Bond Valuation Notes

BOND VALUATION
BONDS are long-term debt securities issued by companies or government entities to raise debt
finance. Investors who invest in bonds receive periodic interest payments, called coupon
payments, and at maturity, they receive the face value of the bond along with the last coupon
payment. Each payment received from the bonds, be it coupon payment or payment at maturity,
is termed as cash flow for investors.
TABLE OF CONTENTS
1 What does “Bond Valuation” Mean?

2 Bond Valuation method
o 2.1 STEP-1 – Estimating Cash Flows
o 2.2 STEP-2 – Determine the appropriate interest rate to discount the cash flows
o 2.3 STEP-3 – Discounting the expected cash flows
3 Present Value Formula for Bond Valuation
4 Example
5 Why Bond Valuation?
LET’S EXPAND AND UNDERSTAND EACH STEP IN DETAIL:
STEP-1 – ESTIMATING CASH FLOWS

Cash flow is the cash that is estimated to be received in future from investment in a bond. There
are only two types of cash flows that can be received from investment in bonds i.e. – coupon
payments and principal payment at maturity.
The usual cash flow cycle of the bond is coupon payments are received at regular intervals as
per the bond agreement, and final coupon plus principle payment is received at the maturity.
There are some instances when bonds don’t follow these regular patterns. Unusual patterns
maybe a result of the different type of bond such as zero-coupon bonds, in which there are no
coupon payments. Considering such factors, it is important for an analyst to estimate accurate
cash flow for the purpose of bond valuation.
STEP-2 – DETERMINE THE APPROPRIATE INTEREST RATE TO DISCOUNT THE CASH
FLOWS
Once the cash flow for the bond is estimated, the next step is to determine the appropriate
interest rate to discount cash flows. The minimum interest rate that an investor should require is
the interest available in the marketplace for default-free cash flow. Default-free cash flows are
cash flows from debt security which are completely safe and has zero chances default. Such
securities are usually issued by the central bank of a country, for example, in the USA it is
bonds by U.S. Treasury Security.
Consider a situation where an investor wants to invest in bonds. If he is considering to invest
corporate bonds, he is expecting to earn higher return from these corporate bond compared to
rate of returns of U.S. Treasury Security bonds. This is because chances are that a corporate
bond might default, whereas the U.S. Security Treasury bond is never going to default. As he is
taking a higher risk by investing in corporate bonds, he expects a higher return.
One may use single interest rate or multiple interest rates for valuation.
STEP-3 – DISCOUNTING THE EXPECTED CASH FLOWS

Now that we already have values of expected future cash flows and interest rate used to
discount the cash flow, it is time to find the present value of cash flows. Present Value of a cash
flow is the amount of money that must be invested today to generate a specific future value. The
present value of a cash flow is more commonly known as discounted value.
The present value of a cash flow depends on two determinants:
 When a cash flow will be received i.e. timing of a cash flow &;
 The required interest rate, more widely known as Discount Rate (rate as per Step-2)
First, we calculate the present value of each expected cash flow. Then we add all the individual
present values and the resultant sum is the value of the bond.
The formula to find the present value of one cash flow is:
PRESENT VALUE FORMULA FOR BOND VALUATION
Present Value n = Expected cash flow in the period n/ (1+i) n
Here,
i = rate of return/discount rate on bond

n = expected time to receive the cash flow
By this formula, we will get the present value of each individual cash flow t years from now. The
next step is to add all individual cash flows.
Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n
Let us understand this by an example:

EXAMPLE
A bond that matures in four years, has a coupon rate of 10% and has a maturity value of US$
100. The bond pays interest annually and has a discount rate of 8%.
Solution:
The cash flow of this bond is:
YEAR CASH FLOW
1 US$ 10
2 US$ 10
3 US$ 10
4 US$ 110
The present value of each cash flow is:
Year 1 – Present Value (PV1) = $10/ (1.08)1 = US$ 9.26

Now adding all cash flows
Thus, Present Value of Bond = 9.25+8.57+7.94+80.85 = US$ 106.62
There are other approaches to bond valuation such as relative price approach, arbitrage-free
pricing approach, and traditional approach. But this present value approach is the most widely
used approach to bond valuation.
WHY BOND VALUATION?

There are many factors such as inflation, credit rating of the bonds, etc. that affect the value of
bonds. Furthermore, there are many features of the bond itself determines its intrinsic value. As
an investor it is important to be fully aware of what we are investing in, what are the risks
involved and how much returns can we expect. Bond valuation tries to take into consideration all
the features to determine an accurate present value. This present value can be very helpful for
investors & analysts to make an informed investment decision

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BOND VALUATION

1 What does “Bond Valuation” Mean?

LET’S EXPAND AND UNDERSTAND EACH STEP IN DETAIL:

STEP-1 – ESTIMATING CASH FLOWS

STEP-3 – DISCOUNTING THE EXPECTED CASH FLOWS

The present value of a cash flow depends on two determinants:

PRESENT VALUE FORMULA FOR BOND VALUATION

Present Value n = Expected cash flow in the period n/ (1+i) n

i = rate of return/discount rate on bond

Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n

Let us understand this by an example:

The cash flow of this bond is:

YEAR CASH FLOW

Year 1 – Present Value (PV1) = $10/ (1.08)1 = US$ 9.26

Now adding all cash flows

Thus, Present Value of Bond = 9.25+8.57+7.94+80.85 = US$ 106.62

WHY BOND VALUATION?

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