Topic 7 :

The Valuation and

Characteristics of
Bonds
 What is a debt / bond?
A long-term debt or instrument refers
to:
– Any promissory note which a borrower
agrees to repay the borrowed funds and
to compensate lender (principal and
interest) over a period of time greater
than 1 year.
 Features of Long-Term
Bonds

u p on
Par Co
valu s
e rate

Maturity
 Features of Long-Term Bonds
Par value
 Par value is the stated face value of the
bond.
 It represents the amount of money the
firm borrows and promises to repay on
the maturity date.
 Generally assume a par value of
RM1,000
 Features of Long-Term Bonds
Coupon Rates

 Coupon Rate / Interest Rate

– - Stated interest rate (generally fixed)
paid by the issuer.

– - Multiply by par value to get dollar

payment of interest.
 Features of Long-Term Bonds
Maturity
A specified maturity
date on which the par
value must be repaid.

 Effective maturity of a
bond declines each year
after it has been issued.
 Bond Valuation:
Value of an Asset
 Basedon the expected future benefits
or cash flow over the life of the asset.

 How much are you willing to pay today for

future stream of cash flow benefits?
– The value is equal to discounted value
(present value) of the future stream of cash
flows.
 Bond Valuation:
Value of a Bond is the Present value of its
Cash Flows
1
1
(1  k d ) n
1
P0  I 
kd 1  k d n

•The first term represents the PV of an annuity of I

per period for n periods.
•Thesecond term represents the PV of a single
payment (usually RM1000) of M in period n.
 Example of Bond Valuation
 Zee Food Company issued RM300m of 7% bonds
maturing on 15 May 2011.
Bonds were issued in RM1,000 par value and pay
interest on 15 May yearly.

 An investor who wishes to purchase the bond on

15 May 2004 requires 8% of return.
Assume the investor will hold the bond until
maturity, what is the price that the investor is
willing to pay?
 Example of Bond Valuation
 Solution:
– Investor will receive 7 annual interest payment
(n=7) of RM70 each (I=RM1,000x0.07), plus
– Principal payment, M, of RM1,000 at the end of
the seventh year, 15 May 2011.
– Expected cash flows are as follows:
‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11

RM70 RM70 RM70 RM70 RM70 RM70 RM70

+
Annuities of RM70 per year for 7 years RM1,000
Single sum of RM1000
 Annuities of RM70 per
year for 7 years Single sum of RM1000
Kd = 8%
 Value for
Annuities the bond:
formula (PVAN) Single sum formula (PV)

 1 
 1 7 
 (1.08)   1000 
o  70   
 0.08   (1.08)
7

 
 
 364.45  583.49
 RM947.94
Therefore, an investor requiring 8% return
would be willing to pay approximately RM948
for it on 15 May 2004.
 Semiannual Interest Payments
•Most corporate bonds pay interest semi-annually.
•Therefore, interest payment, discount rate and number
of periods need to be expressed in semi-annual
terms.
 1 
1  k d n2 
 (1  ) 
I 2 M
P0    n2
2 kd   kd 
 2  1  
 2 

 

 Semiannual Interest Payments
From the previous example:

 1 
 1 
   1000 
14
 (1.04)
o  35 
 0.04   (1.04)14 
 
 
 Lecture Exercises

1. Determine the amount you would be willing

to pay for a RM1000 par value bond paying
RM70 interest each year maturing in 10
years, assuming you wanted to earn 8
percent rate of return.
2. Ah Ming has an outstanding bond that has
a coupon rate of 8.4%. What is the market
price of this bond if it pays interest
annually, the current required rate of
return is 9.5% on bonds and has 14 years
to maturity?
3. What is the value of a PacTen bond with a
10 percent coupon that matures in 15
years? Assume the current market rate for
this bond is 16 percent and that interest is
paid semiannually.
4. What is the value of a Northern Pacific
bond with an 11 percent coupon, maturing
in 15 years? Assume the market rate for
this bond is 14 percent and that the
interest is paid semiannually.
 Bond Pricing Principles

1. Bond values are inversely related to the

required rate of return
2. Bonds trade at a:
discount (below par value),
par (equal to par value), or
premium (greater than par value)
 Bond Pricing Principles
2. Bonds trade at a discount, par, or
premium

If coupon rate > YTM = Premium

If Coupon rate < YTM = Discount
If Coupon rate = YTM = Par Value
Try this:
Suppose a 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?
Answer: RM1,000
Note: if the coupon rate = discount rate, the bond
will sell for par value (RM1,000)
 Suppose the required return on bonds of
similar risk drops to 10%.

