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Valuation of Bonds

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

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Valuation of Bonds

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  1. Valuation of Bonds Financial Management B 642

  2. 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)

  3. 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

  4. Features of a Bond • Face Value • Maturity • Coupon • Callable/Non-callable • Secured/Unsecured Bonds • Registered/Bearer Bonds • Provisions for paying off bonds

  5. Types of Bonds • Zero Coupon Bonds • Floating Rate Bonds • Callable Bonds • Convertibles • Eurobonds

  6. 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

  7. 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

  8. 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

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