Topic 2 :

BASICS OF VALUATION AND

BOND VALUATION
Learning Objectives
 To distinguish between different kinds of bonds.
 To explain the more popular features of bonds.
 To overview the Malaysian bond market.
 To define the term value as used for several different
purposes.
 To explain the factors that determine value.
 To describe the basic process for valuing assets.
 To estimate the value of a bond.
 To compute a bondholder’s expected rate of return.
 To explain five important relationships that exist in bond
valuation
Dr. Rasidah Mohd Rashid
 Definition of Bond
Bond is a type of debt (long-term
promissory note) issued by the borrower,
promising to pay
1. fixed coupon (i.e. interest) at fixed
intervals (i.e. 6 months, 1 year etc) and

2. the par value (or face value) of the bond

at maturity.
Dr. Rasidah Mohd Rashid
Terminology & Characteristic of Bonds..
1. Par Value (M) : the bond’s face value that is returned to the
bondholder at maturity, usually $1000 .
2. Coupon Interest Rate ( I ) : percentage of the par value of the
bond will be paid out annually
3. Maturity ( n ) : The length of time until the bond issuer returns
the par value to the bondholder and terminates the bond

Example :
Par Value : RM1000, Interest 5% (annually), Maturity 4 years
RM1000
RM50 RM50 RM50 RM50

0 1 2 3 4
Terminology & Characteristic of Bonds..

4. Claims on Asset and Income : bonds have a claim on Assets

and Income that comes ahead of common stock and
preferred stock
5. Current Yield : the ratio of the annual interest payment to
the bond’s market price

Current Yield : annual interest payment

market price of the bond
Terminology & Characteristic of Bonds..
6. Indenture : the legal agreement (bond contract) between
the firm issuing the bonds and the bond trustee who
represents the bondholders

Lists all of the bond’s features:

- coupon, par value, maturity, etc.

Lists restrictive provisions which are designed to

protect bondholders.

Describes repayment provisions.

 Terminology & Characteristic of Bonds..
7. Bond Ratings : the ratings involve a judgment about the future risk
potential of the bond.
In other words, bond rating is used to determine the riskiness of the
bond. It indicates the default risk of the bond. Default risk is the
probability that the firm will not be able to make the bond’s
promised payments.
Various rating agencies (such as Standard & Poor’s, Moody’s etc.)
prepare the rating of the bonds available in the bond market.
Rating agencies consider the following issues of a firm in determining
the rating of its bond:
- Financial statements indicating financial strength
- Financing mix/ capital structure
- Profitability/ profitable operations
- variability in past earnings/income
- Firm size
- Quality of the firm’s management
 Example: Bond Ratings and Interpretations

Bond Rating Standard & Moody’s Interpretations

Category Poor’s

Prime or AAA Aaa Highest quality; extremely strong

highest strong capacity to pay
High quality AA Aa Very strong capacity to pay
Upper medium A A-1, A Upper medium quality; strong capacity
to pay
Medium BBB Baa-1, Lower medium quality; changing
Baa circumstances could impact the firm’s
ability to pay

Speculative BB Ba Speculative elements; faces uncertainties

Highly B, CCC, CC B, Caa, Extremely speculative and highly
speculative Ca vulnerable to non-payment
8
Default D C Income bond; doesn’t pay interest
 Types of Bonds

 Debentures
 Subordinated Debentures
 Mortgage Bonds
 Eurobonds
 Zero and Very Low Coupon Bonds
 Junk Bonds (High-Yield Bonds)
 Debentures
 Any unsecured long-term debt
 Viewed as more risky than secured bonds and
provide a higher yield than secured bonds

