Topic 3

Valuing bonds and long-term

debt
Chapters 4 (bonds) & 14 (long-term debt)
Department of Finance
Deakin Business School, T3 2017
1
Recap – Topic 2
• Describe the time value of money
• Understand the power of compound interest
• Calculate the present value and future value
• Calculate the present value and future value of cash
flow streams (i.e. mixed streams, annuities and
perpetuities)
• Identify the differences between stated and effective
annual interest rates
2
Recap

FVn = PV×(1+r)n

FVn
PV 
(1 r ) n
3
 n


FV  CFt  1 r 
nt

t1

n
1
PV  CFt 
1 r 
t
t 1
 r =7% 1000 1000 1000 1000 1000
FV: Ordinary 
annuity: 0 1 2 3 4 5

(1  r ) n  1 FV?
FV  PMT 
r

1000 1000 1000 1000 1000

FV: Annuity 
r =7%
due: 0 1 2 3 4 5
FV?
(1  r ) n  1
FV  PMT   1  r 
r
 1000 1000 1000 1000 1000
PV: Ordinary  r =7%
annuity: 3
0 1 2 4 5
PV?

1000 1000 1000 1000 1000

r =7%
PV: Annuity 
due: 0 1 2 3 4 5
PV?
Perpetuity
• 0
r
PMT PMT PMT …

1 2 3

Growing perpetuity PMT(1+g)1 *(1+g)

0 PMT PMT(1+g)1 PMT(1+g)2 …

r

1 2 3
Frequency of Compounding

r (annual interest rate)
PV FV ?
year

0 1/2 1 3/2 2
m n
 r
FVn  PV  1  
 m

Effective Annual Rate

 r 
m

EAR  1  1
 m
Learning outcomes
After studying this topic, you will be able to
• Understand bond & bond valuation
• Explain the relationship between YTM & coupon
rate
• Explain the relationship between bond prices &
interest rates
• Understand the term structure of interest rates
• Understand the characteristics of long term debt
financing (cost of long term debt)
• Describe the types of long term debts (public issue
9
vs private issue)
4.1 Valuation Basics

• The value of any asset equals the present value of

all its future benefits.
• Therefore, pricing an asset requires knowledge of
future benefits as well as appropriate discount rate.
• Generally, the greater the risk or uncertainty of an
asset’s future benefits, the higher the discount rate
investors will apply when discounting those benefits
to the future.

10
4.1 The Fundamental Valuation
Model
CF 1 CF 2 CF n
P0 = 1
+ 2
+ . . . + n
(1+ r ) (1+ r ) (1+ r )
P0 = price of asset at time 0 (today)
CFt = cash flow expected at time t
r = discount rate (reflecting asset’s risk)
n = number of discounting periods (usually years)

• This model can express the price of any asset at t=0

mathematically.
• Marginal benefit of owning the asset: right to receive the cash
flows.
• Marginal cost: opportunity cost of owning the asset. 11
4.2 Bond Vocabulary

Principal • The amount of money on which interest

is paid.

• The date when a bond’s life ends and the

Maturity date borrower must make the final interest
payment and repay the principal.

Par value • The face value of a bond, which the

borrower repays at maturity.

Coupon • A fixed amount of interest that a bond

promises to pay investors.

• A legal document stating the conditions 12

Indenture
under which a bond has been issued.
4.2 Bond Vocabulary
• The rate derived by dividing the bond’s
Coupon rate annual coupon payment by its par
value.
Annual coupon
Coupon rate 
Par value

• The amount obtained by dividing the

Coupon yield bond’s coupon by its current market
price (which does not always equal its
par value). Also called current yield.

Annual coupon
Coupon yield 
Bond price 13
4.2 Bond valuation: The basic
equation
• +Par Value Single cash flow

C C C C Ordinary annuity
r% …

0 1 2 n‐1 n

PV of coupons PV of par value

PV of ordinary annuity PV of single cash flow

C  1  M
P0   1  n 

r  1  r   (1  r ) n 14

M = Par value
Example 1: Bond valuation
• On 1 January 2012 Platypus United had an
outstanding bond with a coupon rate of 9.125%
and a face value of $1000.
• At the end of each year this bond pays
investors $91.25 in interest (0.09125 x $1000)
and it matures at the end of 2022. Assume a
return of 8%.
• The bond has two types of cash payments,
an eleven year annuity and a lump-sum of 15
$1000 at maturity:
Figure 4.1 Time line for example 1

