ch 7 (Bond Valuation)

ch 7 (Bond Valuation) - Valuation Problems Valuation...

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Chapter 7 Interest Rates and Bond Valuation Slide 7- 1 ± Valuation There are different types of investment, including bonds, stocks, and projects. All valuation problems are the same: Establishing the value today of future cash flows is the central problem of corporate finance. We’ll talk about bonds valuation first, which is the easiest. Valuation Problems Slide 7- 2 ± Definition A bond is a debt security that obligates the issuer (i.e., the seller) to make specified payments to the bondholder (e.g., the buyer). Bonds typically have the following characteristics: Par value (or face value): The principal amount of a bond that is repaid at the end of the term. Coupon : The bondholder receives an interest payment each period until the bond matures, which are coupon payments. The annual coupon payment is determined as a percentage of face value. This percentage is the coupon rate . Maturity : The specified date on which the principal amount of a bond is paid. Price : The amount the bondholder pay today to acquire the bond. Bond Characteristics Slide 7- 3 ± Typical Bond Cash flows Coupon payments (C) + Par value at maturity (Par): ± Pricing a Bond: Two steps Determine the cash flows (size and timing) Calculate the aggregate present value of the cash flows. Bond Value = PV of coupons + PV of par (annuity) (lump sum) 01 2 3 CC t C + Par Bond Valuation

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Slide 7- 4 ± Using the Annuity Formula The price of a bond is the present value of all its cash flows discounted at the required rate of return. (Unless specified otherwise, we take \$1000 as the default face value.) where r is the required interest rate. Bond Valuation () t t t r Par r r C r Par C ... r C r C PV + + + = + + + + + + + = 1 1 1 1 1 1 1 2 Slide 7- 5 ± Example Suppose investors demand an interest rate of 5 percent on a 10-year 6 percent bond. How much should investors pay to acquire the bond (or, what’s the price of the bond)? The cash flows: Par value = \$1,000 Annual coupon = 6%(1,000) = \$60 The value: 22 . 077 , 1 \$ 05 . 1 000 , 1 05 . 1 1 1 05 . 60 PV 10 10 = + = Bond Valuation Slide 7- 6 ± The Value-Interest Rate Relation The interest rate required in the market on a bond is called the bond’s yield to maturity (YTM). A bond’s YTM at any point of time is the interest a bondholder would earn by buying and holding the bond till it matures . Relation between bond price and Interest rate: Interest rates increase Æ PV (and price) of bond decreases Interest rates decrease Æ PV (and price) of bond increases Bond Valuation and Interest Rate t t t r Par r r C r Par C ... r C r C PV + + + = + + + + + + + = 1 1 1 1 1 1 1 2 Slide 7- 7 ± Relation between Coupon Rate and Yield The coupon rate and the discount rate are different. The coupon rate tells us what cash flows the bond produces, while the discount rate reflects the opportunity cost of capital. There are three cases: YTM = Coupon rate In this case, par value = bond price. The bond sells for the face value, which is called a par-value bond.
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ch 7 (Bond Valuation) - Valuation Problems Valuation...

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