Valuation

7-1

McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline

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7-2

Bond Definition

Bond Features

Valuation of a Bond

Bond Relationships

Inflation and Interest Rates

Determinants of Bond Yields

Bond Ratings

Bond Markets

Chapter Outline

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7-3

Bond Definition

Bond Features

Valuation of a Bond

Bond Relationships

Inflation and Interest Rates

Determinants of Bond Yields

Bond Ratings

Bond Markets

What is a bond? 7-4

7-5

A bond is a contract between two parties: one is the investor

(you) and the other is a company or a

Chapter Outline

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7-6

Bond Definition

Bond Features

Valuation of a Bond

Bond Relationships

Inflation and Interest Rates

Determinants of Bond Yields

Bond Ratings

Bond Markets

You are the investor

7-7

The company (or government A bond contains three key items:

1. The par value

(usually $1,000)

2. The length of time

(often 10 or 20 years) 7-8

3. A coupon interest rate You lend money to the borrower and you will get back your original investment plus interest. 7-9

The interest is determined by the coupon interest rate.

For example:

A 6% coupon interest rate yields:

(the coupon interest rate) x ( the par value)

(6%) x ($1,000) = $60 per year for each year of the bond.

7-10

Let’s look at this visually using the time line:

1

2

3

4

5

$60 $60 $60 $60 $60

7-11

Let’s look at this visually using the time line:

Now let’s add the maturity value…

1

2

3

4

5

$60 $60 $60 $60 $60

$1,000

7-12

So the investor receives the principle ($1,000) and earned interest ($60 per year) as payment for loaning the company money.

7-13

Types of Bonds

1. Government Bonds

2. Zero Coupon Bonds

3. Floating-Rate

Bonds

4. Catastrophe (Cat)

Bonds

5. Income Bonds

6. Convertible Bond

7. Put Bond

8. Sukuk

9. James Bond

7-14

Chapter Outline

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7-15

Bond Definition

Bond Features

Valuation of a Bond

Bond Relationships

Inflation and Interest Rates

Determinants of Bond Yields

Bond Ratings

Bond Markets

Our task:

To Value a

Bond

7-16

And how will we accomplish this task?

7-17

7-18

B

A

E

F

E

I

P

V

T

Bring

All

Expected

Future

Earnings

Into

Present

Value

Terms

Just remember:

BAEFEIPVT

7-19

From the previous chapters on the time value of money you know how to bring back a single payment

(lump sum) and an annuity. To value a bond, just put both pieces together!

7-20

Let’s look at this visually using the time line:

1.The annuity

2.The single

0

1

2

3(lump

4

5 payment sum)

$60 $60 $60 $60 $60

$1,000

7-21

Now bring each back into present value terms:

First the annuity…

Secondly, the lump sum…

0

1

2

3

4

5

$60 $60 $60 $60 $60

$1,000

7-22

1

1

t

F

V

(

r )

B

ondV alue C

t

(

1 r )

The Bond Pricing

Equation

Notice that r = the discount rate used to bring back the future dollars.

This discount rate has a name in bonds:

The Yield to Maturity (YTM).

7-23

Your finance calculator can compute both parts (the annuity and the lump sum) simultaneously 7-24

A bond valuation example: 7-25

• 5 year bond

• 14% as the discount rate (YTM)

• 6% coupon interest rate • $1,000 maturity

TI BA II Plus

5 years = N

-725.35

14% = Discount rate (YTM)

$60 = Payment (PMT)

$1,000 = FV

1st

2nd

7-26

PV = ?

A bond valuation example: 7-27

• 5 year bond

• 14% as the discount rate (YTM)

• 6% coupon interest rate • $1,000 maturity

Using Excel to value a bond

• There is a specific formula for finding bond prices on a spreadsheet – PRICE(Settlement,Maturity,Rate,Yld,Redemption

, Frequency,Basis)

– YIELD(Settlement,Maturity,Rate,Pr,Redemption,

Frequency,Basis)

– Settlement and maturity need to be actual dates – The redemption and Pr need to be input as % of par value

• Click on the Excel icon for an example: 7-28

Student alert!

7-29

Notice that we have two

“interest numbers” in our bond problem:

1. The coupon interest rate (6% in our example) and

2. The