• Assuming annual interest payments

• Platypus United, 9.125% coupon, $1000 par value bond, 16

maturing at end of 2022; required return equals 8%

Example 1: Solution
Coupon payment per period ($)
Annual coupon rate  Par value 0.09125 *1000
   91.25
# Coupon payment per year 1

C  1  M
C = 91.25 P0   1  n 

r = 0.08  r  1  r   (1  r ) n
n = 11
M = 1000
$91.25  1  $1000
=  1  11 
+
0.08  (1+ 0.08 )  (1+ 0.08 )11
= $651.43  $428.88  $1080.31
17
4.2 Yield to maturity (YTM)
• Estimate of return investors earn if they buy the
bond at P0 and hold it until maturity.
• The YTM on a bond selling at par will always equal
the coupon rate.
• YTM is the discount rate that equates the PV of a
bond’s cash flows with its price.
• When a bond’s coupon rate exceeds its YTM >
bond trades at premium.
• When a bond’s coupon rate falls short of YTM >
bond sells at a discount.
18
Premium bond
• Bought a10% coupon bond last year at par $1000, term to
maturity = 5 years
Bond A:  100 100 100 100 100 + par value
r%
10% 
coupon 0 1 2 3 4 5

• This year: remaining term to maturity = 4 years

100 100 100 100 + par value
Bond A:  r%
10% 
coupon 0 1 2 3 4

• Market interest rate = 8%, a 8% coupon bond is selling at

par ($1000), term to maturity = 4 years
Bond B:  80 80 80 80 + par value
r%
8% 
coupon 0 1 2 3 4 19
• Price of Bond A > price of bond B = par value
 C  1  M
P0   1   
r  1  r n  (1  r ) n

10% x 1000=100

100  1  1000
Price of Bond A   1     1066 .24
0.08  1  0.08 4  (1  0.08) 4

• When a bond’s coupon rate > its YTM

 a bond sells at premium.

20^
Discount bond
• This year: remaining term to maturity = 4 years
Bond A:  100 100 100 100 + par value
r%
10% 
coupon 0 1 2 3 4

• Market interest rate = 12%, a 12% coupon bond is selling at

par ($1000), term to maturity = 4 years
Bond C:  120 120 120 120 + par value
r%
12% 
coupon 0 1 2 3 4

• Price of Bond A < Price of Bond C = par value

100  1  1000
Price of Bond A   1     939 .25
0.12  1  0.12 4  (1  0.12 ) 4
21
4.2 Bond premiums and
discounts
• What happens to bond values if the required return is not equal
to the coupon rate?
• The bond’s price will differ from its par value.

r > coupon interest rate P0 < par value

= Discount

r < coupon interest rate P0 > par value

= Premium

• Generally, the greater the uncertainty about an asset’s future

benefits, the higher the discount rate investors will apply when 22
discounting those benefits to the present.
 C  1  M
P0   1  n 

• Annual coupon bond r  1  r   (1  r ) n

r% C C C+Par

0 1 2 n

• Semi-annual coupon bond

C/2 C/2 C/2 C/2 C/2+Par
r%

0 1
1 1 2 n
1
2 2

 
 
C/2  1  M 23
P0   1
r / 2   r    r  2n
2 n
M = Par value
 1    1  
  2   2
 4.2 Semi-annual compounding

Note: F (Face value), M (Maturity value) and P (Par value) are the same.

($1000*0.04)
An example
Value a T-bond: $40 $40 $40 $40
1000
• Par value = $1000 P0  2  2  2  2
1 2 3 4
 0.044   0.044   0.044   0.044 
• Maturity = 2 years 1  1  1  1 
 2   2   2   2 
• Coupon rate = 4% 24
• r = 4.4% per year = $992.43

The bond pays coupon semi-annually.

