Bond Valuation SFM CA Final

When a company has to raise long term debt, one of the modes of raising the funds is by issuing debentures. For all practical reasons, a debenture and a bond are one and the same.

Bonds or debentures can be called financial Instruments which are contracts that give rise to a financial liability for one party (the one who issues such bonds) and a financial asset for the other party (the one who holds such bonds or debentures). Bond is a fixed income bearing security that provides interest at a definite rate to the investors.

When an investor acquires a bond, he expects interest over the period and the redeemable value to be received at the maturity date or redemption date. In other word, after acquiring a bond, the investor receives a stream of cash flows. The total present value of such stream of cash flow (including the present value of redeemable value) is considered as the value of such bond.

For the purpose of bond valuation the following terms must be clarified:

1. Face Value
2. Coupon Rate
3. Coupon payments
4. Issue Price
5. Market Price
6. Maturity Date
7. Redemption Price
8. Intrinsic Value
9. Callable & Puttable Bonds
10. Call Date & Call Price
11. Current Yield
12. Yield to Maturity (YTM)
13. Yield to Call (YTC) (For Callable Bonds)
14. Zero Coupon Bonds (ZCB)
15. Deep Discount Bonds (DDB)
16. Annuity Bonds
17. Bond STRIPS
18. Par Bonds, Premium Bonds and Discount Bonds
19. Convertible Bonds (OCDs & CCDs)
20. Straight Value of Convertible Bond
21. Stock Value of Convertible Bond
22. Conversion Parity Price
23. Conversion Premium
24. Clean Price & Dirty Price

Issue Price of a bond is at which a new bond is priced by the issuer. Bonds can be issued at Par, Premium or Discount.

Market Price of a bond indicates the price at which the bond can be bought or sold in the open market.

What do you mean by Coupon Rate and Coupon Payments?

Suppose a bond promises to pay interest at the rate of 8% per annum, then such rate is called “Coupon Rate”. The Coupon Rate is always applicable on the face value of the bond irrespective of its issue price or prevailing market price. For example, 9% Government of India Bonds provide half yearly interest on 30^th June and 31^st December. The face value of the bond is ` 1,000. The interest paid on each bond will be ` 1,000 x 9% x 6/12 = ` 45 on each of the interest payment dates. The interest payment of ` 45 during each of the months June and December are known as “Coupon Payments”.

Coupon Rate is the rate of interest attached to the bond and it applies on the face value, for example, a 9% bond with face value of ` 1,000 will have interest payments of ` 1,000 x 9% = ` 90 every year. It should be noted that the interest on bonds can be payable quarterly, half yearly or annually in general.

What is the Intrinsic Value of the Bond?

Intrinsic value of the bond is the aggregate present value of all coupon payments and the redemption amount, determined by using a discounting rate which is expected rate of return by the investor.

Maturity Date of a bond is the date at which a bond is redeemable or is due for redemption. A bond is generally redeemed at par or premium.

Bond Valuation: Basic Principle

As discussed earlier, the present value of the stream of cash flows including the present value of the redemption price is considered as the value of the bond and more specifically the intrinsic value of the bond or the fair market value of the bond (For this purpose the market price of the bond is always called as Actual Market Price and not Fair Market Price).

In order to arrive at the present value of the stream of cash flows, a discounting rate has to be used. This discounting rate is known as the desired yield rate or required yield rate. In other words the discounting rate is the required rate of return by the investor.

As generally known, increasing the discounting rate results into reduction in present value, and the decrease in discounting rate increases the present value. It can be concluded that the discounting rate or the desired yield rate and bond value are inversely related.

Face Value; Intrinsic Value & Market Value:

(Classification of the bond as Par, Premium or Discount bond)

At the time of issue:

• If the bond is issued at its face value it is par bond
• If issued above its face value it is premium bond
• If issued below its face value it is discount bond

Once the bond is floated:

Then comparison is made among the three values:

• Face Value
• Intrinsic Value and
• Market Value.

If intrinsic value of a bond equals to its face value it is a par bond.

If intrinsic value is more than the face value it is a premium bond.

If intrinsic value is less than the face value it is a discount bond.

It should be noted that the market price of bond will generally be near to its intrinsic value. Therefore, intrinsic value can be considered to be a major force driving the market price of the bond. However, the difference between the intrinsic value and market price is also obvious.

• If market price of a bond is equal to its intrinsic value then such bond is considered to be fairly priced in the market.
• If the market price of bond is more than its intrinsic value, then such bond is considered to be overpriced.
• If the market price of a bond is less than its intrinsic value, then such bond is considered to be underpriced.

Actions to be taken by Investor

1. If the Actual Market Price of bond is less than the Fair Market Value or the Intrinsic Value → Buy such Bonds.
2. If the Actual Market Price of bond is more than the Fair Market Value or the Intrinsic Value → Sell such Bonds.
3. If the Actual Market Price of bond is equal to the Intrinsic Value → Take No Action.