POST GRADUATE CERTIFICATE PROGRAMME MANAGEMENT

Financial Econometrics

PGP I : Term 2

Finance - I
Session # 8
Time Value of Money…continues…
Bond Valuation

Any Questions ??
Quiz Review
Quiz – 1 Review
 Section A Section B
 Mean 9,28 9.68

 Median 9.0 9.75

 Minimum 2.75 1.75
 Maximum 17.25 19.5
 5 percentile 4.64 4.64
 25 percentile 6.8 6.8
 90 percentile 14.5 14.25
 95 percentile 15.30 15.60

 Let me know if you need a tutorial session to cover the basics or

any other concepts.
NOPAT=EBIT(1-T)=60
OpCapital= Net Op Working Capital + Net Fixed Assets=(10+50+40-20-20)+100=160
ROIC = NOPAT/OpCap = 60/160 = 37.5%

Increases

Option C
 =2 / 98 * 365/15 = 2.04* 24.33 = 49.64%

AFN -- Base case: 1000*175/500 - (150+70)*175/500 – 675*0.25*(1-0.3) = 179.875

AFN – DPO increase : 1000*175 / 500 – (150+70)*175/500 – 675*0.25*(1-0.5) = 213.625
As DPO increases from 30% to 50%, AFN increases by USD 33.75 millions

Incremental revenue = {Incremental contribution – Incremental BadDebt cost}*(1-Tax)

= {200*0.25 – (-1000*0.02 + 1200*0.03) }0.75 = 25.5
Incremental cost of capital = 0.08*{1000*15 / 365 } - 0.08{1000*25/365 +200*0.75*25/365}
=3.2877 – 6.3014 =-3.014
Net change in profit = 22.4863. Its worthwhile to relax the collection effort.
EAI = 100000 / 6.7101 = 14,903

Principal Repayment in first installment : 14903 – 0.08*100000 = 6903

Outstanding principal at the end of year 1 : 100000-6903 = 93097

Interest payment in 2nd year : 93097*0.08 = 7448

 What’s the difference between
an ordinary annuity (at the end of the period) and
an annuity due (at the beginning of the period)?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

PV FV
 At the end of 10 years, which of the following investments would have the
highest future value? Assume that the effective annual rate for all investments
is the same and is greater than zero.

a. Investment A gives $250 at the beginning of every year for the next 10 years (a total of 10 payments).
b. Investment B gives $125 at the end of every 6-month period for the next 10 years (a total of 20
payments).
c. Investment C gives $125 at the beginning of every 6-month period for the next 10 years (a total of 20
payments).

d. Investment D gives $2,500 at the end of 10 years (just one payment).

e. Investment E gives $250 at the end of every year for the next 10 years (a total of 10 payments).
At the end of 10 years, which of the following investments would have the
highest future value? Assume that the effective annual rate for all investments
is the same and is greater than zero.
a. Investment A gives $250 at the beginning of every year for the next 10 years (a total of 10 payments).
b. Investment B gives $125 at the end of every 6-month period for the next 10 years (a total of 20
payments).
c. Investment C gives $125 at the beginning of every 6-month period for the next 10 years (a total of 20
payments).

d. Investment D gives $2,500 at the end of 10 years (just one payment).

e.A dominates B because
Investment E gives it end
$250 at the provides
of every the same
year for total10amount,
the next but
years (a total it comes
of 10 faster,
payments).
hence it can earn more interest over the 10 years. A also dominates C and E for
the same reason, and it dominates D because with D no interest whatever is
earned. We could also do these calculations to answer the question:

A $4,382.79 Largest EFF% 10.00% 10 250

B $4,081.59 NOM% 9.76% 125

C $4,280.81 125

D $2,500.00 2500

E $3,984.36 250
Nominal Versus Effective Interest Rates

Nominal Interest Rate: Effective Interest Rate:

Interest rate quoted based on an Actual interest earned or paid in
annual period a year or some other time
period
18% Compounded Monthly

