07 Chapter model
Bonds and Their Valuation
Years to Maturity
Value of bond =
$1,000.00 Thus, this bond sells at its par value.
That situation always exists
if the going rate is equal to the coupon rate.
Refer to the Excel Tutorial for Data Table Instructions.
The value of any financial asset is the present value of the asset's expected future cash flows. The key
inputs are (1) the expected cash flows and (2) the appropriate discount rate, given the bond's risk,
maturity, and other characteristics. The model developed here analyzes bonds in various ways.
Bond valuation requires keen judgment with regard to assessing the riskiness of the bond, i.e., what is
the likelihood that the promised coupon and maturity payments will actually be made at the scheduled
times? Also, investing in bonds requires one to make implicit forecasts of future interest rates--you
don't want to buy long-term bonds just before a sharp increase in interest rates.
We do not deal with
these important but subjective issues in this spreadsheet.
Rather, we concentrate on the actual
calculations used, given the inputs.
A bond has a 15-year maturity, a 10% annual
coupon, and a $1,000 par value.
The required rate of
return (or the yield to maturity) on the bond is 10%, given its risk, maturity, liquidity, and other rates in
the economy. What is a fair value for the bond, i.e., its market price?
Going rate, r
Suppose the going interest rate changed from 10%, falling to 5% or rising to 15%.
How would those
changes affect the value of the bond?
We could go to the input data section above and change the value for r
from 10% to 5% and then 15%,
and observe the change in value.
Alternatively, we can set up a data table to show the bond's value at a
range of rates, i.e. to show the bond's sensitivity to changes in interest rates.