90 = 50 1 - (1 + i )16 + 1000 / (1 + i) 16
i solve using trial and error
BWFF 2043, Department of Finance, SEFB, UUM 32
 YTM Example

P/YR = 2
Mode = end
N = 16
PV = -898.90
PMT = 50
FV =RM 1000
Solve I%YR = 12%
BWFF 2043, Department of Finance, SEFB, UUM 33
 2) YTM: Approximation method
For annual coupon payment:

Semiannual YTM = (for semiannual coupon payment)

= 5.93%
Annual YTM = 5.93% x 2 = 11.86%
C=8%, MP=1050, 10 YTM?
80+ (1000-1050/10)=75
=(1000+1050)/2=1025
=75/1025= 7.32%

BWFF 2043, Department of Finance, SEFB, UUM 34

 Zero Coupon Bonds

• No coupon interest payments.

• The bond holder’s return is determined
entirely by the price discount.

• RM1m….. RM700K

BWFF 2043, Department of Finance, SEFB, UUM 35

 Zero Example
• Suppose you pay RM508 for a
zero coupon bond that has 10
years left to maturity.
• What is your yield to maturity?

-RM508 RM1000

0 BWFF 2043, Department of Finance, SEFB, UUM

10 36
 Zero Example
PV = -508 FV = 1000

0 10
Mathematical Solution:
PV = FV (PVIF i, n )
508 = 1000 (PVIF i, 10 )
.508 = (PVIF i, 10 ) [use PVIF table]

PV = FV /(1 + i) 10
508 = 1000 /(1 + i)10
1.9685 = (1 + i)10
i = 7% BWFF 2043, Department of Finance, SEFB, UUM 37
2.7 Important Factors in Bond Relationships
• First Relationship The value of bond is inversely
related to changes in the market’s required yield to
maturity.
Blank YTM = 12% YTM rises to 15%

Par value $1,000 $1,000

Coupon rate 12% 12%

Maturity date 5 years 5 years

Bond Value $1,000 $899

Bond
Value
Drops

BWFF 2043, Department of Finance, SEFB, UUM 38

Figure 9-1 Bond Value and the Market’s Required Yield to Maturity (5—Year Bond,
12% Coupon Rate)

BWFF 2043, Department of Finance, SEFB, UUM 39

Relationship 2
The market value of a bond will be less than the par value (discount
bond) if the market’s required yield to maturity is above the coupon
interest rate and will be more than the par valued if the market’s
required yield to maturity is below the coupon interest rate.

BWFF 2043, Department of Finance, SEFB, UUM 40

Relationship 3
As the maturity date approaches, the market value of a bond
approaches its par value.
Figure 9.2 clearly demonstrates the value of a bond, whether a
premium or a discount bond, approaches its par value as the maturity
date becomes closer in time.

BWFF 2043, Department of Finance, SEFB, UUM 41

Table 9-5 Bond Prices Relative to Maturity Date

Blank Blank Blank Years to Blank Blank Blank Blank

Maturity

Blank 12% Coupon Bond 5 4 3 2 1 0

Blank 12% yield scenario $1,000.00 $1,000.00 $1,000.00 $1,000.0 $1,000.0 $1,000.0
0 0 0

Discount 15% yield scenario $ 899.44 $ 914.35 $ 931.50 $ 951.23 $ 973.91 $1,000.0
bond 0

Premium 9% yield scenario $1,116.69 $1,097.19 $1,075.94 $1,052.7 $1,027.5 $1,000.0

bond 7 2 0

BWFF 2043, Department of Finance, SEFB, UUM 42

Figure 9-2 Value of a 12% Coupon Bond during the Life of the Bond

BWFF 2043, Department of Finance, SEFB, UUM 43

Relationships 4
• Long term bonds have greater interest-rate risk than short-term
bonds.
• While all bonds are affected by a change in interest rates, the prices of
longer-term bonds fluctuate more when interest rates change than do
the prices of shorter-term bonds (see Table 9.6)

• Bond A= 4%... Mkt int rate= ^ 5%. Drop BV

• = drop 3%. UP BV

BWFF 2043, Department of Finance, SEFB, UUM 44

Table 9.6 Bond Price Fluctuations for Bonds with Different Maturities

Blank Blank Blank Years to Blank Blank Blank

Maturity

Blank 5 10 15 20 25 30

15% (increased yield) $899.44 $849.44 $824.58 $812.22 $806.08 $803.02

% price decrease −10.1% −15.1% −17.5% −18.8% −19.4% −19.7%

$1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00

% price increase 11.7% 19.3% 24.2% 27.4% 29.5% 30.8%

9% (decreased yield) $1,116.69 $1,192.53 $1,241.82 $1,273.86 $1,294.68 $1,308.21

BWFF 2043, Department of Finance, SEFB, UUM 45