chapter 7a bonds valuation
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BOND VALUATION
From: Basic Financial Management
Seventh EditionChapter 7
Chapter
7A

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Terminology and Characteristics of Bonds
Bonds a type of debt or longterm promissory note,
issued by the borrower, promising to pay its holder a
predetermined and fixed amount of interest each year.
Types of Bonds:
Debenture any unsecured longterm debt.
Subordinated Debentures a debenture that is
subordinated to other debentures in being paid in case of
insolvency.
Mortgage Bonda bond secured by a lien on real property.

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Terminology and Characteristics of Bonds
(Continued)
Zero and Very Low Coupon Bondsbonds issued
at a substantial discount from their $1,000 face
value that pay no or little interest.
Junk or LowRated Bonds bonds rated BB or
below.Eurobonds bonds issued in a country different
from the one in whose currency the bond is
denominated for instance, a bond issued inEurope or Asia by an American company that
pays interest and principal in U.S. dollars.

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Features or Characteristics of Bonds
Claim on Assets and Income in case of
insolvency, claims of debt in general, includingbonds, are honored before those of the
preferred and ordinary shares of stock. Bonds also
have claim on income that comes ahead ofcommon and preferred stocks.
Par Value bonds face value that is returned to
the bondholder at maturity, usually $1,000.Coupon Interest Rateindicates what percentage
of the par value of the bond will be paid out
annually in the form of interest.

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Features or Characteristics of Bonds (Continued)
Indenture the legal agreement or
contract between the firm issuing the
bonds and the bond trustee who
represents the bondholders.Current Yield the ratio of the interest
payment to the bonds market price.
Maturity the length of time until thebond issuer returns the par value to the
bondholder and terminates the bond.

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Valuation is an important issue if we are to manage acompany effectively. And understanding of theconcepts and how to compute the value of asecurity underlie much that we do in finance andin making correct decisions for the firm as a
whole. Only if we know what matters to ourinvestors can we maximize the firms value.
Value is defined differently depending on the context.But for us, value is the present value of futurecash flows expected to be received from aninvestment discounted at the investors requiredrate of return.
Definitions of Value

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Definitions of Value (Continued)
Book Valuethe value of an asset as shown on a
firms balance sheet. It represents the historicalcost of the asset rather than its current market
value or replacement cost.
Liquidation Valuethe amount that could be
realized if an asset were sold individually and not
as a part of the going concern.
Market Valuethe observed value for an asset in
the market place.

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Intrinsic or Economic Valuethe present
value of the assets expected future cashflows. This value is the amount the
investor considers to be a fair value, given
the amount, timing, and riskiness of futurecash flows.
Efficient Marketa market in which the
values of securities at any instant in time
fully reflect all available information,
which results in the market value and the
Definitions of Value (Continued)

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Valuation: Understanding the Process
Valuation process can be described as follows:It is assigning value to an asset by calculating
the present value of its expected future cash
flows using the investors required rate ofreturn as the discount rate.
The investors required rate of return, k, equals
the riskfree rate of interest plus a risk
premium to compensate the investor for
assuming risk.

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Elements that affect the value of an asset:
1. The amount and timing of the assets expected
cash flows;
2. The riskiness of these cash flows; and
3. The investors required rate of return for
undertaking the investment.
Valuation: Understanding the Process
(Continued)

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*Bond Valuation*
The value of a BOND is the present value
both of future interest to be received
and the par or maturity value of thebond.

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Bondholders Expected Rates of Return
Expected Rate of Return the discount rate that equates the
present value of the future cash flows (interest and maturity
value) with the current market price of the bond. It is the rate of
return an investor will earn if a bond is held to maturity.
Yield to Maturity the same as the expected rate of return.

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Bond Valuation:
Five Important Relationships
1. A decrease in interest rates (required rates of
return) will cause the value of the bond to
increase; an interest rate increase will cause a
decrease in value. The change in value causedby changing interest rates is calledInterest Rate
Risk.

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Bond Valuation: (Continued)
Five Important Relationships
2. If the bondholders required rate of return
(current interest rate):
a.) Equals the coupon interest rate, the bond
will sell at par, or maturity value.
b.) Exceeds the bonds coupon rate, the bond
will sell below par value, or at a discount.
c.) Is less than the bonds coupon rate, the
bond will sell above par value, or at a
premium.

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3. As a bond approaches maturity, the market
price of the bond approaches the par value.
4. A bondholder owning a longterm bond isexposed to greater interest rate risk than
one owning a shortterm bond.
Bond Valuation: (Continued)
Five Important Relationships

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Bond Valuation: (Continued)
Five Important Relationships
5. The sensitivity of a bonds value to interest
rate changes is not only affected by the time
to maturity, but also by the time pattern ofinterim cash flows, or its duration.

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Bond Valuation:
Exercise Problems
Ex. #1 Wapoco bonds have a coupon rate of 8%, apar value of P 1,000, and will mature in 20 years.
If you require a return of 7%, what price would
you be willing to pay for the bond? Whathappens if you pay more for the bond? What
happens if you pay less for the bond?
B d V l ti

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Value (Vb) = +
Bond Valuation:
Solution to Exercise#1
20
t=1(1.07) t
$80 $1,000
20(1.07)
Thus,
Present value of interest: $80(10.594) =$ 847.52
Present value of par value: $1,000(0.258) =$ 258.00
Value of the Bond (Vb) =$1,105.52
========
If you pay more for the bond, your required rate of return will not be
satisfied. In other words, by paying an amount for the bond that exceeds
$1,105.52, the expected rate of return for the bond is less than the
required rate of return. If you have the opportunity to pay less for the
bond, the expected rate of return exceeds the 7% required rate of return.
B d V l i

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Ex. #2Gandania Co.s bonds, maturing in 7 years
, pay 8% on a $1,000 face value. However,
interest is paid semiannually. If your required
rate of return is 10%, what is the value of thebond? How would your answer change if the
interest were paid annually?
Bond Valuation:
Exercise Problems

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Bond Valuation:
Solution toExercise#2
If interest is paid semiannually:
Value (Vb) =
Thus,
$40(9.899) = $ 395.96
$1,000(0.505) = $ 505.00
Value (Vb) = $ 900.96
=======
If interest is paid annually:
Value (Vb) =
Value (Vb) = $80(4.868) + $1,000(0.513)
Value (Vb) = $902.44
=======
14t=1
(1+0.05)
$40 $1,000
t (1+0.05)14
7
t=1
$80
( 1.10)
t
$1,000
( 1.10)
7
+
+

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Ex. #3 (Expected Rate of Return)
Ganansia Co.s bonds are selling in the market
for $1,045. These 15year bonds pay 7%
interest annually on a $1,000 par value. If
they are purchased at the market price, what
is the expected rate of return?
Bond Valuation:
Exercise Problems
B d V l ti

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$1,045 =
At 6%: $70(9.712) + $1,000(0.417)=$1,096.84
At 7%: Value must equal $1,000.Interpolation:
Expected Rate of Return:
= 6% + (1%) = 6.54%
$1,096.84$1,000 = $ 96.84
$1,096.84$1,045 = $ 51.84
Bond Valuation:
Solution toExercise#3
15$70( 1+k )
$1,000t
t=1+
( 1+k )
15
$51.84
$96.84k