

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 inflow) 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
inflows over the life of the
Bond. But, at Maturity Date there
are 2
Cash
Inflows: (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
67
Financial
Management MGT201
VU
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.
Interest
Rate Tradeoff:
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).
Bond
Maturity (Life)
Tradeoff:
SHORTlife
bonds (ie. 1 year) have less
Interest Rate Risk than
long Bonds (ie. 10 years)
but
the
Shortlife 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% markup paid at
end of each year
Security
= Property Deed for the canteen
space
Note:
This is a simplified case where we
are treating a shortterm 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
68
Financial
Management MGT201
VU
=
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% markup.
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 Tbills
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% markup 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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