The basic valuation formula for any asset is

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Unformatted text preview: set is equal to the present value of all future cash flows it is expected to provide over the relevant time period. The basic valuation formula for any asset is summarized in Table 6.7. LG4 Apply the basic valuation model to bonds and describe the impact of required return and time to maturity on bond values. The value of a bond is the present value of its interest payments plus the present value of its par value. The basic valuation model for a bond is summarized in Table 6.7. The discount rate used to determine bond value is the required return, which may differ from the bond’s coupon interest rate. A bond can sell at a discount, at par, or at a premium, depending on whether the required return is greater than, equal to, or less than its coupon interest rate. The amount of time to maturity affects bond values. Even if the required return remains constant, the value of a bond will approach its par value as the bond moves closer to maturity. The chance that interest rates will change and thereby change the required return and bond LG5 SELF-TEST PROBLEMS LG5 value is called interest rate risk. The shorter the amount of time until a bond’s maturity, the less responsive is its market value to a given change in the required return. Explain yield to maturity (YTM), its calculation, and the procedure used to value bonds that pay interest semiannually. Yield to maturity (YTM) is the rate of return investors earn if they buy a bond at a specific price and hold it until maturity. YTM can be calculated by trial and error or financial calculator. Bonds that pay interest semiannually are valued by using the same procedure used to value bonds paying annual interest, except that the interest payments are one-half of the annual interest payments, the number of periods is twice the number of years to maturity, and the required return is one-half of the stated annual required return on similar-risk bonds. LG6 (Solutions in Appendix B) LG6 ST 6–1 Bond valuation Lahey Industries has outst...
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