What would happen to the bond’s intrinsic

value?
Answer: RM1,170.23
Note: if coupon rate > discount rate, the
bond will sell for a premium (>RM1,000)
 Suppose the required return on bonds of
similar risk rises to 14%.

What would happen to the bond’s intrinsic

value?
Answer: RM867.57
Note: if the coupon rate < discount rate, the
bond will sell for a discount (<RM1,000)
Lecture Exercise
The relationship between a bond’s yield to maturity and
coupon interest rate can be used to predict its pricing level.
For each of the bonds listed, state whether the price of the
bond will be at a premium to par, at par, or at a discount to
par.
Coupon Yield to
Bond interest rate (%) maturity (%) Price
A 6 9 ?
B 7 7 ?
C 10 8 ?
D 4 6 ?
E 13 11 ?
 Yield to Maturity (YTM)
 Bond investors often presented with alternative
bonds that are trading at different prices.

 YTM is used to compare and decide which bond

to be invested.

The discount rate kd that equates the PV0 of all expected

interest payments and the repayment of principal from a
bond to the present bond price.

– YTM tells what an investor is likely to earn of a bond if

purchased at a given price and held to maturity.
Yield to Maturity (YTM) (Cont…)
1
1
(1  YTM) n
M
P0  I 
YTM 1  YTM n

This method requires to identify the discount

rate that equates the PV of future CFs of a
bond to the bond price.
– PV of future CFs of a bond = Current bond price
– Essentially a trial-and-error process
Yield to Maturity (YTM) (Cont…)
Steps in trial-and-error procedure are as follows:
1. Make an approximate estimate of the YTM
If bond is selling at premium, If bond is selling at discount,

Trial rate ‹ Coupon rate Trial rate › Coupon rate

2. Use this rate to compute the PV of the bond’s

CFs
3. Repeat the process by trying higher or lower rate
until a rate is found at which the;
– PV of the bond’s CFs = Current bond price
 Example of YTM Calculation

AT&T Wireless Service (AWE) offer a bond with a

coupon rate of 8.125% and mature on 1 May
2012.

Let’s assume you purchased it on 1 May 2003 at

the last price of RM1,146.46.

What is the YTM?

 Example of YTM Calculation
 Solution:
– Bond price is at premium
 YTM < Coupon rate
– Let’s calculate using discount rate of 5%
 1 
 1 
o   81.25
(1.05) 9   

1000 

 0.05   (1.05) 9 
 
 
 

 RM1,222.53

– The Po is greater than the price RM1,146.46.

 Therefore, YTM should be higher than 5%
 Example of YTM Calculation
 Substitute the discount rate as 6%:
 1 
 1 
o   81.25
(1.06) 9   

1000 

 0.06   (1.06) 9 
 
 
 

 RM1,144.66

 Therefore, YTM is between 5% and 6%

– YTM is below 6%.
 To get the exact YTM:
1%
x

5% YTM 6%
1222.53 1146.46 1144.66

76.07
77.87

X/1% = 76.07/77.87 YTM = 5% + x%

X = 0.98% = 5% + 0.98%
= 5.98%
 Lecture Exercise
 Heyman Co bonds have 4 yrs left to
maturity, Interest is paid annually, and the
bonds have a $1,000 par value and a
coupon rate of 9%.

- What is the yield to maturity at a current

market price of (1) $829 or (2) $1,104?

- Would you pay $829 for the bond if you

think that a "fair" market interest rate for
such bonds is 12 %-that is if kd=12%
Explain your answer.
 Exercise
Ming has an outstanding bond that has a
coupon rate of 8.3%. What is the market
price of this bond if it pays interest semi-
annually, has 15 years to maturity, and the
current required rate of return is 9% on
bonds of similar quality?
"I hear and I forget.
I see and I remember.
I do and I understand."
-- Confucius