Bond And Equity Valuation

Case on evaluating Annie Proposed Investment in Atilier Industrial Bonds

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What is Bond?

What Are Bonds? A bond is a debt security. Buying a bond means you are lending out your money. •Bonds are also called fixed-income securities because the cash flow from them is fixed. •Stocks are equity; bonds are debt. •The key reason to purchase bonds is to diversify your portfolio. •The issuers of bonds are governments and corporations.

•A bond is characterized by its face value, coupon rate, maturity and issuer. •Yield is the rate of return you get on a bond. •When price goes up, yield goes down, and vice versa. •When interest rates rise, the price of bonds in the market falls, and vice versa. •Bills, notes and bonds are all fixedincome securities classified by maturity.

Why Invest in Bonds? • many people invest in them to preserve and increase their capital or to receive dependable interest income • Investing in bonds can help you achieve your objectives

• -Bonds generally appeal to those who are less adventurous.

• -In a balanced investment portfolio, bonds may provide stability. • -Bond prices generally are less volatile than stock prices, and bond interest payments are generally higher than dividend payout rates.

How Well Do You Know Your Bonds?

Suppose that you buy a newly issued, tenyear, 5% bond for $1,000. You know that you will receive interest and a final payment of $1,000 at the end of ten years when the bond matures. In all, you receive 20 interest payments totaling $500

That’s 5% simple interest, or current yield, disregarding the possibility that you may choose to reinvest your interest in order to keep your money in productive use. This is where the idea of yield-to-maturity (YTM) comes in.

The inverse relationship • A bond’s price and a bond’s yield are inversely related • when a bond’s price falls its yield rises and viceversa. Why? • Let's look at our 5% coupon bond again. If you were to buy it for $1000, the current yield would simply be 5% ($50 / $1,000). But if the price drops to $950, the yield - for anyone who bought the bond for $950 - rises to 5.26% ($50 / $950). Intuitively, this is because the guaranteed coupon - $50 - is now a greater percentage of the price of the bond.

• Conversely, if you buy the bond for $1000 and its price rises to $1050, the yield  - for anyone who buys the bond at $1050 - falls to 4.76% ($50 / $1050). This is because the guaranteed coupon $50 - is now a smaller percentage of the price of the bond

Bond Value: Three Important Relationships Fir st r ela tion ship A decrease in interest rates (required rates of return) will cause the value of a bond to increase; an interest rate increase will cause a decrease in value. The change in value caused by changing interest rates is called interest rate risk. Se con d r elati ons hip 1. If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at par, or maturity value. 2. If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at a "discount.“ 3. If the current interest rate is less than the bond's coupon rate, the bond will sell above par value or at a "premium." T hir d r el atio nshi p A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bonds.

What is Valuation? • Valuation is the process that links risk and return to determine the worth of an asset. • To determine an asset’s worth financial manager uses the time value of money techniques

What is Valuation Fundamentals • The (market) value of any investment asset is simply the present value of expected cash flows • The interest rate that these cash flows are discounted at is called the asset’s

required return.

Basic Valuation Model

Suppose an investor is considering to purchase a five year bond of Rs.1,000/- @8% int. The investors required rate of return is 10%. The investor will receive cash of Rs.80/- as interest each year for 5 years and Rs.1,000/- on maturity. So what is the PV value of bond?

So 80 x 3.791 = 303.28 + 621 = 924.28

Yield to Maturity (YTM) • The yield to maturitymeasures the compound annual return to an investor and considers all bond cash flows. It is essentially the bond’s IRR based on the current price. Note that the yield to maturity will only be equal if the bond is selling for its face value ($1,000). • And that rate will be the same as the bond’s coupon rate. • For premium bonds, the current yield > YTM. • For discount bonds, the current yield < YTM

Current Yield • The Current Yield measures the annual return to an investor based on the current price. Current = Yield

Annual Coupon Interest Current Market Price

For example, a 10% coupon bond which is currently selling at $1,150 would have a current yield of: Current = $100 Yield $1,150

=

8.7%

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