PowerPointPrsentation

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Valuing Bonds
Professor Dr. Rainer Stachuletz Corporate
Finance Berlin School of Economics
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Valuation Fundamentals
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The Basic Valuation Model

• P0 Price of asset at time 0 (today)
• CFt Cash flow expected at time t
• r Discount rate (reflecting assets risk)
• n Number of discounting periods (usually years)

This model can express the price of any asset at
t 0 mathematically.
Marginal benefit of owning the asset right to
receive the cash flows
Marginal cost opportunity cost of owning the
asset
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Valuation Fundamentals Example
Company issues a 5 coupon interest rate, 10-year
instrument with a 1,000 par value Assume annual
interest payments

• Investors in companys financial instrument
  receive the contractual rights
• 50 coupon interest paid at the end of each year
• 1,000 principal at the end of the 10th year

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Yield to Maturity (YTM)
Estimate of return investors earn if they buy
the bond at P0 and hold it until maturity
The YTM on a bond selling at par will always
equal the coupon rate.
YTM is the discount rate that equates the PV of
a bonds cash flows with its price.
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Bond Premiums and Discounts

• What happens to bond values if required return is
  not equal to the coupon rate?

The bond's price will differ from its par value
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Semi-Annual Interest Payments
Value a T-Bond Par value 1,000 Maturity
2 years Coupon rate 4 r 4.4 per year
992.43
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Factors that Affect Bond Prices
Time to maturity bond prices converge to par
value (plus final coupon) with passage of time.
Interest rates bond prices and interest rates
move in opposite directions.
Changes in interest rates have larger impact on
long-term bonds than on short-term bonds.
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Interest Rate Risk
What does this tell you about the relationship
between bond prices and yields for bonds with
different maturities?
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Primary vs. Secondary Markets
Primary market the initial sale of bonds by
issuers to large investors or syndicates
Secondary market the market in which investors
trade with each other
Trades in the secondary market do not raise any
capital for issuing firms.
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Bonds by Issuer
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Bonds by Features
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Bonds by Features (Continued)
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Bonds by Features (Continued)
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Bond Markets
The U.S bond market has grown from 250 billion
in 1950 to 22 trillion in 2004
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U.S. Treasury Bond Quotations
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Corporate Bond Quotations
Corporate prices are quoted as percentage of par,
without the 32nds of a dollar quoting convention
Yield spread the difference in
yield-to-maturities between a corporate bond and
a Treasury bond with same maturity
The greater the default risk, the higher the
yield spread
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Bond Ratings
Bond ratings grades assigned to bond issues
based on degree of default risk
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Term Structure of Interest Rates

• Relationship between yield and maturity is called
  the Term Structure of Interest Rates
• Graphical depiction called a Yield Curve
• Usually, yields on long-term securities are
  higher than on short-term securities.
• Generally look at risk-free Treasury debt
  securities
• Yield curves normally upwards-sloping
• Long yields gt short yields
• Can be flat or even inverted during times of
  financial stress

What do you think a Yield Curve would look like
graphically?
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Yield Curves U.S. Treasury Securities
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14
12
10
Interest Rate
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6
4
2
5
10
15
20
30
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3
Years to Maturity
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Bond Valuation

• Bond price equals present value of its coupons
  and principal.
• Bond prices are inversely related to interest
  rates.
• Bonds could have a number of features such as
  convertibility, callability.