Business Finance –ACC501 VU

LESSON 18
VALUING A BOND

· Assume you have the following information.

o BMN, Inc. bonds have a $1000 face value
o The promised annual coupon is $100
o The bonds mature in 20 years
o The market’s required return on similar bonds is 10%

· Present value of the face value

= $1000 × [1/1.1020]
= $1000 × 0.14864
= $148.64

· Present value of the coupon payments

= $100 × [1 - (1/1.1020)]/0.10
= $100 × 8.5136
= $851.36

· The value of each bond = $148.64 + 851.36

= $1000

Valuing a Bond: A Discount Bond

· Assume you have the following information.

o BMN, Inc. bonds have a $1000 face value
o The promised annual coupon is $100
o The bonds mature in 20 years
o The market’s required return on similar bonds is 12%

· Present value of the face value

= $1000 × [1/1.1220]
= $1000 × 0.10366
= $103.66

· Present value of the coupon payments

= $100 × [1 - (1/1.1220)]/0.12
= $100 × 7.4694
= $746.94

· The value of each bond = $103.66 + 746.94

= $850.60

Valuing a Bond: A Premium Bond

· Assume you have the following information.

o BMN, Inc. bonds have a $1000 face value
o The promised annual coupon is $100
o The bonds mature in 20 years
o The market’s required return on similar bonds is 8%

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· Present value of the face value

= $1000 × [1/1.0820]
= $1000 × 0.21455
= $214.55

· Present value of the coupon payments

= $100 × [1 - (1/1.0820)]/0.08
= $100 × 9.8181
= $981.81

· The value of each bond = $214.55 + 981.81

= $1,196.36

Bond Price Sensitivity to YTM

Valuing Bonds

Based on our examples we can write a general expression for the value of a bond. If a bond has
· a face value of F paid at maturity
· a coupon of C paid per period
· t periods to maturity
· a yield of r per period

Its value is:

భ
൜ଵି ൠ ி
ሺభశೝሻ೟
Bond Value = C × +
௥ ሺଵା௥ሻ೟
Where,
భ
൜ଵି ൠ
ሺభశ౨ሻ ౪
· C× is the present value of coupons, and
୰
୊
· is the present value of face amount?
ሺଵା୰ሻ౪

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Business Finance –ACC501 VU
Semiannual Coupons

· Bond yields are quoted like APRs, the quoted rate is equal to the actual rate per period
multiplied by the number of periods in a year.
· When the payments of coupons are made on semiannually, each payment of half of the annual
coupon, it is referred to as semiannual coupon bond
· If an ordinary bond has a coupon rate of 14% then the owner gets $140 per year but in two
installments each of $70. in this case, the Yield to maturity is 16%
· So with a 16% quoted yield, the true yield is 8% per period.
· Now if the bond has seven years to maturity
· What would be the bond’s price?
· What is the effective annual yield on this bond?
· The bond should sell at a discount because it has a coupon rate of 7% per six months when the
market requires 8% every six months.

· Present value of the face value

= $1000 /1.0814
= $1000/2.9372
= $340.46

· Present value of 14 period annuity of $70 at 8% discount rate is

= $70 × [1 - (1/1.0814)] /0.08
= $70 × 8.2442
= $577.10

· Total Present value tells that the bond should sell for:

= $340.46 + 577.10
= $917.56

· To calculate the effective annual yield on this bond, note that 8% every six months is equivalent
to:
EAR = (1 + 0.08)2 – 1
EAR = 16.64%

Interest Rate Risk

· The risk that arises for bond owners from fluctuating interest rates is called interest rate risk.
· The risk on a bond depends on how sensitive its price is to interest rate changes
· The sensitivity directly depends on
· Time to maturity
· Coupon rate
· While looking at a bond following should be kept in mind
· All other things being equal, the longer time to maturity, the grater the interest rate risk
· All other things being equal, the lower the coupon rate, the greater the interest rate risk
· We can illustrate these characteristics graphically

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Interest Rate Risk

Time to Maturity
Interest Rate
1 Year 30 Years
5% $1047.62 $1768.62
10 1000.00 1000.00
15 956.52 671.70
20 916.67 502.11

Interest Rate Risk

· The slope of the line connecting the prices is much steeper for 30-year maturity than it is for 1-
year maturity
· The steepness tells that a relatively small change in interest rate will lead to a substantial change
in the bond’s value.
· In comparison, one year bond is relatively less sensitive to interest rate changes
· The reason for longer term bonds having greater interest rate sensitivity is that a large
proportion of the bond’s value comes from the $1000 face amount.
· The present value of this amount is not affected by small change in interest rate if amount is to
be received in an year
· While, even a small change in interest rate when compounded for 30 years, will have a
significant effect on the present value.
· Interest rate risk increases at a decreasing rate.
· If we compared a 10-year bond with a 1-year bond, obviously, 10 year bond has much greater
risk
· But if we compare a 20 year bond to a 30 year bond, the 30 year bond will have a somewhat
greater interest rate risk but the difference is fairly small.
· The bonds with lower coupons have greater interest rate risk
· If two bonds with different coupon rates have same maturity, the value of the one with the
lower coupon is proportionately more dependent on the face amount to be received. So its
value will fluctuate more as interest rate changes
· In other words, bond with higher coupon has a larger cash flow early in its life, so its value is
less sensitive to changes in discount rate

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