Subordinated Debenture
Unsecured “junior” debt
The claims of subordinated debentures are
honored only after the claims of secured
debt and unsubordinated debentures have
been satisfied.
 Mortgage Bond
A bond secured by a lien on real property
 Typically,the value of the real property is
greater than that of the bonds issued.
Eurobonds
Securities(bonds) issued in a country different from
the one in whose currency the bond is denominated
example – Bond issued in Asia by an American
company that pays interest and principal to the
lender in US dollars.
Reasons of issuing Eurobond:
◦ The borrowing rates are lower
◦ To avoid SEC regulations.
Zero and Very Low Coupon Bonds
• This type of bond pays no or very low
coupon rate (interest).
• Return comes from appreciation of the
bond.
• In other words, the bond holder’s return
is determined entirely by the price
discount.
Issued at a substantial discount from the
$1,000 face value of the bond.
12
Zero and Very Low Coupon Bonds

Disadvantage:
• Issuer faces large cash outflow in excess of the
cash inflow when the bond was issued

Advantages:
• Cash outflows don’t occur with zero coupon
bonds and are relatively low level with low
coupon bonds
• Strong investor demand tends to bid up prices
and yields are bid down.
Junk Bonds (High-Yield Bonds)

 High
risk debt with ratings of BB or below by
Moody’s and Standard & Poor’s

 High
yield — typically pay 3%-5% more than
AAA grade long-term bonds
 Malaysian bond market
 Development of the bond market centers
on the need to establish a well-diversified
financial base to meet the changing needs
of the Malaysian economy.
 Main issuers of bond comes from
Government (from public market) and
Corporate (from private market)
 Malaysia offers a wide variety of Islamic
bonds that are based on Shariah compliant
concept.
15
 Sukuk
 Sukuk are bonds have been created to meet a
demand for assets that comply with Shariah, or
Islamic law.
 Shariah does not permit the charging or paying of
interest.
 Sukuk are typically bought and held to maturity,
and are extremely illiquid.

 Bond Rating agencies in Malaysia:

1. RAM (Rating Agency Malaysia) Holdings and
2. MARC (Malaysia Rating Corporation) Berhad
 Valuation concepts
 Book value: value of an asset as shown on a
firm’s balance sheet
 Liquidation value: the dollar sum that could be
realized if an asset were sold individually and not
as part of a going concern.
 Market value: the observed value for the asset in
the market place
 Intrinsic or economic value: also called fair
value. In general, the intrinsic value of an asset is
the present value of the stream of expected cash
flows discounted at an appropriate interest rate.
 Bond Valuation
 Bond Value = PV of coupons + PV of par
or
 Bond Value = PV of annuity + PV of lump sum

Remarks
 As interest rates increase, present values decrease
 So,as interest rates increase, bond prices
decrease and vice versa

7-18
What is the single biggest factor
that influences the price of bonds?

 Interest Rates
Interest rates go , bond prices go 
Interest rates go , bond prices go 
 The Bond Pricing Equation

 1 
1 -
 (1  i) n  M
Bond Value (Vb)  I  
 (1  i)
n
 i
 

7-20
Valuing a Discount Bond with Annual Coupons
 Example: Consider a bond with a coupon rate of 10% and
annual coupons. The par value is $1,000, and the bond
has 5 years to maturity. The yield to maturity is 11%.
What is the price of the bond?

 Solution:
 1 
1 - (1  i) n  M
Bond Value (Vb)  I  
 (1  i)
n
 i
 

 Vb = 100[{1 – 1/(1.11)5}/ 0.11] + 1,000 / (1.11) 5

 Vb = 369.59 + 593.45 = 963.04
Valuing a Premium Bond with Annual
Coupons
 Example: Suppose you are reviewing a bond that has a
10% annual coupon and a face value of $1000. There are
20 years to maturity, and the yield to maturity is 8%.
What is the price of this bond?

 Solution:
 1 
1 -
 (1  i) n  M
Bond Value (Vb)  I  
 i  (1  i) n

 
Vb = 100[{1 – 1/(1.08)20}/ 0.08]+ 1000 / (1.08)20
Vb = 981.81 + 214.55 = 1196.36
 Examples- Bond Valuation
Suppose ABC firm decides to issue 20-year bonds with a par
value of $1,000 and annual coupon payments. The firm also
decides to offer a 12% coupon interest rate. The required
return on bonds of similar risk is 12%. What would be a fair
price for the bond?

