Principles of Managerial Finance

284 PART 2 Important Financial Concepts

6–13 What are the three key inputs to the valuation process?

6–14 Does the valuation process apply only to assets that provide an annual

cash flow? Explain.

6–15 Define and specify the general equation for the value of any asset, V 0.

6.4 Bond Valuation

The basic valuation equation can be customized for use in valuing specific securi-

ties: bonds, common stock, and preferred stock. Bond valuation is described in

this chapter, and valuation of common stock and preferred stock is discussed in

Chapter 7.

Bond Fundamentals

As noted earlier in this chapter, bondsare long-term debt instruments used by

business and government to raise large sums of money, typically from a diverse

group of lenders. Most corporate bonds pay interest semiannually(every 6

months) at a stated coupon interest rate,have an initial maturity of 10 to

30 years, and have a par value,or face value,of $1,000 that must be repaid at

maturity.^11

EXAMPLE Mills Company, a large defense contractor, on January 1, 2004, issued a 10%

coupon interest rate, 10-year bond with a $1,000 par value that pays interest

semiannually. Investors who buy this bond receive the contractual right to two

cash flows: (1) $100 annual interest (10% coupon interest rate $1,000 par

value) distributed as $50 (1/2 $100) at the end of each 6 months, and (2) the

$1,000 par value at the end of the tenth year.

We will use data for Mills’s bond issue to look at basic bond valuation.

Basic Bond Valuation

The value of a bond is the present value of the payments its issuer is contractually

obligated to make, from the current time until it matures. The basic model for the

value, B 0 , of a bond is given by Equation 6.7:

B 0 I 

n

t 1 

M (6.7)

I (PVIFAkd,n)M (PVIFkd,n) (6.7a)

1



(1kd)n

1



(1kd)t

11. Bonds often have features that allow them to be retired by the issuer prior to maturity; these conversionand call
    features were presented earlier in this chapter. For the purpose of the current discussion, these features are ignored.

Hint A bondholder receives
two cash flows from a bond if
it is held to maturity—interest
and the bond’s face value. For
valuation purposes, the interest
is an annuity and the face
value is a single payment re-
ceived at a specified future date.

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