Week #6, Blog Entry #6:            Capital Investments: Bond Valuations and Net Present Value

 

We learned this week that bonds are instruments for investments of companies and governments to generate capital. Capital investments generate income resources that allow companies and governments to finance their operations. Entities can generate capital in three ways: earning income through the sale of products and services, issuing stocks that give ownership of the entity in exchange for money, or bonds that are loan notes issued by the bond issuer to the purchaser which is the bond-holder. Net present value (NPV) is a calculation used to evaluate the financial feasibility of a capital investment.

 

Bonds

The bond market is bigger than the stock market. Bonds are an investment product where individuals lend money to an entity, business, or government, at an interest rate for a period of time. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations (Fernando, 2024). Many bond products pay a monthly payment in addition to the loan value at the end of the bond term, called paying the bond face value at its maturity. The initial individual bond price of most bonds is typically set at $1,000 of the face value. The actual market price of a bond depends on the credit rating of the issuer, the length of time until its expiration, and the relation between the bond interest rate (called coupon rate) compared to the market interest rate or where the bond is issued.

Bond Characteristics

  • Face value, nominal value, or Par Value: The value of the bond at maturity, usually $1,000 in the bond market, and the reference amount used to calculate interest payments (Fernando, 2024).
  • Coupon Rate: The fixed interest rate paid by the bond issuer on the face value of the bond, determined at bond issuance. The coupon rate is determined by the bond issuer’s credit quality and the time to bond maturity. If the issuer has a poor credit rating, the risk of default is greater causing those bonds to pay higher interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.
  • Coupon Dates: The interest payment dates by the bond issuer to bondholders.
  • Coupon Payments: Payments to bond-holders at coupon dates by bond issuer.
  • Discount Rate: Variable interest rate that fluctuates with the market. Not all bonds have discount rates. Discount rate relationship with the coupon rates can ultimately change the issuing price of a bond.
  • Maturity Date: The date when the bond issuer will pay bondholders the face value of the bond.
  • Issue Price: The price at which the bond was sold by the bond issuer, in many cases bonds are issued at par, or $1,000.
  • Purchase Price: The price at which the bond was sold, either by the bond issuer which would be equal to the issue price, or by a bond holder selling it in the market at a set price that could differ from the issue price.
  • Discounted Bond: Bond sold at a price below the bond face value. In bonds that also have discount rates in addition to coupon rates, if the discount rate is larger than the bond coupon rate, the net change would be that the issuance price would be less than the face value, which means that the bond is being issued at a discount.
  • Premium Bond: Bond sold at a price above the bond face value. In bonds that also have discount rates in addition to coupon rates, if the discount rate is smaller than the bond coupon rate, the net change would be that the issuance price would be higher than the face value, which means that the bond is being issued at a premium.

As prevailing market interest rates fluctuate, fixed-rate bondholders can earn capital if the prevailing market interest rate is less than the bond’s fixed rate. The bond market tends to move inversely with the market’s overall interest rates, bonds tend to trade discounted when market interest rates are high and vice-versa. Adam Hayes explains “Investors can purchase bonds for more than their face value at a premium or less than the face value at a discount”(2024). Bonds can be sold by bond-holder’s in the market prior to their maturity date, which often occurs when the bond value is higher than is initial purchase price.  Some bonds do not issue coupon payments and instead are issued at a discount to their face value at maturity, called zero-coupon bonds like U.S. Treasury bills (Fernando, 2024).

 

Net Present Value 

NPV calculates the amount of cash an investment will produce and cost using the difference between the value of cash expected to be generated (value of cash inflows), taking into consideration the initial capital investment, and comparing it to the cash expected to be generated (value of cash outflows). As Jason Fernando explains “NPV is used in capital budgeting and investment planning to analyze a project's projected profitability” (2024). The calculation takes into account the timing and future cash flow needed at a discount rate to assess the minimally acceptable rate of return. A positive NPV means that the investment generates more value than its cost, whereas a negative NPV means the contrary, the cost surpasses the value of the investment and is probably not worth pursuing. The time value of money is central to NPV, as a dollar today is worth more than a dollar in the future, thus, future cash flows are discounted to reflect their present value.

 

References:

 

Fernando, J. (2024, May 3). Bonds: How they work and How to Invest. Investopedia.com.

https://www.investopedia.com/terms/b/bond.asp

 

Hayes, A. (2024, Oct. 24). Bond Yield: What it is, Why it matters, and How its calculated.

Investopedia.com. https://www.investopedia.com/terms/b/bond-yield.asp

 

Fernando, J. (2024, Aug.14).  Net Present Value (NPV): What it means and steps to calculate it.

Investopedia.com.  https://www.investopedia.com/terms/n/npv.asp

 

 


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