4. Bond valuation

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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 bonds coupon rate, its par value, a bondholders required return, and the bonds resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bonds intrinsic value and its par value. This also results from the relationship between a bonds coupon rate and a bondholders required rate of return.

Remember, a bonds coupon rate partially determines the interest-based return that a bond selector 1

• might
• will

pay, and a bondholders required return reflects the return that a bondholder selector 2

• is obligated
• would like

to receive from a given investment.

Points:

Close Explanation

Explanation:

The mathematics of bond valuation imply a predictable relationship between the bonds coupon rate, the bondholders required return, the bonds par value, and its intrinsic value. These relationships can be summarized as follows:

	When the bonds coupon rate is equal to the bondholders required return, the bonds intrinsic value will equal its par value, and the bond will trade at par.
	When the bonds coupon rate is greater than the bondholders required return, the bonds intrinsic value will selector 1 equal be less than exceed its par value, and the bond will trade at a premium.
	When the bonds coupon rate is less than the bondholders required return, the bonds intrinsic value will be less than its par value, and the bond will trade at selector 2 par a discount a premium .

Points:

For example, assume Jackson wants to earn a return of 9.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 15.75% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bonds intrinsic value:

Intrinsic ValueIntrinsic Value

= =

A(1+C)1+A(1+C)2+A(1+C)3+A(1+C)4+A(1+C)5+A(1+C)6+B(1+C)6A1+C1+A1+C2+A1+C3+A1+C4+A1+C5+A1+C6+B1+C6

Complete the following table by identifying the appropriate corresponding variables used in the equation.

Unknown	Variable Name	Variable Value
A	selector 1 Bondholders required return Bonds semiannual coupon payment Bonds annual coupon payment	selector 2 $118.13 $157.50 $39.38 $78.75
B	selector 3 Bonds par value Bonds annual coupon payment Bonds market price	$1,000
C	Semiannual required return	selector 4 4.5000% 7.1250% 9.2500% 15.7500%

Points:

Based on this equation and the data, it is selector 1

• reasonable
• unreasonable

to expect that Jacksons potential bond investment is currently exhibiting an intrinsic value greater than $1,000.

Points:

Close Explanation

Explanation:

Now, consider the situation in which Jackson wants to earn a return of 13.75%, but the bond being considered for purchase offers a coupon rate of 15.75%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bonds intrinsic value to the nearest whole dollar, then its intrinsic value of selector 1

• $1,048
• $1,258
• $1,362
• $734

(rounded to the nearest whole dollar) is selector 2

• equal to
• less than
• greater than

its par value, so that the bond is selector 3

• trading at a discount
• trading at par
• trading at a premium

.

Points:

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 Jacksons required return.

When the coupon rate is greater than Jacksons required return, the bond should trade at a premium.

When the coupon rate is greater than Jacksons required return, the bonds intrinsic value will be less than its par value.

When the coupon rate is greater than Jacksons required return, the bond should trade at a discount.