1) Bonds are instruments issued by governments and corporations to borrow money from the public. They have attributes like face value, coupon rate, maturity, and yield.
2) There are different types of bonds like zero coupon bonds, which have no interest payments and sell at a discount, and regular bonds, which make fixed interest payments.
3) The price of a bond is determined by discounting its future cash flows using the required rate of return. Higher required rates lower the price.
1) Bonds are instruments issued by governments and corporations to borrow money from the public. They have attributes like face value, coupon rate, maturity, and yield.
2) There are different types of bonds like zero coupon bonds, which have no interest payments and sell at a discount, and regular bonds, which make fixed interest payments.
3) The price of a bond is determined by discounting its future cash flows using the required rate of return. Higher required rates lower the price.
1) Bonds are instruments issued by governments and corporations to borrow money from the public. They have attributes like face value, coupon rate, maturity, and yield.
2) There are different types of bonds like zero coupon bonds, which have no interest payments and sell at a discount, and regular bonds, which make fixed interest payments.
3) The price of a bond is determined by discounting its future cash flows using the required rate of return. Higher required rates lower the price.
1) Bonds are instruments issued by governments and corporations to borrow money from the public. They have attributes like face value, coupon rate, maturity, and yield.
2) There are different types of bonds like zero coupon bonds, which have no interest payments and sell at a discount, and regular bonds, which make fixed interest payments.
3) The price of a bond is determined by discounting its future cash flows using the required rate of return. Higher required rates lower the price.
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Time value of Money
• PV = FV/(1+r)n
• PVA = AMT [(1-(1+r)-n)/r]
• FV = PV(1+r)n
• FVA = AMT [((1+r)n - 1)/r]
What are Bonds • Bonds are instruments issued by Governments and Corporations to borrow money from the public. • Short term Govt. bonds are usually called Treasury Bills. • Long term Government Bonds in Pakistan are called PIBs or Pakistan Investment Bonds and long term corporate bonds are called Term Finance Certificates or TFCs. Attributes of a Bond • Face Value of a bond. • Coupon Rate. • Frequency of Coupon Payments • Maturity. • Price. Classification of Bonds based on nature of Coupon Payments • Zero Coupon • Regular or Plain Vanilla Bond Zero Coupon Bond • No interest payments. • Sells at discount price. • Face Value is paid on Maturity. Face Value Price = M/(1+r)n
r = Required Rate of Time period (n) Return
Price M = Face Value
n = Years till maturity
Example • What is the fair price of a 5 year zero coupon bond with face value of Rs. 1,000 if annual required rate of return is 6%?
Price = M/(1+r)n = 1000/ (1+0.06)5 = Rs. 747.26 Example • What is the fair price of a 4 year Zero Coupon bond with face value of Rs. 1,000 if required rate of return is 6%?
Price = M/(1+r)n = 1000/(1+0.06)4 = Rs. 792.4
• Note: All other things being constant; a longer term
bond is considered riskier than a shorter term bond. A shorter term bond also has a shorter payback period. Treasury Bills (Not Covered) • No interest payments. • Sells at discount price. • Face Value is paid on Maturity. • Risk Free. • Issued for less than a year. Price = M [1-(r x n/360)] Face Value r = Required Rate of Return
M = Face Value Days till maturity (n) n = Days till maturity Price Example • What is the fair price of a 180 day treasury with face value of Rs. 1,000 if annual required rate of return is 6%? Regular or Plain Vanilla Bond • Interest payments at fixed intervals. • Sells at discount or premium (depends on required rate of return and coupon rate). • Face Value is paid on Maturity with last coupon/interest payment. Face Value + Coupon
Coupon Payments
1 2 3 4 5 6 7 8 Time periods Price Price of Regular Bond • Price = C [(1-(1+r)-n)/r] + M/(1+r)n Where C = Coupon Amount r = Periodic required rate of return n = Total number of compounding periods remaining till maturity M = Face Value
• Note: The factor [(1-(1+r)-n)/r] stands for present value
of Annuity Example • What is the fair price of a 5 year bond with face value of Rs. 1,000 and annual coupon rate of 6% (compounded semiannually) if annual required rate of return is 7%? Coupon Payment = 1000 x (0.06/2) = Rs. 30 Price = C [(1-(1+r)-n)/r] + M/(1+r)n = 30 x [(1-(1+0.035)- 10)/0.035] + 1000/(1+0.035)10 = 30 x 8.317 + 1000/ 1.411 = 249.51 + 708.72 = Rs. 958.23 (Discount Price) Example • What is the fair price of a 5 year bond with face value of Rs. 1,000 and annual coupon rate of 6% (compounded semiannually) if annual required rate of return is 5%? Coupon Payment = 1000 x (0.06/2) = Rs. 30 Price = C [(1-(1+r)-n)/r] + M/(1+r)n = 30 x [(1-(1+0.025)- 10)/0.025] + 1000/(1+0.025)10 = 262.56 + 781.20 = Rs. 1043.76 (Premium Price) Price of Bond and RRR • Price of the Bond is inversely proportional to Required Rate of Return or Market Interest Rate. • If RRR < Coupon Rate; Bond’s price will be higher than its face value i.e., sells at a premium. • If RRR > Coupon Rate; Bond’s price will be lower than its face value i.e., sells at a discount. Yield to Maturity (YTM) • Yield to Maturity is the rate of return that the investor earns if bond is held till maturity. • All other things being equal; YTM depends on the price paid for the bond. • If all other factors are held constant; as price paid for the bond increases, YTM decreases and vice versa.
