Bond Valuation A Mini Case and Solution Outline

BOND VALUATION
A Mini Case and Solution Outline
Mr. Ashish Sharma is vice president of Nepal Metal Works Inc. The company is considering
issuing bonds to satisfy part of its financing need for a new venture of Steel Plant, which is
going to be launched in Mid-Western Region of Nepal. He knows that Nepalese Financial
Market is sensitive to the price and terms and condition of bond issue. As a result of this fact
he is reluctant to entertain with new issue. As a financial consultant, he is seeking your help
on certain issues associated with bond contract features, price and yields. You are required to
address the following issues on behalf of Mr. Sharma.
a. What are the key features of a bond?

b. What are call provisions and sinking fund provisions? Do these provisions make bonds
more or less risky?
c. How is the value of a bond determined? What is the value of a 10-year,
Rs 1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10
percent?
d. What would be the value of the bond described in part 'c' if, just after it had been issued,
the expected inflation rate rose by 3 percentage points, causing investors to require a 13
percent return? Would we now have a discount or a premium bond?
e. What would happen to the bond’s value if inflation fell and kd declined to 7 percent?
Would we now have a premium or a discount bond?
BOND VALUATION
f. What would happen to the value of the 10-year bond over time if the required rate of
return remained (i) at 13 percent, (ii) at 7 percent?
g. What is the yield to maturity on a 10-year, 9 percent, annual coupon, Rs 1,000 par value
bond that sells for Rs 887? That sells for Rs 1,134.20? What does the fact that bond sells at
a discount or at a premium tells you about the relationship between kd and bond’s coupon
rate?
h. What are the total return, the current yield, and the capital gains yield for the discount
bond? (Assume the bond is held to maturity and the company does not default on the
bond.)
i. How would the composition of capital gain yield and current yield for a discount bond
changes over the time?
BOND VALUATION
Case Solution Guidelines:
a. Bonds have a number of features. Some of the features are general and some others are
specific in nature. General features of bonds consist of par value, coupon rate and the
maturity. Specific features of bond include call provision, conversion feature, and sinking
fund provision. Specific features largely depend on bond contract (indenture).
b. A call provision gives the issuer the right to call the bonds prior to maturity.
Generally, a company pays the bondholders an amount greater than the par value if they are
called before maturity. The amount that is paid to the bondholder is called call price and the
excess amount over par value is called call premium. When interest rate in the market
decreases, bonds having call provision are called up to redeem back with call price to the
bondholders before bonds mature. Hence call provision increases risk to the bondholders.
Sinking fund provision is a special provision in a bond contract that facilitates the orderly
retirement of the bond. In some cases, the firm may be required to deposit money with
trustee, which invests the funds and then uses the accumulated sum to redeem the bonds at
maturity. Failing to meet the sinking fund requirement is equivalent to default. Thus, sinking
fund provision makes the bond issue less risky.
BOND VALUATION
c. Value of a bond determined as the present value of future stream of interest payment plus
present value of maturity value all discounted at bondholders’ required rate of return.
The value of a 10-year, Rs 1,000 par value bond with a 10 percent annual coupon, if its
required rate of return is 10 percent, is equal to Rs 1,000 par value because bond’s coupon
rate is equal to the required rate of return. In other words, if coupon rate is equal to the
required return on bond, the bond sells at a premium.
d. If required rate of return increases to 13 percent just after the bond issue, the value of
bond will decline, which is as follows:
Vd= I × PVIFAkd, n + M × PVIFkd, n
= Rs 100 × PVIFA13%, 10 + Rs 1‚000 × PVIF13%,10
= Rs 100 × 5.4262 + Rs 1‚000 × 0.2946
= Rs 542.62 + Rs 294.6 = Rs 837.22
Now we would have a discount bond because the bond will sell below par value.
e. If required rate of return declines to 7 percent just after the bond issue, the value of
bond will increase, which is as follows:
Vd= I × PVIFAkd, n + M × PVIFkd, n
= Rs 100 × PVIFA7%, 10 + Rs 1‚000 × PVIF7%,10
= Rs 100 × 7.0236 + Rs 1‚000 × 0.5083
= Rs 702.36 + Rs 508.3 = Rs 1,210.66
Now we would have a premium bond because the bond will sell above par value.
BOND VALUATION
f. (i) If interest rate remains at 13 percent until maturity, the value of discount bond
goes on increasing over time as it approaches to the maturity. Finally, it increases to Rs
1,000 maturity value at the maturity.
(ii) If interest rate remains at 7 percent until maturity, the value of premium bond goes
on decreasing over time as it approaches to the maturity. Finally, it declines to Rs 1,000
maturity value at the maturity.
g. Yield to maturity on a 10-year, 9 percent, annual coupon, Rs 1,000 par value bond
that sells for Rs 887.
Given:
Annual coupon (I) = 0.09 x Rs 1,000 = Rs 90
Maturity value (M) = Rs 1,000
Bond’s price (Vd) = Rs 887
Time to maturity (n) = 10-year.
TheNoteyield to maturity
that 10.96%on is
theonly
bondanis:
approximate YTM. Try to find
out exact YTM by
interpolation.
The bond yields about 10.96 percent.
BOND VALUATION
Yield to maturity on a 10-year, 9 percent, annual coupon, Rs 1,000 par value bond that sells
for Rs 1,134.20
Given:
Annual coupon (I) = 0.09 x Rs 1,000 = Rs 90
Maturity value (M) = Rs 1,000
Bond’s price (Vd) = Rs 1,134.20
Time to maturity (n) = 10-year.
= 0.0703 or 7.03%
The bond yields about 7.03 percent.
The relationship between required rate and coupon rate determines whether a bond sells at
premium or discount. If required rate is higher than coupon rate, the bond sells at discount.
Conversely, if required rate is lower than coupon rate, the bond sells at premium.
Note that 7.03% is only an
approximate YTM. Try to find
out exact YTM by
interpolation.
BOND VALUATION
h. The total return on the discount bond is the yield to maturity, which is 10.96%.
The current yield is calculated as:
Current yield = Annual coupon payment/Price of the bond
=Rs 90/Rs 887
= 0.1015 or 10.15%
The capital gain yield = YTM – Current yield = 10.96% - 10.15% = 0.81%
i. The value of discount bond goes on increasing over the years as it approaches to the
maturity. Therefore, for a discount bond, current yield goes on declining and capital gain goes
on increasing, but total yield remains at 10.96 percent over the years.

Bond Valuation A Mini Case and Solution Outline

Uploaded by

Copyright:

Available Formats

Bond Valuation A Mini Case and Solution Outline

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Bond Valuation A Mini Case and Solution Outline

Uploaded by

Copyright:

Available Formats

BOND VALUATION

A Mini Case and Solution Outline

a. What are the key features of a bond?

Case Solution Guidelines:

You might also like