Solution:
 1 
1 - (1  i) n  M
Bond Value (Vb)  I  
 (1  i)
n
 i
 
 Vb = 120[{1 – 1/(1.12)20}/ 0.12] + 1,000 / (1.12) 20
 Vb = $1000
Dr. Rasidah Mohd Rashid
Suppose interest rate has fallen immediately after the firm
issues the bonds. The required return on bonds of similar risk
dropped to 10%. What would happen to the bond’s intrinsic
value?
Solution:  1 
1 - (1  i) n  M
Bond Value (Vb)  I  
 (1  i)
n
 i
 

 Vb = 120[{1 – 1/(1.10)20}/ 0.10] + 1,000 / (1.10) 20

 Vb = $1170.27

Note: If the coupon rate > investor’s required rate, the bond
will sell for a premium or above face value.
Suppose interest rate has risen immediately after the firm
issues the bonds. The required return on bonds of similar risk
raised to 14%. What would happen to the bond’s intrinsic
value?
Solution:
 1 
1 - (1  i) n  M
Bond Value (Vb)  I  
 (1  i)
n
 i
 
 B = 120[{1 – 1/(1.14) 20}/ 0.14] + 1,000 / (1.14) 20
B = $ 867.54

Note: If the coupon rate < investor’s required rate, the bond
will sell at a discount or below face value.
Exercise : Bonds Valuation (Vb)
1) You own a bond that pay $100 in annual
interest, with a $1000 par value. It matures
in 15 years. Your required rate of return is
12%. Calculate the value of the bond

2) Hwa bonds have 10 years remaining to

maturity. Interest is paid annuall, the bonds
have a RM1000 par value, and the coupon
interest rate is 8%. The bonds have a yield to
maturity of 9%. What is the current market
price of these bonds?
Exercise : Bonds Valuation (Vb)
3) Golden Firm has issued 5-year and RM1000
par bonds that pay 9% interest semi-annually.
Your required rate of return is 10%. The
current market price for the bond is RM1,250.
a. What is the value of the bond to you given
your required rate of return?
b. Should you purchase the bond at the
current market price?
Exercise : Bonds Valuation (Vb)
4) Sime Darby issues 14 year and RM1,000 bonds
that pay RM75 interest annually. The market price
of the bond is RM980. Your required rate of return
is 9%.
a.What is the value of the bond to you?
b.What happens to the value if your required rate
of return (i) increases to 12% or (ii) decreases to
7%?
c.Under which of the circumstances in part (b)
should you purchase the bond?
Semi-annual Coupon Payment
Formula for semi-annual interest payment :

 1 
1 - (1  i/2) 2n  M
Bond Value (Vb)  I/2  
 i/2  (1  i/2) 2n

 
 Example
Suppose ABC firm decides to issue 20-year bonds with a par
value of $1,000 and semi-annual coupon payments. The firm
also decides to offer a 12% coupon interest rate. The required
return on bonds of similar risk is 14%. What would be a fair
price for the bond?
Solution:
 1 
1 - (1  i/2) 2n  M
Bond Value (Vb)  I/2  
 i/2  (1  i/2) 2n

 
 Vb = 120/2[{1 – 1/(1.07) 40}/ 0.07] + 1,000 / (1.07) 40
 Vb = $866.68
 Current Yield
 The ratio of the interest payment to the bond’s current market price.

 Current Yield = Annual interest payment

Current market price of the bond

Example: Suppose a $1,000 bond with 8% coupon rate is currently

selling at $700. Calculate the current yield of the bond.

