Valuation of Bonds
Financial Management
B 642
Outline
 Meaning of a Bond
 Types of Bonds
 Features/characteristics of a Bond
 How to Value a Bond
– Annual Coupon Paying Bonds
– Semiannual Coupon Paying Bonds
 Bond Yields
– Nominal Yield
– Current Yield
– Yield to Maturity (Required Rate of Return)
Meaning of a Bond
 Bond represents an agreement between a borrower
(issuer) and lender (buyer) whereby
– the borrower agrees to make regular interest payments and
– to repay the principal at maturity of the loan
 It is a debt instrument requiring the issuer also called the
debtor or borrower
– To pay interest over some specified period of time
– to repay to the lender/investor the amount borrowed and
 It is the legal obligation of the firm to meet the above two
requirements
Features of a Bond
Face Value
Maturity
Coupon
Callable/Non-callable
Secured/Unsecured Bonds
Registered/Bearer Bonds
Provisions for paying off bonds
Types of Bonds
Zero Coupon Bonds
Floating Rate Bonds
Callable Bonds
Convertibles
Eurobonds
Valuation of Bonds
 Process of determining the fair market value of a
financial asset on the basis of present value of
expected/anticipated cash flows
 Three step process:
– Estimate the expected cash flows
– Determine the appropriate interest rate or interest rates
to discount the cash flows
– Compute the present value of the expected cash flows
in step 1 by discounted them with interest rate (s) in
step 2
Value of a Bond Today
 Depends on the present value of expected cash flows
from the bond
 Need to estimate
– Expected cash flows
– The appropriate required yield/discount rate
 What are the expected cash flows for a plain-vanilla
bond?
– Coupon Payment at regular intervals during the life of the bond
– Repayment of principal at maturity of the bond
 Par Bonds
 Discount Bonds
 Premium Bonds
Bond Yields
Nominal Yield
• Coupon of a bond is the nominal yield of a bond
Current Yield
• Annual coupon amount divided by the current
market price of the bond
Yield to Maturity
– Rate of return promised to an investor if you
purchased the bond at the current market price
given coupon and maturity of the bond