Financial Management

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Financial Management ­ MGT201
VU
Lesson 14
BONDS' VALUATION
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topic.
·  Bonds Valuation and Theory
In the Previous lecture, we have studied about bonds and their different characteristics.
In this lecture, we would study about the Bonds valuation & bond pricing.
We use similar tools for the bond valuation which we have studied in capital budgeting.
Basic principal behind Valuation of direct claim securities:
Value of a Direct Claim Security such as a Bond derives from direct cash flows the form of Coupon
Receipts and Par Recovery at maturity. The value of the bond is directly tied to the Value of the
Underlying Real Assets of the Business (whose operations generate cash receipts from sales of goods
and services). It means that income from the bond starts from the real assets. The coupon payments
made by the company are generated from the cash flows from the real assets of the company.
Now, we would calculate the value of the bond by using Net Present Value or Present Value
formula that we have studied in the capital budgeting. That is called fair or intrinsic value of the bond.
We compare the fair value with the market value of that bond. Whether there is a difference between the
fair value and market value of the bond.
Let's review the present value formula for the bond in detail.
The relationship between present value and net present value
NPV = -Io + PV
When we talk about the present value it is equal to net present value + initial investment.
We calculate the present value of the direct claim securities because it gives us intrinsic value of that
direct claim security should be. It is the starting point of comparing them
Present Value formula for the bond:
n
PV=  CFt / (1+rD)t =CF1/(1+rD)+CFn/(1+rD)2 +..+CFn/ (1+rD) n +PAR/ (1+rD) n
t =1
In this formula
PV = Intrinsic Value of Bond or Fair Price (in rupees) paid to invest in the bond. It is the Expected or
Theoretical Price and NOT the actual Market Price.
rD = it is very important term which you should understand it care fully. It is Bondholder's (or
Investor's) Required Rate of Return for investing in Bond (Debt).As conservative you can choose
minimum interest rate. It is derived from Macroeconomic or Market Interest Rate. Different from the
Coupon Rate!
Recall Macroeconomic or Market Interest Theory: i = iRF + g + DR + MR + LP + SR
CF = cash flow = Coupon Receipt Value (in Rupees) = Coupon Interest Rate x Par Value. Represents
cash receipts (or in-flow) for Bondholder (Investor). Often times an ANNUITY pattern. Coupon Rate
derived from Macroeconomic or Market Interest Rate. The Future Cash Flows from a bond are simply
the regular Coupon Receipt cash in-flows over the life of the Bond. But, at Maturity Date there are 2
Cash In-flows: (1) the Coupon Receipt and (2) the Recovered Par or Face Value (or Principal)
n = Maturity or Life of Bond (in years)
In the next lectures, you would study that how the required rate of return is related to market rate of
return.
The fair value of the bond is the value that we expect the bond to be. We have to compare this value
with the actual price of the bond in the market. The actual price of the bond (market value) varies on the
supply and demand of the bond in the market and it will vary depending upon the interest rate in the
bond.
On the basis of above comparison we decide whether to invest in a particular bond or not.
The market rate of interest prevailing in the market effects price of the bond. Because, market rate
of return will have an impact on rD which is the required rate of return expect by the investor of the
bond.
When Market Interest Rate (ie. Investors' Required Rate of Return) Increases, the Value (or
Price) of Bond Decreases. Check using formula. This is known as Interest Rate Risk. This is a
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simple relationship because rD which will rise and fall with the general interest rate is in the
denominator of the equation. So, when interest rate in denominator goes up the present value (price)
will decrease.
When Market Interest Rate have went behind the coupon interest rate. As the coupon interest
rate has been fixed by the bond issuer .The issuer have to pay that rate but the market rate fluctuates
on daily and hourly basis.
