Back To CourseFinance 301: Corporate Finance
14 chapters | 105 lessons
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M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
Horse Rocket Software has issued a five-year bond with a face value of $1,000 and a 10% coupon rate. Interest is paid annually. Similar bonds in the market have a discount rate of 12%. Before we calculate what this bond is worth, let's define some things. We'll first explain the term, give a definition, and then give a brief example of how the term is expressed in our example we opened with.
|Face value||The value of the bond to be paid at maturity||$1,000|
|Coupon rate||The amount of interest to be received annually||10%|
|Discount rate||The required return rate for an investor||12%|
|Maturity date||The date the bond will be paid to the investor||Five-year time period from the date of the purchase|
The discount rate of bond valuation is subjective for each investor. It reflects the investor's evaluation of the entity issuing the bond in terms of how likely default might be. For example, a U.S. Treasury security will have a very low discount rate since the U.S. has never defaulted on its debts. A new business, on the other hand, will have a higher discount rate since the chances the business fails and defaults on its debts is much higher. A good starting point is the market rate for bonds of similar quality and risk.
A quick review of the amount, rates, and date from our opening example can help us out here. Why would an investor purchase a bond that pays 10% of the face value in annual interest payments when the discount rate is 12%? Ordinarily, they wouldn't, unless the company issuing the bond discounts the purchase price and offers the bond for less than the face value.
The bond is issued at a premium when the coupon rate is greater than the discount rate. The bond's purchase price is greater than the face value. An investor is willing to pay more than the face value because the expected cash flow from the bond will be greater than the required rate of return.
The bond is discounted when the coupon rate is less than the discount rate. The bond's purchase price is less than the face value. Because the expected cash flow from the bond is below the required rate of return, the investor will only purchase the bond when the price is below the face value. The Horse Rocket bond from our opening example will need to be discounted since the discount or required rate is greater than the coupon rate. The value of the bond will tell us how much the discount needs to be.
Calculating the value of a bond is a three-step process. Bonds have two income pieces. One is a stream of periodic interest payments the investor receives. The other is the principal repayment of the investment, which is made when the bond matures. What a bond is worth today is the combined present value of both of these two income pieces.
We begin by calculating the interest payments. Interest payments are paid quarterly, semi-annually, or annually for the duration of the bond. To keep things simple, the Horse Rocket bonds pay interest once per year. Our face value is, as your recall, $1,000. And our coupon rate is 10%. That means we multiply $1,000 by 0.10 and this produces our answer. We make an interest payment of $100. Simple, right?
Next, we calculate the present values for the expected interest payments at a 12% discount rate for five years. Then we calculate the present value of the principal repayment. Here is the basic formula for finding the present value of a stream of cash flow:
As we can see based on these calculations, to get the investor the desired return of 12% to compensate for the default risk these bonds carry, they will be willing to pay $929.03.
The hurdle rate is the minimum return established for investments. If you are a financial manager investing on behalf of a company, your hurdle rate is likely to be the weighted average cost of capital. The weighted average cost of capital (WACC) is simply the company's cost of acquiring the funds used to invest. Any investment needs to clear that hurdle. The financial manager will calculate the bond's value using the WACC as the discount rate. He or she will be willing to pay less than the calculated value to assure a profit on the investment.
On occasion, an investor may choose to sell a bond before it matures. The value of the bond is simply the sum of the remaining discounted cash flows. If an investor chose to sell the Horse Rocket bond after the second interest payment at the end of year two, they'd calculate the present value of the three remaining interest payments plus the present value of the principal. The bond value calculation is $951.97. Notice, the bond value is closer to the face value because the time to maturity has been reduced by two years. The table below includes the compounded discount rates and the PV of the cash flows from when they are scheduled back to the end of year two.
|Year||Compounded Discount Rate||Cash Flow||PV Cash Flow|
|Bond value =||$951.97|
As we can see, after adding up all the PV cash flows, the bond value comes out to be $951.97.
Let's review what we've learned. The value of a bond is the present value sum of its discounted cash flows. Bonds have a face value, a coupon rate, a maturity date, and a discount rate. The face value is the amount paid at maturity. The coupon rate is the interest rate paid to the investor. When calculating the bond value, the investor will use the discount rate to determine the present value of the cash flows. The discount rate is the required rate of return for the investor.
If the investor is purchasing the bond on behalf of a company, the investor will want the hurdle rate, which is the minimum return established for investments to be the weighted average cost of capital (WACC), which is the company's cost of acquiring the funds used to invest. They'll use the WACC to determine the discount rate. If the investor is using personal funds to invest, they may choose to use the average returns to calculate the discount rate.
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Back To CourseFinance 301: Corporate Finance
14 chapters | 105 lessons