Bond Valuation | Introduction to Corporate Finance | CPA Exam BAR | Chp 7 p 1

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Understanding bonds, interest rates, and bond valuation is essential for investors and involves factors like coupon rates, face value, market rates, and bond maturity. The relationship between these elements influences bond prices, which fluctuate based on market interest rates and impact an investor's decision-making process.

Insights

  • Understanding bonds involves recognizing they are borrowed funds issued by entities to raise money, with interest paid to creditors until the principal is repaid, showcasing the importance of bond features, market rates, and cash flows in determining accurate bond values.
  • Bond valuation intricately involves calculating the present value of cash flows, including annuity payments and face value, with market rates directly impacting bond prices; fluctuations in interest rates affect bond values inversely, with longer maturities and lower coupon rates increasing interest rate risk.

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Recent questions

  • What are bonds and interest rates?

    Bonds are debt securities issued by corporations or governments to raise money, involving interest payments to creditors until the principal is repaid. Interest rates affect bond values.

  • How do you calculate bond values?

    Bond values are determined by calculating the present value of cash flows, considering factors like remaining periods until maturity, face value, coupon rate, and market rate.

  • What is the relationship between bond features and market rates?

    Understanding the relationship between bond features, market rates, and cash flows is crucial for accurately determining bond values, as changes in interest rates directly impact bond prices.

  • Why do bond prices and interest rates move inversely?

    Bond prices and interest rates move inversely; as interest rates rise, bond values decline, and vice versa. This relationship is crucial in understanding bond valuation and market dynamics.

  • Why do companies issue long-term bonds?

    Companies issue long-term bonds to lock in low interest rates, with examples like Walt Disney's 100-year bond and Republic National Bank's 1,000-year bond. This strategy helps manage financing costs and secure funding for extended periods.

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Summary

00:00

Bond Valuation and Interest Rate Relationships

  • Chapter 7 covers bonds and interest rates, emphasizing the importance of understanding bonds for calculations.
  • Bonds are a form of borrowing where corporations or governments issue debt securities to raise money from the public.
  • Bonds involve the borrower paying interest to the creditors until the principal amount is repaid at the end of the loan term.
  • Corporate bonds have various features and terminology, including the face value, coupon rate, and time to maturity.
  • The coupon rate is the fixed interest payment made by the borrower to the bondholder annually.
  • Bond values fluctuate based on changes in interest rates in the market, with a direct relationship between interest rates and bond values.
  • Calculating the present value of cash flows from a bond involves knowing the remaining periods until maturity, face value, coupon rate, and market rate.
  • The yield to maturity (YTM) represents the market interest rate on a bond, influencing its current value.
  • An example with Zenith Corporation issuing a bond with a 10-year maturity, $80 annual coupon, and an 8% yield to maturity illustrates bond valuation.
  • Understanding the relationship between bond features, market rates, and cash flows is crucial for determining bond values accurately.

17:09

Bond Valuation with Annuity and Face Value

  • The bond pays $80 to the holder, calculated as 1,000 multiplied by an 8% coupon rate.
  • At year 10, the bond pays $1,000, known as the face value.
  • The Zenith bond comprises an annuity component of $80 paid at regular intervals and a single $1,000 payment.
  • To determine the bond's market value, calculate the present value of the annuity and the $1,000 separately, then combine the results.
  • Use the market rate, assumed to be 8%, for discounting to find the present value of the $1,000 payment.
  • The present value of the $1,000 payment is $463.19.
  • The annuity's present value is $536.81, calculated using the annuity table.
  • Combining the present value of the annuity and the $1,000 payment results in a bond price of $1,000.
  • If the market rate increases to 10%, the bond's value decreases to $888.42 due to the higher interest rate.
  • The bond is considered a discount bond when it sells for less than its face value, reflecting the increased market rate.

33:04

Bond Pricing Dynamics and Interest Rate Risk

  • When interest rates drop by 2%, the value of a bond with an 8% fixed coupon and a market rate of 6% will increase.
  • The bond will sell at a premium due to the higher coupon rate compared to the market rate.
  • Calculating the bond price involves finding the present value of the face value and the present value of the annuity.
  • The bond price will be $1,136.03, $20 higher than the market rate, reflecting the premium investors are willing to pay.
  • The general expression for bond value includes the face value and coupon payment present values.
  • Corporate bonds in the US typically make semi-annual coupon payments, with the total annual payment divided into two.
  • Adjusting for semi-annual payments and market rates is crucial in determining bond prices accurately.
  • The effective yield on a bond with an 8% semi-annual payment is 16.64%.
  • Bond prices and interest rates move inversely; as interest rates rise, bond values decline, and vice versa.
  • Interest rate risk in bonds depends on time to maturity and coupon rate, with longer maturities and lower coupon rates increasing risk.

48:39

Bond Price Sensitivity to Interest Rates

  • Plot prices under different interest rate scenarios for a 10% coupon bond with maturities of one year and 30 years, noting the steeper slope for the 30-year bond.
  • The longer the bond's maturity, the higher the risk and the lower the price, while higher coupon rates offer more protection.
  • At a 5% interest rate, a one-year bond is valued at $1,470, a 10-year bond at $1,000, a 15-year bond at $956, and a 20-year bond at $920.
  • Bonds with lower coupon rates have greater interest rate risk due to their dependence on face value, leading to more significant value fluctuations with interest rate changes.
  • Companies issue long-term bonds to lock in low interest rates, with examples like Walt Disney's 100-year bond and Republic National Bank's 1,000-year bond.
  • To find the yield to maturity, use formulas to determine the market rate, with methods like trial and error or financial calculators.
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