So, When Market Interest Rate < Coupon Interest Rate, Market Value (or Price) of Bond > Par
Value. Because when market is offering lower rate of return then the bond then the bond becomes
valuable. This is known as a Premium Bond. If Required Rate = Coupon Rate then Market Value =
Par Value. Check using formula. As Maturity Date approaches, Market Value of Bond will
approach its Par Value. Note: Market Rate varies but Coupon Rate is fixed.
Bonds have the limited life and as the life of a bond expires the bond approaches its maturity
date the market value of the bond approaches to par value of the bond.
Long Bond - Risk Theory:
Interest Rate Risk for Long Term Bonds (i.e. 10 year bonds) is more than the Interest Rate Risk
for Short Term Bonds (i.e. 1 year bonds) provided the coupon rate for the bonds is similar. When
investor buy a long term bond he is locked in investment for long term period there are more chances of
fluctuation in interest rate and the inflation rate.
So, the impact of interest rate changes on Long Term bonds is greater. Long Term Bond Prices
fluctuate more because their Coupon Rates are fixed (or locked) for a long time even though Market
Interest Rates are fluctuating daily; therefore the price of Long Bonds has to constantly keep adjusting.
Price of the long term bond fluctuates more as compared to the short term bond. Because, you
have a long term bond with fix coupon rate but the market interest rate is fluctuating in between the
years
Bond Portfolio Theory:
Changes in Market / Macro Interest Rates have 2 Major Impacts on the Portfolio (collection of bond
investments) of the Bondholder:
(1) Interest Rate Risk: In this, the value of Bond Portfolio Drops if interest rates Rise) and
(2) Reinvestment Risk: In this, the overall Rate of Return (or Yield) on the Bond Portfolio
Rises when interest rates rise the opportunity cost for the bond holder has changed. For
example, somebody may have bought a short term bond with coupon rate of 15 % for one
year. At maturity there is a risk that bondholder may not find another investment that can
yield as much as 15%.
When old bonds mature, bondholders are forced to invest in
bonds at lower coupon rates). It is higher for short term bonds.
The 2 Effects Cancel Each Other Out. When market Interest Rates Rise, Bond Prices Drop
(Interest Rate Risk Goes Up) BUT Overall Returns on future reinvestment in bonds go up (ie.
Reinvestment Risk Goes Down).
SHORT-life bonds (ie. 1 year) have less Interest Rate Risk than long Bonds (ie. 10 years) but
the Short-life bonds have MORE Reinvestment Rate Risk.
Bond Valuation - Café Case Study
Example:
You do not have enough money to start your business so you approach a bank. The bank offers
to lend you Rs 100,000 and you sign a bond paper. The bank asks you to issue a bond in their favour on
the following terms required by the bank:
Par Value = Rs 100,000 (ie. Loan Principal Amount)
Maturity = 2 years
Coupon Rate = 15% mark-up paid at end of each year
Security = Property Deed for the canteen space
Note: This is a simplified case where we are treating a short-term bank loan like a Bond.
For the Bank, what is the Value of Investing in a Bond with you?
CF = Cash Flow = Coupon Value
= Coupon Rate x Par Value
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= 15% x Rs 100,000 = Rs15,000 pa.
The bank will receive Rs 15,000 in interest every year for two years from you because you have
agreed to pay 15% mark-up.
Assume the Bank's Required Return (rD) = 10% pa. The bank's opportunity cost is 10% because it
can earn this much by investing risk free in T-bills
Now compute the PV or Fair Price of Bond:
­  PV = 15,000 / 1.1 + 15,000 / (1.1)2 + 100,000 / (1.1)2 = 13,636 + 12,397 + 82,645 =
+Rs. 108,678 (= PV and NOT NPV!)
So, what is the Value of this Financing Deal to the Bank? Lending (ie. negative Rs 100,000) to you
today at 15% mark-up for 2 years is worth positive Rs 108,678 to the bank today, i.e. A net gain in
value for the bank. BUT, if some other bank offers to pay Rs 110,000 to this bank to buy this deal
from them, then this bank should sell!
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