BOND VALUATION
A. Definition of Bond Valuation
Bond valuation means the process of determining the fair price of a bond. Bond valuation process:
Important terms in bond valuation:
- Bond, is the debt instrument indicated when a company (or government) borrows money from the public or banks (bondholders) and agrees to pay it back later.
- Par Value, The amount of money that the company borrows.
- Coupon Payments, This is like interest. The company makes regular payments to the bondholders, like every 6 months or every year.
- Indenture, The legal stuff. A written agreement between the company and the bond holder. They talk about how much the coupon payments will be, and when the money (par value) will be paid back to the bondholder.
- Maturity Date, date when the company pays the par value back to the bondholder.
Formula :
Bo = (I x PVIFAi,n) + (M x PVIFi,n)
Semiannual coupon payment :
Bo = (I/2 x PVIFAi/2,nx2) + (M x PVIFi/2,nx2)
Where:
Bo : Value of the bond at the time zero
I : Annual interest paid in dollars
n : number of years maturity
M : par value in dollars
rd : required return on bond
Yield to maturity (YTM)
The rate of return that investors earn if they buy the bond at a specific price and hold it until maturity date.
Where:
I : Annual interest paid in dollar
n : number of years maturity
M : par value in dollars
V : market value
Current Yield
The cash return of the bond for the year, calculated by dividing the bond’s annual interest payment by its current price.
CY = I/V
Where:
I : Annual interest paid in dollars
V : Market value
Criteria:
Discount | sell price < par value | M -Bo |
Required return > coupon interest rate | ||
Premium | sell price > par value | Bo -M |
Required return < coupon interest rate | ||
Par Value | sell price = par value Required return = coupon interest rate | Bo = M |
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