Valuation of Bonds or Debentures

Principle & Practice of Management

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Valuation of Bonds or Debentures

Meaning: A bond or debenture is an instrument of long-term debt issued by a borrower.
Debentures
The technique of Valuation of Bonds or Debentures: The value of bonds or debentures is, generally, determined through the technique known as the Capitalization technique.
The process of determination of the present value of a bond or debenture can be considered under two headings viz.,
1. When a bond or debenture is redeemable (i.e. definite maturity period).
2. When a bond or debenture is irredeemable (i.e. as no specified definite maturity period).

Present Value of a Redeemable Bond or Debenture

When a bond or debenture is redeemable, its present value can be determined by estimating its future cash flows, and then, discounting the estimated future cash flows at an appropriate capitalisation rate or discount rate.
The estimated cash flows from the bond or debenture consists of the stream of future interest payments plus the principal repayment.
The appropriate capitalization rate or discount rate to be applied to discount the cash flows from the bond or debenture will depend upon the risk associated with the bond or debenture. If the risk is low, a lower discount rate will be applied. On the other hand, if the risk is high, a higher discount rate would be applied.
The following formula may be used to find out the present value of the bond or debenture (assuming that the bond has a maturity period of 4 years):
V=I1/(1+K)+I2/(1+K)(1+K)+I3/(1+K)(1+K)(1+K)+I4+M/(1+K)(1+K)(1+K)(1+K)
Where,
V = the present value of the bond or debenture.
I = annual interest payment.
K = the capitalization rate or the discount rate.
M = the maturity value of the bond or debenture.

Present Value of a Perpetual or Irredeemable Bond or Debenture

When a bond or debenture is irredeemable, its present value can be determined by simply discounting the stream of interest payments for the infinite period by an appropriate capitalization rate or discount rate.
The following formula may be used to determine the present value of the bond or debenture.
V = 1/Kd
Where,
V – means the present value of the bond or debenture.
I – means annual interest payment.
Kd – means the capitalization rate or the discount rate.