• Note: YTM is not Coupon rate of the bond
• YTM is also called IRR or Internal Rate of Return of the bond. YTM of a Zero Coupon Bond • Price = M/(1+r)n
Price x (1+r)n = M
(1+r)n = M/Price
1+r = (M/Price)1/n
r = (M/Price)1/n - 1 Example • A 5 year zero coupon bond with face value of Rs. 1,000 is being sold for Rs. 800. What is its YTM? r = (M/Price)1/n – 1
r = (1000/800)1/5 – 1
= 1.0456 - 1
= 0.0456 = 4.56% YTM of a Regular Bond • Can be calculated manually using trial and error • Usually Calculated using MS Excel or a Financial Calculator YTM using Excel • What is the YTM of a 5 year bond with face value of Rs. 1,000 and annual coupon rate of 6% (compounded semiannually) if it is being sold for Rs. 950?
• Note: Excel will give you periodic IRR. You have to annualize it by multiplying it with number of compounding periods in a year. Callable Bonds • Has the option of being redeemed by the issuer before maturity date. Called the call date. • Usually pays a higher coupon rate than a regular bond with same attributes. • Issuer pays a premium on face value if called before the maturity date. Callable Bond Valuation • Price = C [(1-(1+r)-n)/r] + M/(1+r)n Where C = Coupon Amount i = Periodic required rate of return n = Total number of compounding periods remaining till Call date M = Call Value Example • What is the fair price of a 5 year callable bond with face value of Rs. 1,000 and annual coupon rate of 6% (compounded semiannually) if annual required rate of return is 7%? Bond has the option to be called back 4 years from now at Rs. 1,100.
• C? • M? • n? • r?
Note: Whenever confused in such problems, make a bond payment
structure. Bank Loans and Mortgages (NOT COVERED) • Funds for House as collateral. • Housing Finance. • Builder schemes in Pakistan may also be called mortgages under certain circumstances. Mortgage Payments Attributes (NOT COVERED) • Down payment. • Interest rate (can be floating rate). • Each Payment consists of interest and Principal. Amortization schedule (NOT COVERED) Stock Common Stock Preferred Stock Voting Rights for electing directors No Voting rights No fixed dividend rate Fixed dividend rate Not mandatory to distribute dividends Even if dividends are not distributed, they are recorded as liability Common Stock Valuation • Constant Growth Model (perpetuity) • Non Constant Growth Model (perpetuity) • Non perpetual model Common Stock Valuation (Contd.) Non Perpetual P0 = D1/(1+r)1 + D2/(1+r)2 +---- Dn/(1+r)n + PE/(1+r)n
lower than current market price. Common Stock Valuation (Contd.) • Stock value is the present value of expected future cash dividends. • P0 = Price of stock today • D0 = Most recent dividend • D1, D2, D3, Dn = Expected dividend at end of Year 1, Year 2, Year 3 and so on. • PE = Expected stock price at the time of sale. • r = Required rate of return Constant Growth Model If g = Dividend growth rate & Expected dividend is Dt = D0(1+g)
Constant Growth Model (Perpetuity)
P0 = D0(1+g)/(r-g) Example • A common stock has declared dividend of Rs. 3 per share. Dividends are expected to grow at a constant rate of 5%. What will be the fair price of this stock if required rate of return is 8%? P0 = D0(1+g)/(r-g) = 3(1+0.05) / (0.08-0.05) = Rs. 105 Non constant Growth model Growth rates
5% 6% 4% Called point of Horizon.
6% After this point, growth rate stabilizes
1 2 3
P0 D0 = Rs. 3 r = 10% Non constant Growth model (Contd.) • Calculate D1, D2, D3 and then bring them back to P0 from their respective time periods
D1 = D0(1+g)
D2 = D1(1+g)
D3 = D2(1+g)
• Calculate P3 which is point of horizon here. Use constant growth
model.
P3 = D3(1+g)/(r-g) Non constant Growth model (Contd.) • Bring back P3 using PV for single payment. Also bring back D1, D2, D3 using present value equations for single payment and add them up. P0 = D1 /(1+r)1 + D2 /(1+r)2 + D3 /(1+r)3 + P3/(1+r)3 Non perpetual model • P0 = D1/(1+r)1 + D2/(1+r)2+ ---PE/(1+r)n Non perpetual model Growth rates
5% 6% 4% 6% 100 8%
1 2 3 4 7
P0 D0 = Rs. 3 r = 10% Free Cash Flow Value of operations • V0 = FCF1/(1+WACC)1 + FCF2/(1+WACC)2+ ---FCFn/(1+WACC)n
Where
V0 = Value of operations.
FCF1, FCF2, FCF3---FCFn = Free Cash flow for year 1, 2, 3 and so on until n.
WACC = Weighted Average Cost of Capital for the company issuing stock.
Constantly growing FCF (Perpetual/Infinity Model)
VH = FCFH(1+g)/(WACC-g)
Again Point N after which Cash flows stabilize and grow at a constant rate is called point of Horizon. Example • A company’s Free Cash Flow for current year is Rs. 1,000,000. FCF for the coming first and second years are expected to be Rs. 2,000,000, Rs. 3,000,000 respectively. After second year FCF is expected to continue growing at constant rate of 5%. If your required rate of return is 8% and company’s WACC is 10%, what is the value of operations of the company? Solution FCF1 = 2,000,000 FCF2 = 3,000,000
