Bond Valuation pdf

1 Bond Valuation Bond Valuation Learning Module Learning Module 2 Definitions Definitions   Par or Face Value Par or Face Value - -   The amount of money that is paid to the bondholders at The amount of money that is paid to the bondholders at maturity. For most bonds this amount is $1,000. It also generall maturity. For most bonds this amount is $1,000. It also generall y y represents the amount of money borrowed by the bond issuer. represents the amount of money borrowed by the bond issuer.   Coupon Rate Coupon Rate - -   The coupon rate, which is generally fixed, determines the The coupon rate, which is generally fixed, determines the periodic coupon or interest payments. It is expressed as a periodic coupon or interest payments. It is expressed as a percentage of the bond's face value. It also represents the percentage of the bond's face value. It also represents the interest cost of the bond to the issuer. interest cost of the bond to the issuer. 3 Definitions Definitions   Coupon Payments Coupon Payments - -   The coupon payments represent the periodic interest payments The coupon payments represent the periodic interest payments from the bond issuer to the bondholder. The annual coupon from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the payment is calculated by multiplying the coupon rate by the bond's face value. Since most bonds pay interest semiannually, bond's face value. Since most bonds pay interest semiannually, generally one half of the annual coupon is paid to the generally one half of the annual coupon is paid to the bondholders every six months. bondholders every six months.   Maturity Date Maturity Date - -   The maturity date represents the date on which the bond The maturity date represents the date on which the bond matures, matures, i.e., i.e., the date on which the face value is repaid. The the date on which the face value is repaid. The last coupon payment is also paid on the maturity date. last coupon payment is also paid on the maturity date. 4 Definitions Definitions   Original Maturity Original Maturity - -   The time from when the bond was issued until its maturity date. The time from when the bond was issued until its maturity date.   Remaining Maturity Remaining Maturity - -   The time currently remaining until the maturity date. The time currently remaining until the maturity date.   Call Date Call Date - -   For bonds which are callable, For bonds which are callable, i.e., i.e., bonds which can be redeemed bonds which can be redeemed by the issuer prior to maturity, the call date represents the by the issuer prior to maturity, the call date represents the earliest date at which the bond can be called. earliest date at which the bond can be called. 5 Definitions Definitions   Call Price Call Price - -   The amount of money the issuer has to pay to call a callable The amount of money the issuer has to pay to call a callable bond (there is a premium for calling the bond early). When a bond (there is a premium for calling the bond early). When a bond first becomes callable, bond first becomes callable, i.e., i.e., on the call date, the call price on the call date, the call price is often set to equal the face value plus one year's interest. is often set to equal the face value plus one year's interest.   Required Return Required Return - -   The rate of return that investors currently require on a bond. The rate of return that investors currently require on a bond. 6 Definitions Definitions   Yield to Maturity Yield to Maturity - -   The rate of return that an investor would earn if he bought the The rate of return that an investor would earn if he bought the bond at its current market price and held it until maturity. bond at its current market price and held it until maturity. Alternatively, it represents the discount rate which equates the Alternatively, it represents the discount rate which equates the discounted value of a bond's future cash flows to its current discounted value of a bond's future cash flows to its current market price. market price.   Yield to Call Yield to Call - -   The rate of return that an investor would earn if he bought a The rate of return that an investor would earn if he bought a callable bond at its current market price and held it until the callable bond at its current market price and held it until the call date given that the bond was called on the call date. call date given that the bond was called on the call date. 7 Bond Valuation Bond Valuation   Bonds are valued using time value of money Bonds are valued using time value of money concepts. concepts.   Their coupon, or interest, payments are Their coupon, or interest, payments are treated like an equal cash flow stream treated like an equal cash flow stream (annuity). (annuity).   Their face value is treated like a lump sum. Their face value is treated like a lump sum. 8 Example Example   Assume Hunter buys a 10 Assume Hunter buys a 10 - - year bond from the KLM year bond from the KLM corporation on January 1, 2003. The bond has a face corporation on January 1, 2003. The bond has a face value of $1000 and pays an annual 10% coupon. The value of $1000 and pays an annual 10% coupon. The current market rate of return is 12%. Calculate the price current market rate of return is 12%. Calculate the price of this bond today. of this bond today. 1. 1. Draw a timeline Draw a timeline $100 $100 $100 $100 $100 $100 $100 $100 $100$100 $1000 + ? ? 9 Example Example 2. 2. First, find the value of the coupon stream First, find the value of the coupon stream   Remember to follow the same approach you use Remember to follow the same approach you use in time value of money calculations. in time value of money calculations.   You can find the PV of a cash flow stream You can find the PV of a cash flow stream   PV = $100/(1+.12) PV = $100/(1+.12) 1 1 + $100/(1+.12) + $100/(1+.12) 2 2 + $100/(1+.12) + $100/(1+.12) 3 3 + $100/(1+.12) + $100/(1+.12) 4 4 + $100/(1+.12) + $100/(1+.12) 5 5 + $100/(1+.12) + $100/(1+.12) 6 6 + + $100/(1+.12) $100/(1+.12) 7 7 + $100/(1+.12) + $100/(1+.12) 8 8 + $100/(1+.12) + $100/(1+.12) 9 9 + + $100/(1+.12) $100/(1+.12) 10 10   Or, you can find the PV of an annuity Or, you can find the PV of an annuity   PVA = $100 * {[1 PVA = $100 * {[1 - - (1+.12) (1+.12) - - 10 10 ]/.12} ]/.12}   PV = $565.02 PV = $565.02 10 Example Example 3. 3. Find the PV of the face value Find the PV of the face value   PV = CF PV = CF t t / (1+r) / (1+r) t t   PV = $1000/ (1+.12) PV = $1000/ (1+.12) 10 10   PV = $321.97 PV = $321.97 4. 4. Add the two values together to get the total PV Add the two values together to get the total PV   $565.02 + $321.97 = $886.99 $565.02 + $321.97 = $886.99   Alternatively, on your calculator Alternatively, on your calculator   PMT = 100 PMT = 100 FV = 1000 FV = 1000 n = 10 n = 10 i = 12 i = 12 PV = ? PV = ?   Note that if the payments had been semiannual, Note that if the payments had been semiannual, PMT=50, FV=1000, n=20, i=6, PV=?=$885.30. PMT=50, FV=1000, n=20, i=6, PV=?=$885.30. [...]... be asked to find the realized rate of return for a bond  This is the return that the investor actually realized from holding a bond  Using time value of money concepts, you are solving for the required rate of return instead of the value of the bond 11 Example  Doug purchased a bond for $800 5-years ago and he sold the bond today for $1200 The bond paid an annual 10% coupon What is his realized... You plug in numbers until you find the rate of return that solves the equation The realized rate of return on this bond is 19.31% 12 Example    This is much easier to find using a financial calculator: n=5 PV = -800 FV = 1200 PMT = 100 i = ?, this is the realized rate of return on this bond Note that if the payments had been semiannual, n=10, PV=-800, FV=1200, PMT=50, i=?=9.47% Thus, the realized . date given that the bond was called on the call date. 7 Bond Valuation Bond Valuation   Bonds are valued using time value of money Bonds are valued using. call a callable bond (there is a premium for calling the bond early). When a bond (there is a premium for calling the bond early). When a bond first becomes