Financial Management

Chev Adam D. Repique

September / 7 / 2019
BOND VALUATION- FINANCIAL MANAGEMENT
Unit 1: Introduction to Finance, Financial Statements, and Financial Analysis
Ratios for financial statement analysis and analysis of cash flows. The main ratios explained are:
a) Solvency (or liquidity ratios)
b) Financial ratios
c) Profitability ratios
d) Market value ratios
Bond Is where a company or a government borrows money from the public or banks (bond
holders) in the form of coupon payments and agrees to pay back at the future. At the maturity date,
the full face value of the bond is repaid to the bondholder.
Par value - is the amount of money the company or government borrows
Coupon Payments – are like interest the company or the government makes regular payments to
the bondholders at a regular date – monthly or yearly basis.
Indenture – is the legal agreement stating the conditions under which a bond is issued between
the company and the bondholder - to ensure that the issuer does not default on its contractual
commitment to the bondholders.
Maturity Date - is the date when the company pays the par value back to the bond holder
The Present value is used for better understanding one of several factors an investor may
consider before buying the investment.
The Market interest rate is the current interest rate for a bond.
It changes everyday.
Bond valuation is a technique for determining the theoretical fair value of a particular bond. It
includes calculating the present value of the bond's future interest payments, also known as its cash
flow, and the bond's value upon maturity, also known as its face value or par value.
Because a bond's par value and interest payments are fixed, an investor uses bond valuation to
determine what rate of return is required for a bond investment to be worthwhile.
The characteristics of a regular bond include:
 Coupon rate: also known as interest rate, which is paid to bondholders semi-annually. The
coupon rate is the fixed return that an investor earns periodically until it matures.
 Maturity date: All bonds have maturity dates. When the bond matures, the bond issuer
repays the investor the full face value of the bond.
 Corporate bonds, the face value of a bond is $1,000 and
 Government bonds, the face value of a bond is $10,000.
 Current Price: Depending on the level of interest rate in the environment, the investor
may purchase a bond at par, below par, or above par.
Since bonds are an essential part of the capital markets, investors and analysts seek to understand
how the different features of a bond interact in order to determine its intrinsic value. Like a stock,
the value of a bond determines whether it is a suitable investment for a portfolio and hence, is an
integral step in bond investing.
Bond valuation - is calculating the present value of a bond’s expected future coupon payments.
The theoretical fair value of a bond is calculated by discounting the present value of its coupon
payments by an appropriate discount rate.
The discount rate used is the yield to maturity, which is the rate of return that an investor will get
if s/he reinvested every coupon payment from the bond at a fixed interest rate until the bond
matures. It takes into account the
1) Price of a bond,
2) Par value,
3) Coupon rate,
4) Time to maturity.
Calculating the value of a coupon bond factors in the annual or semi-annual coupon payment and
the par value of the bond.
(present value of expected cash flows) + (the present value of the face value of the bond)
as seen in the following formula:
Where C = future cash flows, that is, coupon payments
r = discount rate, that is, yield to maturity t = number of periods
F = face value of the bond T = time to maturity
For example, The value of a corporate is $1,000 bond with an annual interest rate of 5%, making
semi-annual interest payments for 2 years, after which the bond matures and the principal must
be repaid. Assume a YTM of 3%.
F = $1000 for corporate bond
 Coupon rate annual = 5%, therefore,
 Coupon rate semi-annual = 5%/2 = 2.5%
Future cash Flows = 2.5% x $1000 = $25 per period
t = 2 years x 2 = 4 periods for semi-annual coupon payments
T = 4 periods
Present value of semi-annual payments = 25/(1.03)1 + 25/(1.03)2 + 25/(1.03)3 + 25/(1.03)4
= 24.27 + 23.56 + 22.88 + 22.21
= 92.93
Present value of face value = 1000/(1.03)4
= 888.49
Therefore, value of bond = $92.93 + $888.49 = $981.42
Term structure of interest rates
The term structure of interest rates is the relationship between the maturity and rate of return for
bonds with similar levels of risk. A graphic depiction of the term structure of interest rates is called
the yield curve. The yield of maturity is the compound annual rate of return earned on a debt
security purchased on a given point in time and held to maturity.

Yield curve: Graphical representation of the term structure

The slope of the curve reflects an expectation about the movement of interest rates over time.

1) Normal yield curve is an upward-sloping yield curve indicates that long-term interest rates
are generally higher than short-term interest rates.
- Normal = upward-sloping  Long Term > Short Term
2) Inverted yield curve is a downward-sloping yield curve indicates that short-term interest
rates are generally higher than long-term interest rates. Borrowing costs are relatively similar
for short- and long-term loans.
- Inverted = downward-sloping  Long Term < Short Term
3) A Flat yield curve is a yield curve that indicates that interest rates do not vary much at
different maturities.
The yield curve reflects investor expectations about future interest rates, with the differences based
on inflation expectations. The curve can take any of the three forms. An upward-sloping curve is
the result of increasing inflationary expectations, and vice versa.
The liquidity preference theory is an explanation for the upward-sloping yield curve. This theory
states that long-term rates are generally higher than short-term rates due to the desire of investors
for greater liquidity, and thus a premium must be offered to attract adequate long-term investment.
The market segmentation theory is another theory that can explain any of the three curve shapes.
Since the market for loans can be segmented based on maturity, sources of supply and demand for
loans within each segment determine the prevailing interest rate. If supply is greater than demand
for short-term funds at a time when demand for long-term loans is higher than the supply of
funding, the yield curve would be upward sloping. Obviously, the reverse also holds true.