Nominal Interest
interest rate period

Annual
percentage
rate (APR)
18% Compounded Monthly
 What It Really Means?
 Interest rate per month (i) = 18% / 12 = 1.5%
 Number of interest periods per year (N) = 12

 In words,
 Bank will charge 1.5% interest each month on your unpaid
balance, if you borrowed money
 You will earn 1.5% interest each month on your remaining
balance, if you deposited money
Effective Annual Interest Rate
ia = (1 + r / M ) M − 1

r = nominal interest rate per year

ia = effective annual interest rate
M = number of interest periods per year

18% compounded monthly

❑ Question: Suppose that you invest $1 for 1 year at 18%
compounded monthly. How much interest would you
earn?
Solution: F = $1(1 + i ) = $1(1 + 0.015)
12 12

= $1.1956
ia = 0.1956 or 19.56%
 Suppose your savings account pays 9% interest compounded quarterly. If you
deposit $10,000 for one year, how much would you have?
(a) Interest rate per quarter:
9%
i= = 2.25%
4
(b) Annual effective interest rate:
ia = (1 + 0.0225) 4 − 1 = 9.31%
(c) Balance at the end of one year (after 4 quarters)
F = $10, 000( F / P , 2.25%, 4)
First quarter= $10,Base amount $10,000
000( F / P , 9.31%,1)
+ Interest (2.25%) + $225
= $10, 9 31
= New base amount = $10,225
Second quarter
+ Interest (2.25%) +$230.06

= New base amount = $10,455.06

Third quarter
+ Interest (2.25%) +$235.24

= New base amount = $10,690.30

Fourth quarter
+ Interest (2.25 %) + $240.53
= Value after one year = $10,930.83
You plan to invest some money in a bank account.
Which of the following banks provides you with the highest effective rate of interest?

a.
Bank 1; 6.1% with annual compounding.
b.
Bank 2; 6.0% with monthly compounding.
c.
Bank 3; 6.0% with annual compounding.
d.
Bank 4; 6.0% with quarterly compounding.
e.
Bank 5; 6.0% with daily (365-day) compounding.

A bank is quoting 8% interest per annum with semi-annual compounding. What is the
effective annual rate of interest?
a. 8% b. 16% c. 8.16% d. 7.85%

If you deposit Rs.25000/- per quarter for 3 years in a bank. The bank pays 12% per
annum with quarterly compounding then what is the maturity value at the end?
Quarterly compounding, so, 3%; 12 periods; ordinary annuity; 25k*14.192 = Rs354800
Customer gets more than ___% return !!
How about Gold Jewellery schemes….?

Pay Rs.10000/- every month for 10 months. Purchase for 110k anytime in the 11th month.
You are in negotiations to make a 7-year loan of Rs. 25,000 to DeVille
Corporation. To repay you, DeVille will pay Rs. 2,500 at the end of Year 1, Rs.
5,000 at the end of Year 2, and Rs. 7,500 at the end of Year 3, plus a fixed but
currently unspecified cash flow, X, at the end of each year from Year 4 through
Year 7. You are confident the payments will be made, since DeVille is
essentially riskfree. You regard 8% as an appropriate rate of return on a low
risk but illiquid 7-year loan. What cash flow must the investment provide at the
end of each of the final 4 years, that is, what is X?
Interest rate 8%

Time line:

0 1 2 3 4 5 6 7

- Rs. 25,000 Rs. 2,500 Rs. 5,000 Rs. 7,500 X X X X

Step 1: First find the present value of cash flows from t0 to t3. = - Rs 12,444.75

Step 2: Calculate the future value of this amount, calculated in step 1, at the end of
t3 = -Rs.15, 676.80
Step 3: Now calculate the annual payment to be made for a 4 year annuity that equal
the value calculated in step 2. = Rs 4733.15
Bond Valuation

Key features of bonds

Bond valuation
 Growing companies must acquire land, buildings,
equipment, inventory, and other operating assets.
 The debt markets are a major source of funding.

