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LEARNING OBJECTIVES

Understand the Debt vs. Equity financing

SOURCES OF FINANCE - BOND Valuation of bond
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Understand the implications of interest
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rate risk for the value of a bond.

Bond ratings
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The impact of inflation on interest rates

The components of required return

CAPITAL STRUCTURE
DEBT vs. EQUITY

DEBT EQUITY THE BOND MARKET

Fixed return Variable return
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Contractual interest rate Dividend only when declared
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Fixed life Indefinite life
Redeemed on maturity date No maturity date
Security Security
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Paid before shareholders Residual claim on assets

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No tax exemption
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Tax exemption
Tax shield Income taxed twice

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DEFINITION OF A BOND TYPES OF BOND

A bond is a security that obligates the issuer to make specified

interest and principal payments to the bond holder on Zero-coupon Bonds (Pure Discount Bond)
specified dates Pay no coupons prior to maturity
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Coupon: the stated interest payment on a bond. Payment is Pay the bonds face value at maturity
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constant and payable every year or half-year

Face value (par value): the principal amount of a bond that is Coupon Bonds
repaid at the end of the term Pay a stated coupon at periodic intervals prior to
maturity
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Coupon rate: Annual coupon divided by the face value of a Pay the bonds face value at maturity
bond.

Maturity (term): The specified date on which the principal

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amount of a bond is paid 6

TYPES OF BOND

Government bond (Treasuries)

Issued by the government
No default risk, only interest rate risk
T-Bill : < 1 year
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T-note: 1 year -> 10 years
T-bond: 10 year -> 30 years or more
Municipal bond
Issued by local state
Corporate bond
Different corporate bonds have different level of default risk
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Types of corporate bond

Secured bond (asset-backed bond)
Unsecured bond (debenture)
Convertible bond
Call vs. Put option
7 8 Junk bond

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TYPES OF CORPORATE BOND BOND MARKET CONVENTIONS

Secured bond (asset-backed bond)
Bonds are secured by a fixed change over specific assets (eg. Coupon rate
Real estate, buildings, etc.) Rate used to compute the interest payment
Unsecured bond (debenture)
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Bonds are backed only by general faith and credit of issuers
Yield to maturity (YTM)
Convertible bond
Bonds that allow holders to convert bond into prescribed Market interest rate that equates a bonds present
number of common stock at an agreed upon price value of interest payments and principal
Call provision vs. Put provision repayment with its price.
Call Provision: allows the issuer to repurchase (call back) the (the yield holder gets by buying the bond today
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bond at a specified price prior to maturity and holding onto it until maturity)
Put Provision: holders of the bonds has option to cancel the
deal early
Junk bond Rates are quoted as nominal rates (APR)
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High yield bonds, but also high default risk

EXAMPLE OF A BOND HOW TO VALUE A BOND

STEP 1. Identify the size and timing of cash flows.

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STEP 2. Discount at the correct discount rate.
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If you know the price of a bond and the size and timing of
cash flows, the yield to maturity (YTM) is the discount
rate.
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Note: Bond yields are quoted like APRs:

Quoted rate = actual rate per period x no. of periods.

so a 6% quoted yield and semiannual payments would

11 12 have a true yield of 3% per 6 months.

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BOND VALUATION

COUPON BOND VALUATION

ZERO COUPON (PURE DISCOUNT)

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EXAMPLE
COUPON BOND VALUATION
ZERO COUPON BOND EXAMPLE
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CLASS EXERCISE 1 BOND CLASS EXERCISE 1 BOND

VALUATION VALUATION
The value of the bond would be:

A bond with a face value of $1,000 and a coupon

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rate of 6% has 10 years to maturity. Bonds coupon
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are paid yearly.

The bond is selling below its face value. A bond that is issued
What is the market price of this bond if the market for less than its par (or face) value, or a bond currently
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trading for less than its par value in the secondary market is
interest rate is 10 %? called discount bond. Vice versa, a bond trading for more
than its par value is called premium bond.

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CLASS EXERCISE 2 BOND WHAT HAPPENS WHEN INTEREST

VALUATION RATES CHANGE?
Doing exercise 1, assume now that the bonds Ex: What is the market price of a bond that has a coupon rate of
6%, a face value of $1,000 and matures exactly 3 years from
coupons are paid half-yearly (semiannually).
today if the required yield to maturity is 6% p.a. compounded
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The value of the bond would be:
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semiannually?

Ex: Suppose you purchase the bond described earlier and

immediately thereafter interest rates fall so that the new yield to
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maturity on the bond is 8% p.a. compounded semiannually.

What is the bonds new market price ?

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RELATIONSHIP BETWEEN BOND YTM AND BOND VALUE

PRICES AND INTEREST RATES (YIELDS)
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INTEREST RISK RATE AND TIME TO COUPON RATE AND BOND PRICE
MATURITY VOLATILITY

Interest rate 1 year 30 years

5% $1 047.62 $1 768.62
10 1 000.00 1 000.00
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15 956.52 671.70
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20 916.67 502.11

Bond: coupon 10%

Par : 1,000
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CURRENT YIELD vs. YIELD TO CURRENT YIELD EXAMPLE

MATURITY
Current yield: A bonds annual coupon divided by its current Current yield =
market price.
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YTM:
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What is the difference between current yield and yield to
maturity ? YTM is the rate you earn by purchasing a bond
today and holding it until maturity.

Current yield example: Bond D quoted price of $1,080.42;

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Face value $1,000; semiannual coupons $30 for each payment;
5 year maturity.
What is the current yield? What is its YTM?
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BOND RATE OF RETURN BOND RATE OF RETURN

Bond rate of return: the total income per period per Ex: 10% coupon bond, with semiannual coupons,
dollar invested face value of $1,000 ; 20 years to maturity,
(Note: This formula is used for calculating the bond rate YTM 8%
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of return for one year only)
Calculate the current bond price
Annual _ coupon price _ change What is the bond price after one year,
Rate _ of _ return assume that you can sell the bond at YTM of 9%
investment
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?
What is the rate of return on your
investment over the year?
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BOND RATE OF RETURN

10%, semiannual coupon bond, with face value of $1,000;

20 years to maturity and YTM 8%
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After one year, the YTM increases to 9%

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