What is Bond Valuation?
Bond valuation are the notes issued by the corporation to raise long-term funds for the business. The corporations are required to pay the interest on such liabilities at a specified rate of interest (termed as coupon rate) at specified dates which may be on semi-annual or annual basis. These interest payments may be in the form of coupons.
How to Use Bonds for Issuing Funds
The interest rate is specified at the time of issuance of bonds which is termed as the coupon rate of interest which may be equal to, higher than, or lower than the market interest rate.
The bonds may be issued by the corporation at par value, at a discount or at a premium. For the purpose of bond valuation, the bond prices depend upon both the coupon interest rate and market interest rate. When the coupon interest rate is equal to the market interest rate, the bond prices are equal to face value. But when the market interest rate is higher than the coupon interest rate, then the bond prices will be lower than the face value and the bonds will have to be issued at a discount. This is due to the reason that the investors generally forego the interest income when investing in the respective bonds as compared to when the investment is made in the market. They will be ready to forego the income only when the present value of the bond’s prices is lower than the par value.
Moreover, when the market interest rate is lower than the coupon interest rate, then the bond prices will be higher than the face value and the bonds will be issued at a premium. This is due to the fact that the demand for such bonds will be higher in the market as they yield higher returns. Therefore, the investors will be ready to pay the prices higher than the par value.
Thus, the cash flows from the issuance of bonds shall depend on the comparison of the coupon rate and market rate. The cash flows which can be realized on the issuance of bonds are computed on the basis of the value of a bond. The value of a bond is computed by taking the present value of all the cash flows during the lifetime of the bonds to the investors. For the purpose of present value computation, the discount rate that needs to be taken shall be the market interest rate.
The cash flows that are realized during the lifetime of the bonds till the final maturity of the bonds comprises of the periodic coupon payments made by the corporation and the sum payable by the corporation at the time of the maturity which is generally a face value of the bonds payable.
The period of the bonds and market interest rate shall be required to be adjusted as per the periodic coupon payments. For example, the bonds with a coupon rate of 12% has been issued for the period of ten-year and the coupon payment are made on annual basis. Then, for discounting, the number of periods shall be taken as 10 and discount rate shall be 12%. However, when the coupon payments are made on a semi-annual basis, then the number of periods for the coupon payments made is 20 (i.e., 2 periods for each year) and market-rate will be reduced to half (i.e., 6% for each period).
Thus, the bonds valuation and cash flows which will be derived from the issuance of bonds is computed by adding up the present values of the two amounts, as discussed below.
- The present value of coupon payments made on a periodic basis and for this purpose, the annuity present value factor table shall be used.
- The present value of the maturity value (generally a face value) payable at the end of maturity for which the present value factor table shall be used.
The sum of both the above two present values shall be taken as the value of bonds. The concept of the bond valuation above is based on the IRR concept. This is so because the investors expect to earn the yield to maturity equal to the market rate prevailing in the current situation.
How to Compute the Carrying Valuation of Bonds
After issuing bonds on deciding the cash flows from the issuance, the next step is to compute the carrying value of the bonds at the time of reporting the financial statements. For the purpose of computing the carrying value of the bonds, the three situations arise.
Situation 1: When the Bonds are Issued at Par
In this case, the corporation pays the periodic coupon payment and the bonds are standing in the books at the par value. Therefore, the carrying amount of the bonds shall always be the face value of bonds till their final maturity.
Situation 2: When the Bonds are Issued at Discount
In this case, the market rate of interest is higher than the coupon rate and the bond's initial carrying value is lower than the face value. The difference between the par value of bonds and the carrying value of bonds shall be taken as an unamortized discount. In such cases, the interest expense of the period is computed by applying the market interest rate on the carrying value of the previous period, and the actual cash interest paid is computed by applying the coupon rate on the par value. In such a situation, the interest expense first computed is always higher than the cash interest paid and the difference is taken as the discount amortized during the period. Such discount amortized is deducted from the unamortized discount and added in the carrying value of bonds of the previous period to arrive at the carrying amount of the current period.
Situation 3: When the Bonds are Issued at Premium
In this case, the market rate of interest is lower than the coupon rate, and the bond's initial carrying value is higher than the face value. The difference between the carrying value of bonds and the par value of bonds is taken as an unamortized premium. In such case, the interest expense of the period is computed by applying the market interest rate on the carrying value of the previous period, and the actual cash interest paid is computed by applying the coupon rate on the par value. In such a situation, the interest expense first computed is always lower than the cash interest paid, and the difference is taken as the premium amortized during the period. Such premium amortized thereafter is deducted from unamortized premium and finally from the carrying value of bonds of the previous period to arrive at the carrying value of the current period.
In this way, the bond valuation is made on the basis of the cash flows derived by the investors at different period of time along with the maturity; and the bonds prices are based on interest rates applicable on the cash flows in the market and coupon rate stated in the terms of issuance which finally becomes the base for the computation of cash flows
The care must be taken when the carrying value of bond is lower than the face value i.e., bonds are issued at discount, than the interest expense is always higher than the coupon payment and carrying value of each succeeding period is on the rise. However, when the bonds are issued at a premium, than the interest expense is always lower and the carrying value of each succeeding period is on the fall.
Context and Application
This topic is important in the examination of undergraduate and graduate courses such as
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