 Every manager should have a working knowledge of

 types of bonds companies and govt. agencies issue,
 the terms that are contained in bond contracts,
 the types of risks to which both bond investors and issuers
are exposed, and
 procedures for determining the values of and rates of return
on bonds.
A long-term contract between two parties
Borrower receives money today
He agrees to make payments on specific dates
Principal
Interest amount
‘Bond indenture’ provides the terms of contract

Lender Today: Rs. 1000 Borrower

(Bond (Bond Issuer)

holder)
Rs. 100 each on coupon day +
Rs. 1000 on last coupon day

Issue date: October 23, 2024

Coupon dates: October 23 of 2025….2034
Key Features of a Bond
Par value or Face Value, which
Is paid at maturity:
Borrower to Lender

Coupon rate,
Agreed interest rate
Between borrower n lender
Maturity and Issue Dates

Coupon payment schedule

Coupons and coupon

payment
 Key Features of a Bond

1. Par value: Face Value mentioned on Bond which is paid at maturity.

2. Coupon interest rate:

• Rent on the money borrowed. (Annual interest / Par value)
• Set at the going rate. Can be Fixed / Variable / Market Linked.

3. Maturity: Years until bond must be repaid.

• Maturity declines by 1 year each year

4. Issue date: Date when bond was issued.

5. Default risk:
• Risk that issuer will not have cash to make interest or principal payments ➔ higher
the rating, lower the default risk
Intrinsic / Fair / Present value of a Bond
Bond pricing is, in theory, no different than pricing any set of known cash flows. Once the cash
flows have been identified, they should be discounted to time zero at an appropriate discount rate.
Note: Coupon Rate is different from Discount rate.
Coupon rate is fixed over life of bond. rd, Discount / market interest rate changes as per market.

0 1 2 n
r
...
Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + + ... + .
(1+ rd) 1
(1+ rd)2
(1+ rd)n
 Bond Valuation:

T=0 T=1 T=2 T=3 T=4 T=n-1 T=n

Value of INT INT INT INT ------------------------------------------------ INT INT + PAR

Bond

Coupons
Represent
Annuities

One annuity
And one lump
Payment
The value of a bond therefore is…
1
1− M
(1 + rd )t
Bond Value = 𝐼𝑁𝑇 +
rd (1 + rd )t

Note: Coupon Rate is different from Discount rate.

Coupon rate is fixed over life of bond. Discount / market interest rate changes as per market.

Market rate of interest is same as required rate of return or discount rate : rd

The Present Value of The Present Value of a

Lumpsum received at
‘n’ Annuity payments
The time of maturity
How is bond value determined?
What is the value of the bond that has
TTM = 15-year,
Par value = $1,000
Coupon rate = 10%
Annual coupon
if its required rate of return (market rate of interest) is 10 percent?
Valuing a Straight Bond
 You are trying to value a straight bond with a fifteen year maturity and a 10% coupon rate.
The current (market) interest rate on bonds of this risk level is 10%.
PV of cash flows on bond = 100* PV(A,10%,15 years) + 1000/1.115 = $ 1000
 If (market) interest rates rise to 15%,
PV of cash flows on bond = 100* PV(A,15%,15 years)+ 1000/1.1515
=100*5.8474+1000*0.1229
= $707.6
 If (market) interest rate fall to 5%,
PV of cash flows on bond = 100* PV(A,5%,15 years)+ 1000/1.0515
= 100*10.3797+1000*0.481
=$1,518

 The longer the maturity of a bond, the more sensitive it is to changes in interest rates.
 The lower the coupon rate on the bond, the more sensitive it is to changes in interest rates.
What would be the value of the bond if, just after it had been issued, the expected
inflation rate rose by 3 percentage points, causing investors to require a 13% return?
Would we now have a discount or a premium bond?

What would happen to the bonds' value if inflation fell, and rd declined to 7%?
Would we now have a premium or a discount bond?
At maturity, the value of any bond must equal its par value.
The value of a premium bond would decrease to $1,000.
The value of a discount bond would increase to $1,000.
A par bond stays at $1,000 if rd remains constant.
1,372 rd = 7%.
1,211

1,000
rd = 10%. M

837
rd = 13%.
775

30 25 20 15 10 5 0

Years remaining to Maturity