Reading 65: Introduction to the Valuation of Debt Securities- 2011, statements, valuation, question, finance

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Session 16: Fixed Income: Analysis and Valuation
Reading 65: Introduction to the Valuation of Debt Securities

LOS a: Explain the steps in the bond valuation process.

 

 

Answering an essay question on a midterm examination, a finance student writes these two statements:

Statement 1: The value of a fixed income security is the sum of the present values of all its expected future coupon payments.

Statement 2: The steps in the bond valuation process are to estimate the bond’s cash flows, determine the appropriate discount rate, and calculate the present value of the expected cash flows.

With respect to the student's statements:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Statement 1 is incorrect. The value of a fixed income security is the sum of the present values of its expected future coupon payments and its future principal repayment. Statement 2 is correct. The three steps in the bond valuation process are to estimate the cash flows over the life of the security; determine the appropriate discount rate based on the risk of the cash flows; and calculate the present value of the cash flows using the appropriate discount rate.

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A bond is issued with the following data:

• $10 million face value.
• 9% coupon rate.
• 8% market rate.
• 3-year bond with semiannual payments.

What is the present value of the bond?

A) $10,138,754.

B) $10,000,000.

C) $10,262,107.

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FV = 10,000,000; PMT = 450,000; I/Y = 4; N = 6; CPT → PV = -10,262,107

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A corporate bond with the following data is issued:

• $1,000 par value.
• 8% coupon payments.
• 5 years to maturity with semiannual coupon payments.
• Market interest rates are 10%.

What is the total interest expense?

A) 923.

B) 545.

C) 477.

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Total interest expense is the difference between the amount paid by the issuer and the amount received from the bondholder.

Present value of the bond is computed as follows: FV = 1,000; PMT = [(1,000)(0.08)] / 2 = 40; I/Y = 5; N = 10; CPT → PV = -923

[($40 coupon payments)(10 periods) + $1,000 par value] – $923 present value of the bond = 477

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Assume a city issues a $5 million bond to build a new arena. The bond pays 8% semiannual interest and will mature in 10 years. Current interest rates are 9%. What is the present value of this bond and what will the bond's value be in seven years from today?

Present Value

Value in 7 Years from Today

A) 4,674,802 4,931,276

B) 4,674,802 4,871,053

C) 5,339,758 4,871,053

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Present Value:
Since the current interest rate is above the coupon rate the bond will be issued at a discount. FV = $5,000,000; N = 20; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT → PV = -$4,674,802

Value in 7 Years:
Since the current interest rate is above the coupon rate the bond will be issued at a discount. FV = $5,000,000; N = 6; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT → PV = -$4,871,053

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By purchasing a noncallable, nonputable, U.S. Government 30-year bond, an investor is entitled to:

A) full recovery of face value at maturity or when the bond is retired.

B) annuity of coupon payments plus recovery of principal at maturity.

C) annuity of coupon payments.

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Bond investors are entitled to two distinct types of cash flows: (1) the periodic receipt of coupon income over the life of the bond, and (2) the recovery of principal (or face value) at the end of the bond’s life.

1215

It is easier to value bonds than to value equities because:

A) Both of these choices are correct.

B) the future cash flows of bonds are more stable.

C) there is no maturity value for common stock.

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Bonds pay out a specified periodic cash flow (coupon payment) throughout the life of the bond and pay out a lump sum at the maturity date.  Common stocks don't have a maturity date and have more volatility than bonds.