The value of a bond- or any asset, real or financial is equal to the present value of the cash flows expected from it. Hence determining the value of a bond requires
- An estimate of expected cash flows
- An estimate of the required return
The following assumptions are made to simplify the analysis of bond valuation
- The coupon interest rate is fixed for the term of the bond
- The coupon payments are made every year and the next coupon payment is
- Receivable exactly a year from now.
- The bond will be redeemed at par on maturity
First, we need to find the present value (PV) of the bond’s future cash flows. The present value is the amount that would have to be invested today to generate that future cash flow. PV is dependent on the timing of the cash flow and the interest rate used to calculate the present value. To figure out the value, the PV of each individual cash flow must be found. Then, just add the figures together to determine the bond’s price.
PV at time T = expected cash flows in period T / (1 + I) to the T power
After calculating the expected cash flows, add the individual cash flows:
Value = present value @ T1 + present value @ T2 + present value @Tn
Illustration:
Consider a 10 year, 12 % coupon bond with a face value of Rs.1000. The required yield on this bond is 13%. The cash flows for this bond are:
10 annual coupon payments of Rs.120
Rs.1000 principal repayment 10 years from now
Therefore the value of the bond is
P = 120 x PVIFA13%,10yr + 1000 x PVIF 13%,10yr.3
= 120 x 5.426 +1000 x 0.295
= 651.1 + 295 = Rs.946.1
