6. Bond valuation Aa Aa E The process of bond valuation is based on the fundamental concept that the current price of a security can be determined by calculating the present value of the cash flows that the security will generate in the future. There is a consistent and predictable relationship between a bond's coupon rate, its par value, a bondholder's required return, and the bond's resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bond's intrinsic value and its par value. These result from the relationship between a bond's coupon rate and a bondholder's required rate of return. pay, and a bondholder's required return Remember, a bond's coupon rate partially determines the interest-based return that a bond reflects the return that a bondholder to receive from a given investment. The mathematics of bond valuation imply a predictable relationship between the bond's coupon rate, the bondholder's required return, the bond's par value, and its intrinsic value. These relationships can be summarized as follows: When the bond's coupon rate is equal to the bondholder's required return, the bond's intrinsic value will equal its par value, and the bond will trade at par. its par When the bond's coupon rate is greater to the bondholder's required return, the bond's intrinsic value will value, and the bond will trade at a premium. When the bond's coupon rate is less than the bondholder's required return, the bond's intrinsic value will be less than its par value, and the bond will trade at For example, assume Grace wants to earn a return of 7.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 12.25% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value: Intrinsic Value = (a fcg + 1603 + 1fcja + dfca + dtcgs + difcs + ates Complete the following table by identifying the appropriate corresponding variables used in the equation. Unknown Variable Name Variable Value $1,000 Semiannual required return to expect that Grace's potential bond investment is currently exhibiting an intrinsic value Based on this equation and the data, it is greater than $1,000. Now, consider the situation in which Grace wants to earn a return of 10.25%, but the bond being considered for purchase offers a coupon rate of 12.25%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of (rounded to the nearest whole dollar) is its par value, so that the bond is Given your computation and conclusions, which of the following statements is true? A bond should trade at a par when the coupon rate is greater than Grace's required return. O When the coupon rate is greater than Grace's required return, the bond should trade at a discount. When the coupon rate is greater than Grace's required return, the bond should trade at a premium. When the coupon rate is greater than Grace's required return, the bond's intrinsic value will be less than its par value. 7. More on the characteristics of bonds Aa Aa E Based on the descriptions given in the following table, identify the type of bond that best matches each description: Type of Bond Description Bonds that are offered at a discounted price at the time of issue Bonds that pay coupons in the form of additional bonds Suppose you invested in company A's bonds, and the company used a large amount of that debt to acquire another firm. (Such a deal is called a leveraged buyout.) This deal led to significant losses for bondholders and had a negative impact on the firm's credit risk. , the yield to maturity will In such a situation, the company's bond rating is likely to and the value of its outstanding bonds will 8. Bond ratings Aa Aa E Rating agencies such as Standard & Poor's, Moody's Investor Services, and Fitch Ratings-assign credit ratings to bonds based on both quantitative and qualitative factors. The factors used and their importance to the rating given to an individual bond issue are unique to each rating agency. The bond ratings indicate the issue's, and sometimes the issuer's, credit risk, including the risk of default. The issue's default risk rating affects its interest (coupon) rate, which in turn affects the issuer's cost of debt capital. On the basis of these ratings, bonds are classified along a continuum from the higher-rated investment-grade bonds down to the lower-rated junk bonds. Which of the following bonds is more likely to be classified as a junk bond? A bond with a B rating, an 11% yield, and a debt ratio of 60% A bond with a BBB rating, an 8% yield, and a debt ratio of 42% O Consider the bond described in the prior question. You've heard that the rating agencies have downgraded the bond's rating. The yield on the bond is likely to 9. Valuing semiannual coupon bonds Aa Aa E Bonds often pay a coupon twice a year. For the valuation of bonds that make semiannual payments, the number of periods doubles, whereas the amount of cash flow decreases by half. Using the values of cash flows and number of periods, the valuation model is adjusted accordingly. Assume that a $1,000,000 par value, semiannual coupon U.S. Treasury note with two years to maturity (YTM) has a coupon rate of 6%. The yield to maturity of the bond is 9.90%. Using this information and ignoring the other costs involved, calculate the value of the Treasury note: $1,116,928.30 $791,157.54 $930,773.58 $586,387.36 Based on your calculations and understanding of semiannual coupon bonds, complete the following statements: Assuming that interest rates remain constant, the T-note's price is expected to The T-note described is selling at a When valuing a semiannual coupon bond, the time period variable (N) used to calculate the price of a bond reflects the number of periods remaining in the bond's life