A bond is a necessary part of the financial market that assists massive companies and government bodies to boost capital for numerous functions and it is an alternative to the investors who hesitate to take higher risks by financing stocks.
However, it is terribly crucial to grasp if the invested capital in a explicit bond may be a smart investment and hence finding the honest price of the bond is vital
Bond valuation is the method to workout the honest value of the bond. Honest price calculation consists of calculating the cash flow of the bond and the face value (par value) i.e. the bonds value once it matures.
The bond cash flow consists of the fixed periodic interest payments and the principal amount paid at the maturity date.
The valuation will help an investor to determine the discounted rate i.e. the expected rate of return a bond needs to pay to be considered a worthwhile investment.
Factors to think about once evaluation a bond include:
Pricing a bond is straightforward albeit the opposite financial skills could also be a bit daunting
- Determining the bond face value or the par value i.e. the value the bond will pay at the maturity is important in order to calculate the bond valuation.
- Simultaneously a bond coupon rate and maturity date plays an important role in the calculation of value of a bond.
- The cash flows consisting the inflows and outflows in the form of interest payments is needed to insert under the mentioned formula with the help of annual coupon and face value
Cash flow = Coupon rate * face value
- Calculating the discounted cash flow i.e. the method to estimate the value an investor would be willing to pay for an investment given the required rate of return of an investment based on the forecasted cash flows
DCF= cash flow / (1+r)^n
The above formula will generate the final face value payment that value the bond as a whole
- The value of the final face value at the time of maturity to be calculated with the mentioned formula:
Final face value= face value / (1+r)^n
For example:
A company issues a bond of Rs. 1000 with a coupon rate of 3% and having a maturity of 30 years . The prevailing interest rate in the market for similar bond is 5%
Therefore the bond issuer will pay the bond holder Rs. 50 as interest payment annually for a period of 30 years.
Since the tenure is 30 years the bondholder will have a 30 series of cash flow of Rs.50 each year and one cash flow of Rs.1000
Applying the DCF formula= Cash flow / (1+r)^n
DCF=30 / (1+0.05)^1+30/(1+0.05)^2….+30/(1+0.05)^30
And the final face value payment in 30 years is
1000 / (1+0.05)^30
This formula will generate the price of the bond i.e. Rs. 692.55.
However, when the price of the bond is below the face value of the bond it is termed as a bond trading at a discount and when the price of the bond is above the face value it is termed to be trading at premium.Bond price and interest rate always share an inverse relationship.
