1. King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA 2010-2011 Dr Abdeldjelil Ferhat BOUDAH 1

2. King Faisal University [ ] CHAPTER 7 BOND VALUATION 2 Dr Abdeldjelil Ferhat BOUDAH

3. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Introduction I- Valuation Fundamentals I-1 Key inputs for valuation I-2 The basic valuation models II- Bond Fundamentals II-1 Basic Bond valuation Conclusion 3 Dr Abdeldjelil Ferhat BOUDAH

4. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Introduction As was noted in Chapter 6, all major financial decisions must be viewed in terms of expected risk, expected return. 4 Dr Abdeldjelil Ferhat BOUDAH

5. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Valuation is the process that links risk and return to determine the worth of an asset at a given point in time. To do this the financial manager uses the time value of money techniques presented in Chapter 5 and the concepts of risk and return developed in Chapter 6. 5 Dr Abdeldjelil Ferhat BOUDAH

6. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION I- Valuation Fundamentals I-1 Key Inputs for Valuation The key inputs to the valuation process include cash flows (returns), timing, and the required return (risk). Each is described briefly in what follows: 6 Dr Abdeldjelil Ferhat BOUDAH

7. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION A- Cash flows (returns): The value of any asset depends on the cash flow that is expected to provide over the ownership period. 7 Dr Abdeldjelil Ferhat BOUDAH

8. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Example: Celia Sargent, Financial analyst for Groton Corporation, a diversified holding company, wishes to estimate the value of three of its assets- common stock in Michaels Enterprises, an interest in Oil well, and Original painting. 8 Dr Abdeldjelil Ferhat BOUDAH

9. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Example: - Stock in Michaels Enterprises: Expect to receive cash dividends of $300 per year indefinitely. - Oil well: Expect to receive cash flow of $2,000 at the end of 1 year, $4,000 at the end of 2 years, and $10000 at the end of 4 years when the company is to be sold. 9 Dr Abdeldjelil Ferhat BOUDAH

10. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Example: - Original painting: Expect to sell the painting in 5 years for $85,000. Having developed these cash flow estimates, the financial analyst has taken the first step toward placing a value on each of these assets. 10 Dr Abdeldjelil Ferhat BOUDAH

11. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION B-Timing: It is customary to specify the timing along with the amounts of cash flow. For example the cash flows $2,000, $4,000, and $10,000 for the Oil Well in the previous example were expected to occur at the end of years 1, 2, and 4 respectively. 11 Dr Abdeldjelil Ferhat BOUDAH

12. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION C- Required return: Risk describes the chance that an expected outcome will not be realized. The level of risk associated with a given cash flow can significantly affect its value. In general the greater the risk of a cash flow, the lower its value. In terms of present value a greater risk can be incorporated into an analysis by using a higher required return or discount rate. 12 Dr Abdeldjelil Ferhat BOUDAH

13. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Example: Let us return to our previous example concerning Gorton Corporation’s original painting, which is expected to provide a single cash flow of $85,000 from its sale at the end of 5 years, and consider two scenarios : 13 Dr Abdeldjelil Ferhat BOUDAH

14. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Example: Scenario 1- Certainty If the painting will be sold definitely at the end of 5 year with $85,000 worth, the financial analyst would consider that operation as if money is deposited in a bank with an interest rate risk free of 9% when calculating the value of painting. 14 Dr Abdeldjelil Ferhat BOUDAH

15. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Example: Scenario 2- High risk If the value of the original painting is fluctuating widely over the past 10 years, between 30,000 and 14,000. Due to the high uncertainty surrounding the painting value. The financial analyst would believe that the painting value require 15% required return (discount rate) is appropriate. 15 Dr Abdeldjelil Ferhat BOUDAH

16. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION I-2 The Basic Valuation Model Simply stated, the value of any asset is the present value of all future cash flows it is expected to provide over the relevant time period. The value of an asset is therefore determined by discounting the expected cash flows back to their present value. 16 Dr Abdeldjelil Ferhat BOUDAH

17. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Back to Chapter 5 it has been explained the equation that shows us the way how cash flows that can be calculated in terms of present value. See table 7.1 17 Dr Abdeldjelil Ferhat BOUDAH

18. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION 18 Dr Abdeldjelil Ferhat BOUDAH

19. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION II- Bond Fundamentals II-1 Basic Bond Valuation Bonds are long-tern debt instruments used by business and government to raise large sums of money, typically from a diverse group of lenders. As noted in Chapter2 most corporate bond pay interest. Bond price quotations regularly appear in published news media. 19 Dr Abdeldjelil Ferhat BOUDAH

20. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION The value of a bond is the present value of the contractual payments its issuer is obligated to make from the current time until it matures. The appropriate discount rate would be the required rate of return, k d,which depends on prevailing interest rates and risk. The basic equation for the value, B 0, of a bond is given by the following equation: 20 Dr Abdeldjelil Ferhat BOUDAH

21. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION 21 Dr Abdeldjelil Ferhat BOUDAH

22. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Where, B 0 = Value of the bond at time zero I = annual interest paid in dollars n = number of years to maturity M = par value in dollars k d = required return on a bond 22 Dr Abdeldjelil Ferhat BOUDAH

23. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION EXAMPLE Suppose that Mills Company has the following data: -Date of a new issue : January 1, 1998. - Interest is paid annually. - The required rate of return is equal to the bond’s coupon interest rate - I = $100, k d = 10 %, M= $1,000, n = 10 years. 23 Dr Abdeldjelil Ferhat BOUDAH

24. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION SOLUTION Table use : Substituting the values noted above into the following equation: Then, And, See figure: Time-line use 24 Dr Abdeldjelil Ferhat BOUDAH

25. King Faisal University [ ] CHAPTER 7: BOND VALUATION CHAPTER 7: BOND VALUATION Conclusion It is so crucial to mention that bond valuation is based as a matter of fact on techniques that have been discussed in the preceding Chapters. For instance, Chapter 5 is so fundamental especially when it comes to apply concepts of the present value. 25 Dr Abdeldjelil Ferhat BOUDAH

26. King Faisal University [ ] 26 بحمد الله