What is Cost of Equity? – Meaning, Concept and Formula
February 12, 2025
America is a developed country and an inclusive society. It should ideally no longer face the problems of racism and social inequality and yet it does. It is no accident that a large number of poor and destitute consist of people from African American and Latin American communities. In fact, it is a result of […]
Capital structure ratios are very important to analyze the financial statements of any company for the following reasons: Same Business Can Yield Different Returns Investors understand that the way a business is funded can have a lot of impact on the returns it provides. Although the total return provided will always be the same, the […]
The ICICI bank is the largest private sector bank in India. It was also famous for being one of the organizations where a woman was able to break the glass ceiling and hold the top job. Chanda Kocchar, the bank’s woman Chief Executive Officer had been responsible for its rapid growth. The bank had scaled […]
Bank runs have been part of the banking industry for a long time. This is an unintended consequence of the fractional reserve banking system which is followed by the banking industry across the globe. Bank runs were common during the 1920s when the Great Depression took place. However, with the passage of time, the banking […]
In the previous article, we have already seen how certain football clubs in Europe have been using their money power in order to muscle their way to the top of the league. Hence, in order to prevent this, certain organizations such as EUFA have created certain financial fair play rules. The aim of these rules […]
The present value of a bond is the sum of all the future cash flows that can be derived from it. In this sense, the valuation of bonds really becomes simple, isn’t it? All we need to do is find out the future stream of payments that are due on the bond and then find out their present value and we call find out what the valuation of that bond is. Well, this may be theoretically this simple.
However, in practical life estimating the parameters like discount rate which go into the calculation can be very difficult. Also, using different discount rates can cause us to come up with very different valuations. So, bond valuation really is a game about guessing what the future discount rate will be.
Now, let’s have a look at a theoretical example of bond valuation. Here is a step by step procedure of how the calculation must be done:
The calculation of the present value of the bond is done in two components. They are as follows:
Also, it must be understood that bonds can have 2 values. The face value is the original issue value of the bond whereas the market value is its current market price. So, if the interest payments are not directly given, we need to compute them using the face value. Remember that interest payments are always computed using face value and not market value!
Hence, the annual interest rate needs to be converted into a semi-annual rate or whatever rate is appropriate. Then, it must be plugged into the annuity formula along with the other details to derive the present value of the coupon payments that are due.
The final step is to add the present value of the annuity as well as of the lump sum payment. This adds the present values of the interest payments as well as the principal payments. Hence, we get the present value of the bond.
Example:
Let’s find the present value of a bond whose face value is $100. Interest rate is 12% on an annual basis. The bond will make semi-annual interest payments for 10 years after which the principal has to be repaid and the bond expires.
Number of periods = 20 periods (10 years, however the payment is semi-annual)
Discount Rate = 6% per period (Since we have doubled the number of periods, we need to cut the discount rate into half)
Payment: $6 per period (6% * face value of $100)
Therefore, present value of the annuity equals $68.82. This is the present value of the interest payments due.
The principal that needs to be repaid is $100. It needs to be repaid after 20 periods and the discount rate we are considering is 6% per period. The present value of the principal therefore is $31.18
To find the present value of the bond we need to add $68.82 + $31.18. In this case, this adds up to $100. Therefore the present value of the bond is $100.
It must, however be noted that in real life bond values swing based on the expectation of what the future discount rate will be like. It is not really the current discount rate which determines the bond value!
Your email address will not be published. Required fields are marked *