Example 2: Semi annual coupons
• Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of $1000, 5
years to maturity and the yield to maturity is 6%
• What is the semiannual coupon payment
10%x1000/2 = $50
• How many periods (n) are there?
n = 5 x 2 = 10
• What is r?
r = 6%/2=3%
• What is the bond’s price?
25
Example 2: Semi-annual coupons

 
 
C/2  1  M
P0   1 
r/2   r
2 n 
 r
2 n
 1    1  
  2    2

 
$ 100 / 2  1  $ 1000
=  1   +
0.06 / 2  (1 + 0.06 25  (1 + 0.06 25
) )
 2  2
= $ 426 .51  $744 .09
 $ 1170 .60
26
4.2 Bond prices and interest rates

• Time to maturity: bond prices converge to par value

(plus final coupon) with the passage of time.
• Interest rates: bond prices and interest rates move in
opposite directions, they are inversely related.
• Changes in interest rates have a larger impact on
long-term bonds than on short-term bonds.
• Bond price = present value of coupons + present value
of principal.

27
Figure 4.2 The relationship between bond prices
and required returns for bonds with differing times
to maturity but the same 6% coupon rate

$1162.22

$865.8

28
Figure 4.2 The relationship between bond
prices and required returns for bonds with
differing times to maturity but the same 6%
coupon rate

29
Bond Price Sensitivity to YTM: The
Price-Yield Relationship
Bond price

$1,800
Coupon = $100
20 years to maturity
$1,600 $1,000 face value
Key Insight: Bond prices and YTMs 
$1,400 are inversely related.
$1,200 When we say that the bond price is 
negatively related to the market 
$1,000 interest rate, the latter is referred to 
the YTM.
$   800

$   600 Yield to maturity, YTM
4% 6% 8% 10% 12% 14% 16%

30
4.2 Inflation and Interest Rates
• Inflation is the rate at which the general level of prices
for goods and services is rising and, consequently,
the purchasing power of currency is falling.
• Suppose you have $100 today (at t = 0) which could pay
for 1 microwave oven. The price of the oven is $100/unit.
• You can deposit the money at the interest rate of 5% and
purchase it next year (at t = 1).
• Assume that the price of the oven rises to $103/unit at
t=1 due to the inflation of 3%.
• How many units of the same brand microwave oven you
can purchase at t = 1?
$100*(1  5%)
 1.0194 units 31
$103
Inflation and Interest Rates
• The relationship between nominal (observed) and real
(inflation-adjusted) interest rates follows the equation:
1  rnominal
1  rreal 
1  inflation
• That is, inflation “eats into” your savings. In the previous
example, 1  5%
1  rreal  1.0194
1  3%
rreal 1.0194 1 1.94%

• Approximately,
rreal  rnominal  inflation
32
Real Interest Rate
• Currently, the best interest rate for a 12-month term
deposit in Australia is about 2.90%.
• The expected inflation rate is about 1.7%.
• If you consider to put some money in the term deposit,
what is the expected real interest rate?
1  rnom
1 rreal  (This formula is called the Fisher Equation.)
1  inflation
1  2.9%
1  rreal  1.011799
1  1.7%
rreal  1.18%

Or, roughly, the expected real interest rate equals 2.9% -

1.7% =1.2%, which is low by historical standards. 33
4.3 Types of Bonds: By issuer

• Usually with par $1000 and

Corporate semiannual coupon
bonds • Bonds if maturity > 10 years; notes if
maturity < 10 years

• If < 1 year to maturity, short-term

bonds are called Treasury bills
Australian
• If between 1 year and 10 years to
Government maturity: Treasury notes
bonds • If > 10 years to maturity: Treasury
bonds
• Used to fund budget deficits 34
4.3 Types of Bonds: By features
• Floating-rate bond: coupon tied to prime
rate, Australian Government Bond Rate ,
Fixed vs Bill Bank Swap Rate, LIBOR, other interest
rates.
floating rates • Floating rate = benchmark rate + spread.
• Floating rate can also be tied to the inflation
rate: Capital Indexed Bonds, for example.

• Unsecured bonds (debentures) are backed

only by general faith and credit of issuer.
Secured vs • Debenture bonds are secured bonds
backed by specific assets (collateral).
unsecured • Examples are mortgage bonds, collateral
bonds trust bonds, equipment trust certificates
which are bonds secured by real estate ,
financial assets held in trust or
transportation equipment. 35
ASX
Table 4.3 Bond ratings

