Lesson 17

Business Finance –ACC501 VU
LESSON 17
BONDS
· An evidence of debt issued by a corporation or a governmental body.

· When a corporation (or government) wishes to borrow from public on a long term basis, it
does so by issuing or selling debt securities generally called bonds
· A bond represents a loan made by investors to the issuer. In return for his/her money, the
investor receives a legal claim on future cash flows of the borrower.
· The issuer promises to:
o Make regular coupon payments every period until the bond matures, and
o Pay the face/par/maturity value of the bond when it matures.
· Default - since the abovementioned promises are contractual obligations, an issuer who fails to
keep them is subject to legal action on behalf of the lenders (bondholders).
· B Corporation:
o Wants to borrow $1,000 for 30 years at 12 % interest rate
o Will pay 0.12 x $1,000 = $120 in interest every year for 30 years.
o Will repay $1,000 at the end of 30 years
· B Corporation
o $120 regular interest payments are the bond’s coupons
o $1,000 is the par value or face value of the bond
o Annual coupon divided by the par value ($120/$1000 = 12%) is the coupon rate
o 30 years is the maturity time
Bond Values and Yields
· The value of bonds may fluctuate as the interest rates change by time in the market place,
though the cash flows from a bond remain the same.
· When interest rates rise, the present value of the bond’s remaining cash flows decline and the
bond is worth less
· When the interest rates fall, the bond is worth more.
· To determine the value of bond at a particular point in time, we need to know:
o No. of periods remaining till maturity,
o The face value,
o The coupon rate, and
o The market interest rate for similar bonds
· The interest rate required in the market on bonds is called the bond’s Yield to Maturity
· The X Corporation issues a bond with 10 years to maturity having annual coupon of $80.
Similar bonds have a yield to maturity of 8%.
· X bond’s cash flows have two components:
o an annuity component (coupons) and
o a lump sum (face value paid at maturity)
· The X Corporation
· At the going interest rate of 8% the present value of $1,000 paid in 10 years is:
PV = $1,000 / 1.0810 = $1,000 / 2.1589 = $463.19
· Present value of the annuity of 80$ per year for 10 years is:
PV = $80 × (1 – 1/1.0810) / 0.08

PV = $80 × 6.7101
PV = $536.81
The X Corporation
· To get the bonds value we add up both parts

© Copyright Virtual University of Pakistan 70
Business Finance –ACC501 VU
Total Bond Value = $463.19 + $536.81
Total Bond Value = $1,000
· This means that the bond sells for exactly its face value.
Alternatively,
· Interest rate change

· Interest rate risen to 10% after one years (9 years to maturity)
· Now the present value of $1,000 paid in nine years at 10% is
$1,000 / 1.109 = $1,000/2.3579 = $424.10
· And present value of $80 annuity for 9 years at 10% is
$80 × (1 – 1/1.109)/0.10 = $80 × 5.7590 = $460.72
· Adding both parts:
Total bond value is $424.10 + 460.72 = $884.82
· Therefore, the bond should sell for about $885

· Because the bond sells for less than the going rate, investors are willing to lend something less
than $1,000.
· Because the bond sells for less than face value, it is said to be a discount bond.
· The investor who purchased and kept bond would get $80 per year and would have a $115 gain
at maturity as well. This gain compensates the lender for below-market coupon rate.
Another way to see why bond is discounted by $115 is to note that the $80 coupon is $20 below the
coupon on a newly issued par value bond. So the investor who buys and keeps the bond gives up $20
every year for 9 years. At 10 % this annuity is worth:
$20 × (1 – 1/1.109)/0.10 = $20 × 5.7590 = $115.18
Just as rise of interest rates reflected a decline in the price of the bond, a drop of 2% in interest rates
would result in the bond being sold for more than $1000. Such a bond is said to sell at a premium or is
called a premium bond.
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Business Finance –ACC501 VU

· An evidence of debt issued by a corporation or a governmental body.

Bond Values and Yields

PV = $1,000 / 1.0810 = $1,000 / 2.1589 = $463.19

PV = $80 × (1 – 1/1.0810) / 0.08

· To get the bonds value we add up both parts

· Interest rate change

$1,000 / 1.109 = $1,000/2.3579 = $424.10

· And present value of $80 annuity for 9 years at 10% is

$80 × (1 – 1/1.109)/0.10 = $80 × 5.7590 = $460.72

· Adding both parts:

Total bond value is $424.10 + 460.72 = $884.82

· Therefore, the bond should sell for about $885

$20 × (1 – 1/1.109)/0.10 = $20 × 5.7590 = $115.18

© Copyright Virtual University of Pakistan 71

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