A bond is a long-term debt instrument used by firms as well as governments to raise additional capital to finance their projects. A bond has a face value which must be repaid to the bondholder at the maturity of the bond. It also involves periodic payments of interest to the holder at a stated coupon rate. Interest on a bond is an annuity paid until the bond matures while the face value is a single payment at the maturity of the bond (Scott and Brigham 241). The value of a bond is therefore given by the following formula:
B0 = current value of the bond (at time zero).
I = annual interest paid in shillings (coupon interest x face value)
n = number of years to maturity
M = par value (face value) in shillings
= required return on a bond
The above formula can be simplified as:
In perfect conditions, the par value of a bond should be equal to its market value. However, this is not the case in real practice. This is caused by the fact that the coupon rate of interest differs from the required rate/market rate of interest. This difference is brought about by changes in economic conditions and or changes in the firm’s class of risk (Scott and Brigham 241). When the market/required rate of return is more than the coupon interest, the value of the bond will be less than its par value hence it will be selling at a discount. On the other hand, if the coupon interest rate is more than the required rate, the value of the bond will be more than the face value hence it will be selling at a premium (Scott and Brigham 241).
Bond value depends on5 required rate of return, time to maturity and interest rate risk. When the required rate of return is high, the value of the bond will be lower. As the bond moves to its maturity, its value will move towards the par value. Interest rate risk is the risk that market interest rates and hence required rate of return on a bond will change. Interest rate risk increases with time to maturity. A bond with a longer time to maturity will have a greater interest rate risk than one with a shorter time to maturity. When the coupon interest rate is lower, the bond will have a greater interest rate risk. This is because the value of a bond with a lower coupon interest rate is largely dependent on the face value (amount received at maturity) hence holders will be so sensitive to changes in interest rates as interest rate determines the amount receivable at maturity (Scott and Brigham 241).
Besley, Scott, and Eugene F. Brigham. Essentials of managerial finance. 12th ed. New York: Cengage Learning, 2008. Print.