Moody’s handbook, Credit rating of countries

36
High-yield Bonds
• High-yield bonds are also called junk bonds.
• Bonds rated below investment grade are junk bonds
or high-yield bonds. See Table 4.3.
• Some are fallen angels: bonds received investment-
grade when first issued but later fell to junk status.
• Others are speculative grades to start with.
• The prices of junk bonds can be very volatile ---
futile ground for speculators.
• Recommended background reading: Merchants of
Debt, by George Anders.
37
4.5 Term structure of interest
rates
• Relationship between yield and maturity is called
the term structure of interest rates
• Graphical depiction called a yield curve
• Usually, yields on long-term securities are higher than on
short-term securities
• Generally look at risk-free Treasury debt securities

• Yield curves are normally upwards-sloping

• Long yields > short yields
• Can be flat or even inverted (i.e. downwards sloping) during
times of high financial uncertainty

Demand of long term  Long term interest rates  38
borrowing decreases drop
39*
What’s the shape of the yield
curve currently?
• See the current data from Bloomberg:
https://www.bloomberg.com/markets/rates-
bonds/government-bonds/australia

• The yield curve is upwardly sloped.

• All bonds listed there are sold at premium because the

YTM is less than the coupon rates, indicating the decline
in interest rates over the last few years.

• Usually when a coupon bond is issued, its price is equal 40

to or close to the par value (=100).
Topic 3 - Part 2

Long-Term Debt
Chapter 14

41
14.1 Characteristics of long-
term debt financing
• Must be registered with ASIC
(Australian Securities and Investments
Public issue Commission)
• Almost always issued with the help of
investment bankers
• Vast majority are fixed rate offerings

Loans: private debt agreements with

financial institution
Private • Term loans or syndicated loans
issue • Most are floating-rate issues, with the
rate set as a fixed spread from some
base interest rate
Private placements: unregistered 42
issues sold directly to accredited
investors
14.1 Loan covenants
• Loan covenants are contractual clauses within debt
agreements that constrain borrowers’ actions.
• Often borrowers have a certain period of time to take actions
to remedy the technical default, but it often lowers the
borrower's credit rating.
Things the borrower ‘must do’, such as:
• Maintain satisfactory accounting records in
Positive accordance with GAAP.
covenants • Maintain a minimum level of net working
capital.
• Maintain life insurance on ‘key employees’.
• Spend borrowed funds on a proven financial
need.

Things the borrower ‘must not do’, such as:

Negative • Sell accounts receivable to generate cash.
covenants • Issue additional debt, unless company requires
that additional debt be subordinated. 43
• Avoid certain types of leases or other fixed-
payment obligations.
14.1 Cost of long-term debt
• Determined by at least four factors:
• Yield curves typically slope upward.
Loan maturity • Longer maturities mean longer terms and
so greater exposure to default risk.

• Trade-off between administrative cost per

Loan size dollar and risk exposure that increases with
the loan size.

• The greater the risk of default, the higher

Borrower risk the rate that the lender will charge.

• The greater the prevailing rate on lowest-

Cost of money risk money (such as Australian 44
Government bonds), the greater the rate
on other loans.
14.2 Corporate long-term debt
Institutional debt:

•Private loans from financial institutions.

•Have initial maturities of more than one year.
•Generally have maturities of 5-12 years.

Marketable debt:

•Various corporate bonds

45
14.3 Corporate Bonds
• Debt security carrying a promise to pay cash flows
to the holder.
• Most maturities range from 10-30 years with a par
(face) value of $1,000.

46
NOT COVERED IN CH.14
• Please note that the following areas from
Chapter 14 will not be covered in this trimester
and are not examinable:
• 14.3b Legal Aspects of Corporate Bonds
• 14.3c Methods of issuing bonds
• 14.3d General characteristics of a bond issue
• 14.3e High-yield bonds
• 14.3f International corporate bond financing
• 14.3g Bond refunding options
• 14.4 Leasing 47
Learning outcomes
After studying this topic, you will be able to
• Describe main principle of valuation
• Understand bond & bond valuation
• Explain the relationship between YTM & coupon
rate
• Explain the relationship between bond prices &
interest rates
• Understand the term structure of interest rates
• Understand the characteristics of long term debt
financing (cost of long term debt)
• Describe the types of long term debts (public issue 48
vs private issue)
• End of Week 3 lecture

 Read Chapters 4 and 14 (relevant sections only) and revise

today’s lecture slides and your notes
 Remember to do your scheduled Aplia homework
 Form a team for your Assignment Part 2
 Prepare Chapters 5 and 12 for next week

49