EMBA 807
Corporate Finance
Dr. Rodney Boehme
Page 1
CHAPTER 5:
HOW TO VALUE BONDS AND STOCKS
(Assigned problems are 1, 4, 5, 7, 8, 9, 13, 16, 17, 18, 21, 22, 23, 25, 26, 29, 31, and 33.
Omit
the Appendix to this chapter).
This notes package contains two Addendums.
I.
BOND VALUATION
Bonds are “Fixed Income” securities, since the cash flows that the bondholder will
receive have been fixed or prespecified in the bond contract.
The current
fundamental
or
intrinsic
value of a bond (or any other financial asset)
is equal to the Present Value
or PV
0
of all future
expected
cash flows.
1
An investor’s actual return on a bond, for any holding period, comes in two forms:
(1) the coupon yield (from the payment of coupon interest)
(2) the capital gain (bond’s change in price)
Zero Coupon Bonds:
a
zero coupon
bond will pay its stated face or par value
at maturity.
It pays no other future cash flows during its life.
Zeroes are also
known as
pure discount
bonds.
The return here comes entirely as a
capital gain
.
Example:
A zero coupon bond will mature exactly 2 years from today.
It was
sold or issued by the U.S. Treasury and therefore is free of default risk.
The par or
face value is $100.
This bond currently sells for $84.17 in the market.
What
annual rate of return does the market expect on this bond?
From Chapter 4, we know:
PV
0
= FV
n
/[1 + r]
n
.
Here, PV
0
=$84.17, FV
2
=$100, and
n=2 years.
We need to solve for
r
.
A time line of this bond is shown below:
PV
0
= FV
n
/[1 + r]
n
→
r = [FV
n
/PV
0
]
1/n
– 1 = [100/84.17]
0.5
– 1 = 0.09 or
9.0%
Actually, anytime we calculate the annual yield
r
by using the current bond price
and future payments, the
r
is referred to as the Yield-to-Maturity or YTM.
What will happen to this bond’s price tomorrow if the current market rate of
interest or YTM on this and similar two-year bonds
falls
from 9.0% to 8.8%?
1
Intrinsic
value refers to a
private
estimate of value – a private estimate of Present Value.
This is not the same
concept as
market
value, which refers to the current price at which a bond or stock is trading for.
t=0
t=1
t=2
PV
0
= 84.17
FV
2
= 100