 Current Yield = Annual interest payment

Current market price of the bond

Current yield = $80 / $700 = 11.4 %

Dr. Rasidah Mohd Rashid
 Yield To Maturity (YTM)

• Also known as the expected rate of return (k) on a

bond.
• The discount rate that equates the PV of future
cash flow with the current market price of the
bond.
• The rate of return investors earn on a bond if they
hold it to maturity.
 Calculation of YTM
(Approximate method)

P-M
YTM =
I +
n
P+M
2
I = Amount of Coupon Interest
P = Par Value of the bond
M = Market Price of the bond
n = Number of years to maturity
Example :
A bond’s market price is $1100. It has a $1000
par value, will mature in 5 years and pays
interest 10% annually. What is your expected
rate of return (YTM)?

YTM= 100 + (1000 -1100) / 5

= 7.62%
(1000 + 1100) / 2
 Example
• Suppose you paid $898.90 for a $1,000 par 10%
coupon bond with 8 years to maturity and semi-
annual coupon payments. What is your yield to
maturity (YTM)?

YTM= 50 + (1000 - 898.90) / 16

= 6.00%
(1000 + 898.90) / 2
So,
YTM = 6% X 2 = 12%
 Exercise : YTM

1. You just purchased a bond which matures in 5 years. The

bond has a face value of RM1,000 and has an 8% annual
coupon. The bond has a current yield of 8.21%. What is
the bond’s yield to maturity?
 Exercise : YTM
2. BCD's $1,000 par value bonds are currently sell for
$798.50. The coupon rate is 10%, paid semi-annually. If
the bonds have five years before maturity, what is the
yield to maturity or expected rate of return?

Solution:
YTM= 50 + (1000 -798.50) / 10
= 7.80%
(1000 + 798.50) / 2
So,
YTM = 7.80% X 2 = 15.60%
 Exercise : YTM

3) If you are willing to pay $1,392.05 for a 15-year, $1,000

par value bond that pays 10% interest semi-annually,
what is your expected rate of return or YTM?

4) Lambda Co. has bonds outstanding that mature in 10

years. The bonds have $1,000 par value, pay interest
annually at a rate of 9%, and have a current selling
price of $1,125. Calculate the yield to maturity (YTM)
on the bonds.
 Zero Coupon Bonds
• No coupon interest payments.
• The bond holder’s return is determined entirely by
the price discount.
Example: Suppose you pay $508 for a zero-coupon
bond that has a face value of $1000 and 10 years
left to maturity. What is your yield to maturity
(YTM)?
Solution:

YTM= 0 + (1000 - 508) / 10

= 6.53%
(1000 + 508) / 2
Bond Prices: Relationship Between Coupon
and Yield
 If YTM = coupon rate, then par value = market price of
bond
 If YTM > coupon rate, then par value > market price of
bond
 Why? The discount provides yield above coupon rate
 Ifthe market price of a bond is below par value, it is
called a discount bond.
 If YTM < coupon rate, then par value < market price of
bond
 Why? Higher coupon rate causes value above par
 Ifthe market price of a bond is above par value, it is
called a premium bond.
FIVE IMPORTANT RELATIONSHIPS IN BOND VALUATION
First Relationship
The value of the bond is inversely/negatively related to
changes in the investor’s required rate of return, kb :
 If kb decreases, the value of the bond will increase
 If kb increases, the value of the bond will decrease

Second Relationship
The relationship between market price (M) and par value (P)
of a bond depends on the investor’s required rate of return
(kb) and the coupon rate (I).
 If kb = I, then M=P
 If kb > I, then P > M (discount bond)
 If kb < I, then P < M (premium bond)
Third Relationship
As the maturity approaches, the market value of the
bond approaches its par value.

Fourth Relationship
Long-term bonds have greater interest rate risk than
do short–term bonds.

Fifth Relationship
The sensitivity to changes of a bond’s value depends
on:
 Length of time to maturity
 The pattern of the cash flows provided by the bond
Thank You For Your Attention !!!