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Portmore Community College

Financial Management (ACCT2302)

Bonds Valuation
A bond is a long-term debt instrument used by governments, corporations, and firms to raise debt
financing. Most of the bonds have following three attributes generally.
Pay interest annually, semi-annually, or quarterly
They have defined maturity period
They have defined face value usually $100 or $1000

Par value or face value is the amount mentioned at the face of the bond representing the sum to
be borrowed at which interest is to be paid and also will be repaid at the expiry of maturity
period. Coupon rate is the stated rate of interest and interest payable will be calculated by
multiplying coupon rate to the par value. Maturity period refers to the number of year after
which the principle amount will be repaid or refunded to bondholder.
In financial management the true value of a physical or financial asset is determined by
discounting its future expected net benefits to the present values. The value of the bond is the
sum of present values of the interest payments (contractually agreed upon at the stated rate of
interest) discounted at the required rate of return plus the present value of par value repayable at
the end of maturity period. The required rate of return is the commensuration of prevailing
interest rate and risk. The key inputs to valuation process are expected returns in terms of cash
flows together with their timings and risk in terms of required returns. Bond valuation model can
be presented as follows:

PVB = I [ 1- (1 +i/m)-mn] + M(1+i/m)


i/m
OR
VB = I x (PVIFA)i,n + M x (PVIF)i,n
Where,
VB = Value of the bond
I = Annual interest payment
N = life of the bond in years
M = Maturity value of par value
i = Required rate of return

Question 1
A firm issued a 10% coupon interest bonds for a period of 10 years with a face value of $1000.
The required rate of interest is also 10% and interest is paid annually.

Required : Determine the value of the bond.

In the above example the bond value is equal to the par value i.e. $1000. This is due to the fact
that when required return is equal to the coupon rate the bond value equals the par value. But in
reality it seldom happens when required rates and coupon rates are equal therefore market value
of the bond generally remains lower or greater than the par value.
Significance of Required Returns to the Bond Value

As mentioned above that market value of the bond will differ from it par value if required return
is different from the coupon rate. These two rates differ due to the following reasons:
Changes in the basic cost of long-term funds
Changes in the basic risk of the firm
When the required return is more than coupon rate of interest the bond market value is less than
par value or bond will sell at discount. On the contrary if required return is less than coupon rate
the market value of the bond would be more than its par value or bond will sell at premium. This
phenomenon can be more easily understood by the use of examples.

Question 2
A firm issued a 10% coupon interest bonds for a period of 10 years with a face value of $1000.
The required rate of interest is 12% and interest is paid annually.

Required : Determine the value of the bond.

Question 3
A firm issued a 10% coupon interest bonds for a period of 10 years with a face value of $1000.
The required rate of interest is 8% and interest is paid annually.

Required : Determine the value of the bond.

Because the required return is less than coupon rate in the above example the bond value is
greater than its par value.
The above two examples clearly show that required rate of return is the major determinant of
market value of the firms bonds.
If the required rate of return remain constant over the life of the bond the bonds market price
approaches its par value. On the other hand under the changing circumstances of required returns
the shorter the time to maturity, the smaller the impact on bond value caused by given changes in
the required return.

Semiannual Interest and Bond Value

The procedure towards the calculation of bonds value paying interest semiannually is similar. As
interest is two times in a year therefore half yearly interest should be calculated to find the
present value. The required return over that the interest payments are discounted is also needed
to be divided by two. Number of years in the maturity period is converted to discounting period
by multiplying by two. Symbolically:

VB = I / 2 x (PVIFA)i/2 , 2n + M x (PVIF) i/2 , 2n


Question 4
A firm issued a 10% coupon interest bonds for a period of 10 years with a face value of $1000.
The required rate of interest is 14% and interest is paid semiannually.

Required : Determine the value of the bond.

Yield to Maturity

Definition
The term Yield to Maturity also called as Redemption Yield often abbreviated as YTM and used
when it comes to bond funds, is defined as the rate of return obtained by buying a bond at the
current market price and holding it to maturity. Yield to Maturity is the index for measuring the
attractiveness of bonds. When the price of the bond is low the yield is high and vice versa. YTM
is beneficial to the bond buyer because a rising yield would decrease the bond price hence the
same amount of interest is paid but for less money. Where the coupon payment refers to the total
interest per year on a bond. Yield to maturity can be mathematically derived and calculated from
the formula

YTM is therefore a good measurement gauge for the expected investment return of a bond.
When it comes to online calculation, this Yield to Maturity calculator can help you to determine
the expected investment return of a bond according to the respective input values. YTM deals
only with the time-value-of-money calculations between the price, coupons and face value of the
bond at hand, not with other potential future investments. If the coupons and face value are paid
as promised the bond earns its yield-to-maturity

Review Questions

Question1:

a)The Don-Paul and Company Limited issues a bond with a par value of $1 000.00 and
coupon interest rate of fifteen percent (15%) with maturity date of 15 years. If the required
rate of the investor is 20% per annum, how much would you be willing to pay for this
bond today if interest is paid:

i. annually?
ii. semi-annually?

b)The Don-Paul and Company has a bond which has 14 years remaining to maturity. Interest
is paid annually. The bond has a par value of $1 000.00 and a coupon interest rate of 15%.
What is its yield to maturity if this bond sells for $1 368.31?
Question 2
a). XYT Limited issued bonds with a coupon rate of 15% which pay interest semiannually
and have ten (10) years remaining until maturity. The required rate of return is 18%.
What will the bonds sell for today?

b).RFT Limited bonds sell for $1 368. They mature in fourteen (14) years, pay an annual
coupon of 20% and have par value is $1 000. What will be the approximate yield to
maturity of XYT bonds?

c).National Cement is selling $1 000 par value bonds with a maturity period of fifteen (15)
years and which pays 8% in interest annually. The market price of this bond is $1 085.

i.Compute the yield to maturity.


ii. Determine the value of the bond to you given your required rate of return of 10%.
iii. Should the bond be purchased? Explain reason for your answer.

Question 3
Bond Yields

N&N Co. has 10.5 percent coupon bonds on the market with 8 years left to maturity. The bonds
make annual payments. If the bond currently sells for $1,070, what is its YTM?

Question 4

Bond Yields

Jerry's Spaghetti Factory issued 12-year bonds two years ago at a coupon rate of 9.5 percent. The
bonds make semiannual payments. If these bonds currently sell for 96 percent of par value, what
is the YTM?