Financial Management - Bond Valuation.pptx

Valuation of Bond

1. Financial Management

2. A ssets can be real or financial; securities like shares and bonds are called financial assets while physical assets like plant and machinery are called real assets . The concepts of return and risk , as the determinants of value, are as fundamental and valid to the valuation of securities as to that of physical assets. Introduction

3. Features of a Bond Face Value : Face value is called par value . A bond (debenture) is generally issued at a par value of Rs100 or Rs1,000, and interest is paid on face value. Interest Rate—fixed or floating : Interest rate is fixed and known to bondholders (debenture-holders). Interest paid on a bond/debenture is tax deductible. The interest rate is also called coupon rate . Coupons are detachable certificates of interest. Maturity: A bond (debenture) is generally issued for a specified period of time . It is repaid on maturity. Redemption value: The value that a bondholder (debenture-holder) will get on maturity is called redemption , or maturity, value. A bond (debenture) may be redeemed at par or at a premium (more than par value) or at a discount (less than par value). Market Value: A bond (debenture) may be traded in a stock exchange . The price at which it is currently sold or bought is called the market value of the bond (debenture) . Market value may be different from par value or redemption value.

4. Bonds Values and Yields Bonds with maturity Pure discount bonds Perpetual bonds

5. Bond with Maturity Bond value = Present value of interest + Present value of maturity value:

6. Example

7. Yield to Maturity The yield-to-maturity ( YTM ) is the measure of a bond’s rate of return that considers both the interest income and any capital gain or loss . YTM is bond’s internal rate of return. Example Calculate the yield-to-maturity of 5-year bond, paying 6 per cent interest on the face value of Rs 1,000 and currently selling for Rs 883.40

8. Yield to Maturity A perpetual bond’s yield-to-maturity : Example If the rate of interest on `1,000 par value perpetual bond is 8 per cent, and its price is `800, its YTM will be:

9. Current Yield Current yield is the annual interest divided by the bond’s current value . Example: The annual interest is Rs 60 on the current investment of Rs 883.40. Therefore, the current rate of return or the current yield is: 60/883.40 = 6.8 per cent. Current yield does not account for the capital gain or loss .

10. Bond Values and Semi-annual Interest Payments It is a practice of many companies in India to pay interest on bonds (or debentures) semi-annually. The formula for bond valuation can be modified in terms of half-yearly interest payments and compounding periods as given below:

11. Example A 10-year bond of Rs 1,000 has an annual rate of interest of 12 per cent. The interest is paid half-yearly. What is the value of the bond if the required rate of return is ( i ) 12 per cent and (ii) 16 per cent?

12. Given the required rate of return of 12 per cent, the value of the bond is

13. If the required rate of return were 16 per cent, then the value of the bond would be

14. Pure Discount Bonds Pure discount bond do not carry an explicit rate of interest . It provides for the payment of a lump sum amount at a future date in exchange for the current price of the bond. The difference between the face value of the bond and its purchase price gives the return or YTM to the investor.

15. Pure Discount Bonds Pure discount bonds are called deep-discount bonds or zero-interest bonds or zero-coupon bonds. The market interest rate , also called the market yield , is used as the discount rate. Value of a pure discount bond = PV of the amount on maturity:

16. Pure Discount Bonds Example: A company may issue a pure discount bond of Rs 1,000 face value for Rs 520 today for a period of five years. The rate of interest can be calculated as follows:

17. Solution

18. Consider the IDBI bond with a face value of Rs 500,000 with a maturity of 30 years. Suppose the current market yield on similar bonds is 9 per cent. The value of the IDBI pure-discount bond today is as follows: Example

19. Solution

20. Perpetual Bonds Perpetual bonds , also called consols , has an indefinite life and therefore, it has no maturity value . Perpetual bonds or debentures are rarely found in practice.

21. Example Suppose that a 10 per cent Rs 1,000 bond will pay Rs 100 annual interest into perpetuity. What would be its value of the bond if the market yield or interest rate were 15 per cent? The value of the bond is determined as follows :

22. Bond Values and Changes in Interest Rates The value of the bond declines as the market interest rate (discount rate) increases . The value of a 10-year, 12 per cent Rs 1,000 bond for the market interest rates ranging from 0 per cent to 30 per cent .

23. Bond Duration and Interest Rate Sensitivity The longer the maturity of a bond, the higher will be its sensitivity to the interest rate changes . Similarly, the price of a bond with low coupon rate will be more sensitive to the interest rate changes. However, the bond’s price sensitivity can be more accurately estimated by its duration. A bond’s duration is measured as the weighted average of times to each cash flow (interest payment or repayment of principal).

24. Numericals

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