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VALUATION OF BONDS

 Centre for Financial Management , Bangalore

 Real and Nominal Rate of Interest

Real rate of interest changes with inflation, liquidity

preference and risks.

Nominal rate of Interest changes due to

• Sacrificing today’s consumption with future

• Inflation thus higher prices of goods in future. So people
don’t save unless they get a return which would be high
enough to buy goods they desire in future (inflation
premium)
• Risky investment
 Example

Mr. Abhinav has $ 10 and can buy candy for $ 0.25 per piece. Thus He can buy
40 candies if he wishes to consume at present.

He decides to invest $ 10 at a nominal rate of interest of 7% and the expected

inflation rate is 4%.
After 1 year he will get $ 10.70 from the savings
Price of Chocolate after 1 year = $ 0.25+ 0.0 4* $ 0.25= $ 0.26
Thus he can buy ($ 10.70/0.26) = $ 41.2 pieces of chocolates

(41.2-40)= 1.2/ 40 = 3% increase in Abhinav’s buying power

7% nominal return is eroded by inflation of 4%. So real return is 3%.
Nominal Rate of Interest of Security 1 = RF + RP1

Where RF = R* + IP
 VALUE OF A BOND
n
P=Σ C
+
M
(1+r)t (1+r)n
t=1

P = C x PVIFAr,n + M x PVIFr,n

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 TERMINOLOGY
Par Value
Coupon Rate
Maturity Period
Yield to maturity (YTM) is the total return
anticipated on a bond if the bond is held until it
matures
Bond yield
Current yield = Annual Interest/Price
It does not measure the total return
 ILLUSTRATION
To illustrate how to compute the price of a bond, consider a 10-year, 12
percent coupon bond with a par value of 1,000. Let us assume that the
required yield on this bond is 13 percent. The cash flows for this bond
are as follows:
• 10 annual coupon payments of Rs. 120
• Rs. 1000 principal repayment 10 years from now
The value of the bond is:
P = 120 x PVIFA13%, 10 yrs + 1,000 x PVIF 13%, 10 yrs
= 120 x 5.4262 + 1,000 x 0.295
= 651.1 + 295 = Rs. 946.1

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 ILLUSTRATION
The government is proposing to sell a 5- year
Bond of Rs. 1000 at a coupon rate of 8 % per
annum. The Bond amount will be repaid
equally over its life. If an investor has a
minimum required rate of return of 7%, what
is the bond’s present value to him?
VALUE OF A BOND WITH SEMI-ANNUAL
INTEREST

2n
P = Σ C/2
(1+r/2)t
+
M
(1+r/2)2n
t=1

P = C/ 2 x PVIFAr/2,2n + M ( PVIFr2,2n)

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 ILLUSTRATION
As an illustration, consider an 8 year, 12 percent coupon bond with a par
value of Rs. 100 on which interest is payable semi-annually. The
required return on this bond is 14 percent.
Applying Eq.(7.2) the value of the bond is:

16
P=Σ 6
+
100
t=1 (1.07)t (1.07)16

= 6(PVIFA7%,16) + 100 (PVIF7%,16)

= Rs. 6(9.447) + Rs.100 (0.339) = Rs. 90.6

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 ILLUSTRATION
A 10 year bond of Rs. 1000 has an annual rate
of interest of 12 percent. The interest is paid
half yearly. What is the value of Bond if the
required rate of return is 16 percent

Answer: Rs. 803.59

Relationship between Coupon Rate, Required Yield and
Price

Consider a Bond carrying a coupon rate of 14% issued 3 years ago

for Rs. 1000 (par) by Signal Corporation. The original maturity of
the bond was 10 years. The interest rate has fallen over the year and
now the investors expect a return of 10% from the Bond. Calculate
the price of the Bond
 Coupon Rate, Required Yield, & Price

To sum up, the relationship between the coupon rate,

the required yield, and the price is as follows:
Coupon rate > Required yield Price > Par (Premium bond)

Coupon rate = Required yield Price = Par

Coupon rate < Required yield Price < Par (Discount bond)

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PRICE-YIELD RELATIONSHIP

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 BOND YIELDS
A Rs.1000 par value Bond carrying a coupon rate of 9%, maturing
after 8 years. The Bond is currently selling at Rs, 800. What is YTM
on this Bond?
• YIELD TO MATURITY
C C C M
P = + + …. +
(1+r) (1+r)2 (1+r)n (1+r)n
8 90 1,000
800 =  +
t=1 (1+r)t (1+r)8
AT r =
13% … RHS = 808
AT r =
14% … RHS = 768.1
808 - 800
YTM = 13% + (14% - 13%) = 13.2%
808 - 768.1
C + (M - P) / n
YTM ≃
0.4M + 0.6 P
• YIELD TO CALL
n* C M*
P =  +
t=1 (1+r)t (1+r)n
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 VALUATION OF PREFERENCE STOCK
n
P=Σ D
+
M
t=1 (1+rp)t (1+rp)n

Since the stream of dividends is an ordinary annuity, we can apply the

formula for the present value of an ordinary annuity. Hence the value of
the preference stock is:
Po = D x PVIFArp,n + M x PVIFr p,n
To illustrate how to compute the value of a preference stock, consider an
8 year, 10 percent preference stock with a par value of Rs. 1000. The
required return on this preference stock is 9 percent.

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VALUATION OF PREFERENCE STOCK

The value of the preference stock is

P = 100 x PVIFA 9%, 8yrs + 1000 x PVIF 9%, 8 yrs

= 100 x 5.535 x 1000 x 0.502

= Rs. 1110.5

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 DIVIDEND DISCOUNT MODEL
• SINGLE PERIOD VALUATION MODEL
D1 P1
P0 = +
(1+r) (1+r)
• MULTI - PERIOD VALUATION MODEL
 Dt
P0 = 
t=1 (1+r)t
• ZERO GROWTH MODEL
D
P0 =
r
• CONSTANT GROWTH MODEL
D1
P0 =
r-g
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 SUMMING UP
• A basic property of a bond is that its price varies inversely
with yield.
• The relationship between coupon rate, required yield, and
bond price is as follows:
Coupon rate < Required yield Price < Par (Discount bond)
Coupon rate = Required yield Price = Par
Coupon rate > Required yieldPrice > Par (Premium bond)

• The current yield on a bond is defined as: Annual interest /

Price.

 Centre for Financial Management , Bangalore

 SUMMING UP
• The yield to maturity (YTM) on a bond is the rate of return the
investor earns when he buys the bond and holds it till maturity.

It is the value of r in the bond valuation model. For estimating

YTM readily, the following approximation may be used:
C + (M-P)/n
YTM =
0.4M + 0.6P
• According to the dividend discount model, the value of an
equity share is equal to the present value of dividends expect-
ed from its ownership.
• If the dividend per share remains constant rate, the value of the
share is:
PO = D / r

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