Understanding Finance 3FNCE001C

2024/2025, Semester 2

Lecture 7. Bonds Valuation

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 Lecture 7. Bonds Valuation

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Learning Outcomes

Learning outcomes
• Identify the major sources of external long-term
financing for corporations
• Compare characteristics of corporate bonds with
respect to bondholder security, time to maturity, and
income return
• Explain how bonds are valued

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 Long-Term External Financing
• Internal funds (profits)

• External funds (capital markets)

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 Long-Term External Financing
• The proportion of internal to external
financing varies over the business cycle:
• Economic expansion – external funds
• Economic contraction – internal funds

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 Long-Term External Financing
• External funds
• Stocks (~10%)
• Bonds (~90%)
• Borrowing is cheaper
• Have maturity

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 Bonds
• Agreement or contract between investor
(lender) and a debtor (borrower), typically a
business firm or government body
• Senior claim on assets and cash flow

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 Bonds
• No voting rights
• Par value (face value)
• Principal amount that the issuer is obligated to repay at maturity
• Bond rating
• Improves the issue’s marketability to investors
• Covenants
• Impose restrictions or extra duties on the firm

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 Bonds
• Interest
• Tax deductible to the issuing firm
• Usually fixed over the issue’s life
• Maturity
• Usually fixed
• Security
• Can have senior claim on specific assets pledged in case of default or can be
unsecured

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 Bonds
• Principal / Par Value / Face Value / Maturity
Value
• The amount of money on which interest is paid
• The face value of a bond, which the borrower repays at maturity
• Coupon
• A fixed amount of interest that a bond promises to pay investors

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 Bonds
• Coupon Rate
• The rate derived by dividing the bond’s annual coupon
payment by its par value
• Maturity Date
• The date when a bond’s life ends and the borrower must
make the final interest payment and repay the principal

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 Bonds
• Zero-coupon bond
• no coupon payments
• payment of the bond’s principal at maturity
• Perpetual bonds (perps or consol bonds)
• no maturity date
• a steady stream of interest in forever

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 Valuation of Bonds
All securities are valued on the basis of the cash
inflows that they are expected to provide to their
owners or investors
Price = CF1/(1 + r)1 + CF2/(1 + r)2 + CF3/(1 + r)3 + . . . +
CFn/(1 + r)n

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 Valuation of Bonds
Price = PV (coupons) + PV (maturity value)

Price = C1/(1 + r)1 + C2/(1 + r)2 + C3/(1 + r)3 + . . . +

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 Valuation of Bonds
• Coupon payments
• Same amount
• Limited number of periods
• Annuity
• Principal repayment
• One payment in the future
• Simple Present Value

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 Valuation of Bonds
• P (Bond) = C{[1 – (1 / (1 + r)m)] / r} + MVm/(1 + r)m

• P (Zero-coupon) = MVm/(1 + r)m

• P (Perpetual) = C/r

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 Coupon Rate vs Required Rate
• Cr = r
• P = MV
• Bond sells at Par
• Cr = 10%, r = 10%, MV = $1000, n = 5 years
• C = 0.1*1000 = 100
• P = 100/0.1(1 - 1/(1+0.1)^5) + 1000/(1+0.1)^5
• P = 1000(1-0.62) + 1000/1.61
• P = 380 + 620 = 1000 = 1000

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 Coupon Rate vs Required Rate
• Cr > r
• P > MV
• Bond sells at Premium
• Cr = 10%, r = 5%, MV = $1000, n = 5 years
• C = 0.1*1000 = 100
• P = 100/0.05(1 - 1/(1+0.05)^5) + 1000/(1+0.05)^5
• P = 2000(1-0.78) + 1000/1.47
• P = 440 + 784 = 1224 > 1000

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 Coupon Rate vs Required Rate
• Cr < r
• P < MV
• Bond sells at Discount
• Cr = 10%, r = 15%, MV = $1000, n = 5 years
• C = 0.1*1000 = 100
• P = 100/0.15(1 - 1/(1+0.15)^5) + 1000/(1+0.15)^5
• P = 667(1-0.5) + 1000/2.01
• P = 333.5 + 497.2 = 830.7 < 1000

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Today you have learnt

• The major sources of external long-term financing

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 ESSENTIAL READINGS
Melicher R.W. (2016), Introduction to Finance: Markets, Investments, and
Financial Management, 16th Edition, Chapter 10 (10.1, 10.2, 10.7)

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 THANK YOU

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