In the Fisher equation, r r* IP RP, the risk premium, RP, consists of the following issuer- and issue-
related components:
Default risk: The possibility that the issuer will not pay the contractual interest or principal as
scheduled.
Maturity risk or interest rate: The possibility that changes in the interest rates on similar
securities will cause the value of the security to change by a greater amount the longer its maturity,
and vice versa.
Liquidity risk: The ease with which securities can be converted to cash without a loss in value.
Contractual provisions: Covenants included in a debt agreement or stock issue defining the rights
and restrictions of the issuer and the purchaser. These can increase or reduce the risk of a security.
Tax risk: Certain securities issued by agencies of state and local governments are exempt from
federal, and in some cases state and local taxes, thereby reducing the nominal rate of interest by
an amount that brings the return into line with the after-tax return on a taxable issue of similar risk.
Upward-Sloping Yield Curve

Downward-Sloping Yield Curve

Yield to Maturity (YTM)
Yield to maturity is also referred to as "book yield" or "redemption yield."
Yield to maturity is the total return anticipated on a bond if the bond is held until it matures. Yield
to maturity is considered a long-term bond yield but it is expressed as an annual rate. In other
words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the
bond until maturity, with all payments made as scheduled and reinvested at the same rate.

The term Interest rates is usually applied to debt instruments such as bank loans or bonds;
 The compensation paid by the borrower of funds to the lender;
 The borrowers point of view, the cost of borrowing funds
The term Required return is usually applied to equity instruments such as common stock; the
cost of funds obtained by selling an ownership interest.

Interest rates and required returns: Interest Rates Fundamentals

Inflation - A rising trend in the prices of most goods and services.
Risk - leads investors to expect a higher return on their investments
Liquidity preference - A general tendency for investors to prefer short-term (that is, more
liquid) securities.
The Real rate of interest - is the rate that creates an equilibrium between the supply of savings
and demand for investment funds.
- It changes w/ changing economic conditions, tastes & preferences.
The Nominal rate of interest is the actual rate of interest charged by the supplier and paid by the
demander.
Nominal or Actual rate of interest (Return) - The actual rate of interest charged by the supplier
of funds and paid by the demander. Affected by inflation and risk.
- Expected Inflation Premium (IP) – a higher rate of return the investors will demand if
they expect inflation.
- Risk Premium (RP) – a higher rate of return the investors will demand on risky
investments.
The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid
by the demander
The nominal rate of interest differs from the real rate of interest due to two factors:
(1) a premium due to inflationary expectations reflected in an inflation premium (IP) and
(2) Issuer and issue characteristics such as default risks and contractual provisions as reflected
in a risk premium (RP).
When people are save money and invest they are sacrificing consumption today in return to gain
higher future money compensation when investors expect inflation to incur they believe that the
price of the consuming goods and services will be higher in the future than the present.
The nominal rate can be viewed as having 2 basic components; a risk-free rate of return, Rf and a
risk premium, RP1
R1 = Rf + RP1

The risk free rate can be represented as

Rf = r* + IP

The risk free rate is represents real rate of return + the expected inflation premium. It means
that we are protected from the inflation that is expecting and we’re also receiving our real rate of
return. Inflation premium is driven by investors expectation about where they think inflation is
about to head on to.
More inflation higher the nominal interest rate
Less inflation lower the nominal interest rate

Bonds adjust for Inflation

- One disadvantage of a bond is that they usually are fixed interest rate.
- This represents a serious risk to bond investors, because if inflation rises while the nominal
rate on the bond remains fixed, the real rate of return falls
- Once the bond is issued the interest rates typically cannot be adjusted as expected inflation
changes. Therefore when inflation change the nominal rate stays the same, ergo the real
rate of return falls.

Future Values: General Formula

FV = PV(1 + r)t

o FV = future value
o PV = present value
o r = period interest rate, expressed as a decimal
o t = number of periods
Simple interest - Interest earned only on the original principal
Compound interest - Interest earned on principal and on interest received. “Interest on interest”
- interest earned on reinvestment of previous interest payments.
For a given interest rate: For a given time period:
- The higher the interest rate,
- The longer the time period, - The larger the future value
- The higher the future value - For a given t, as r increases, FV
- For a given r, as t increases, FV increases
increases
Present Value: General Formula
Present Value - the current value of an amount to be received in the future. “Discounting” -
finding the present value of one or more future amounts.

PV = FV(1+r)-t
or

𝐹𝑉
PV = (1+r)^t

o FV = future value
o PV = present value
o r = period interest rate, expressed as a decimal
o t = number of periods
For a given interest rate: For a given time period:
- The longer the time period, - The higher the interest rate
- the lower the present value - the smaller the present value
- For a given r, as t increases, PV - For a given t, as r increases, PV
decreases decreases

Discount Rate: General Formula

To find the implied interest rate, rearrange the basic PV equation and solve for r:

r = (FV / PV)1/t – 1

Time Period: General Formula

 FV 
ln 
t  
PV
ln(1  r )
Special Application of Time Value: Loan Amortization

CF = (PV x r) ÷ [1 - 1/(1+r)n]