Chapter 6

The Valuation and

Characteristics of Bonds
Slides developed by:
Pamela L. Hall, Western Washington University

The Basis of Value

Securities are worth the present value of

the future cash income associated with
owning them

The security should sell in financial markets

for a price very close to that value
However, I might think Security A has a different
intrinsic value then someone else thinks, because
we have different estimates for the
Discount rate
Expected future cash flows

The Basis for Value

Investing

Using a resource to benefit the future rather than

for current satisfaction
Putting money to work to earn more money
Common types of investments
Debtlending money
Equitybuying an ownership in a business

A return is what the investor receives divided

by what s/he invests
Debt investors receive interest

The Basis for Value

Rate of return is the interest rate that

equates the present value of its expected
future cash flows with its current price
return
PV = FV (1 + k)
Return is also known as

Yield
Interest

Bond Valuation

A bond issue represents borrowing from

many lenders at one time under a single
agreement

While one person may not be willing to lend a

single company $10 million, 10,000 investors
may be willing to lend the firm $1,000 each

Bond Terminology and Practice

A bonds term (or maturity) is the time from the

present until the principal is to be returned

Bonds mature on the last day of their term

A bonds face value (or par) represents the

amount the firm intends to borrow (the principal)
at the coupon rate of interest

Bonds typically pay interest (coupon rate) every six

months
Bonds are non-amortized (meaning the principal is
repaid at once when the bond matures rather than
being repaid in increments throughout the bonds life)
6

Interest Rates for Various Treasury

Securities of Differing Maturities

Interest Rate (Annualized)

Interest Rates for Various Treasury

Securities of Differing Maturities
10
9
8
7
6
5
4
3
2
1
0
1990

Note that bonds with a longer

maturity generally have a
higher interest rate and that
interest rates on Treasury
securities move in tandem.
3-Month Treasury Bill
30-Year Treasury Bond
1-Year Treasury Bill

1992

1994

1996

1998

2000

Date

Bond ValuationBasic Ideas

Adjusting to interest rate changes

Bonds are sold in both primary (original sale)
and secondary markets (subsequent trading
among investors)
Interest rates change all the time
Most bonds pay a fixed interest rate

What happens to the price of a bond paying a

fixed interest rate in the secondary market when
interest rates change?

Bond ValuationBasic Ideas

You buy a 20 year, $1000 par bond today for par (meaning you pay
$1,000 for it) when the coupon rate is 10%

This implies that your required rate of return was 10%

For that purchase price, you are promised 20 years of coupon
payments of $100 each, and a principal repayment of $1,000 in 20
years

After youve held the bond investment for a week, you decide that
you need the money (cash) more than you need the investment

You decide to sell the bond

Unfortunately, interest rates have risen
Other investors now have a required rate of return of 11%
They can buy new bonds with an 11% coupon rate in the market for $1,000
Will they buy your bond from you for $1,000?
NO! Theyll buy it for less than $1,000

Determining the Price of a

Bond
Remember, Intrinsic Value is the present
value of all future expected cash flows
With a bond, predicting the future cash
flows is somewhat easy, because the
promised cash flows are specified.

Interest (usually)
Principal (usually)
Maturity (in years)

In practice most
bonds pay
interest semiannually.

10

Determining the Price of a

Bond

Example

Q: A bond has 10 years to maturity, a par value of

$1,000, and a coupon rate of 10%. What cash flows
are expected from the bond?
A:
0

$100

a year for 10 years

10

$100
$1,000

$1,100

11

Determining the Price of a

Bond

The Bond Valuation Formula

The price of a bond is the present value of a

stream of interest payments plus the present
value of the principal repayment
PB PV(interest payments) + PV(principal repayment)
Interest payments are annuities--can use
the present value of an annuity formula:
PMT[PVFAk,n ]

Principal repayment is a lump sum in the

future--can use the future value formula:
FV[PVFk, n ]

12

Figure 6.1: Cash Flow Time

Line for a Bond

This is an
ordinary
annuity.

This is a
single
sum.

13

Determining the Price of a

Bond

Two Interest Rates and One More

Coupon rate
Determines the size of the interest payments

Kthe current market yield on comparable bonds

The appropriate discount rate that makes the present value
of the payments equal to the price of the bond in the market
AKA yield to maturity (YTM)

Current yieldannual interest payment divided by

bonds current price

14

Solving Bond Problems with a

Financial Calculator

Financial calculators have five time value of money keys

With a bond problem, all five keys are used

Nnumber of periods until maturity

Imarket interest rate
PVprice of bond
FVface value (par) of bond
PMTcoupon interest payment per period
With calculators that have a sign convention the PMT and FV must be of
one sign while the PV will be the other sign

The unknown will be either the interest rate or the present value

When solving for the interest rate, the price of the bond must be
inputted as a negative value while the PMT and FV must be inputted as
a positive value

Sophisticated calculators have a bond mode allowing easy

calculations dealing with accrued interest

15

Determining the Price of a

BondExample

Example

Q: The Emory Corporation issued an 8%, 25-year bond 15 years ago. At the time
of issue it sold for its par (face) value of $1,000. Comparable bonds are yielding
10% today. What must Emorys bond sell for in todays market to yield 10%
(YTM) to the buyer? Assume the bond pays interest semiannually. Also
calculate the bonds current yield.
A: We need to solve for the present value of the bonds expected cash flows at
todays interest rate. Well use Equation 6.4 to do so:

PB PMT[PVFA k, n ] + FV[PVFk, n ]
The payment is 8%
x $1,000, or $80
annually. However,
it is received in the
form of $40 every
six months.

The future value is

the principal
repayment of $1,000.

K represents the periodic current

market interest rate, or 10% 2.

N represents the
number of interestpaying periods until
maturity, or 10 years
x 2 = 20.

16

Bond Example
A: Substituting the correct values into the equation gives us:

Example

PB $40[PVFA 5%, 20 ] + $1,000[PVF5%, 20 ]

$40[12.4622] + $1,000[0.3769]
$498.49 $376.90
This could also be calculated
$875.39
via a financial calculator:

This is the price at

which the bond must sell
to yield 10%. It is
selling at a discount because
the current interest rate
is above the coupon rate.
The bonds current yield is
$80 $875.39, or 9.14%.

20

PV

-875.39

FV

1000

Answer

PMT 40
I/Y

5
17

Maturity Risk Revisited

Relates to term of the debt

Longer term bonds fluctuate more in

response to changes in interest rates than
shorter term bonds

AKA price risk and interest rate risk

As time passes, if interest rates dont
change the price of a bond will approach
its par

18

Table 6.1

19

Maturity Risk Revisited

Comparison of Bonds With Differing Coupons
$1,400.00
$1,200.00

Price

$1,000.00

Zero Coupon

$800.00

10% Coupon

$600.00

15% Coupon

$400.00
$200.00
$0.00
0

10

Time Remaining Until Maturity

20

Finding the Yield at a Given

Price

Weve been calculating the intrinsic value

of a bond, but we could calculate the bond
yield (based on its current value in the
market) and compare that yield to our
required rate of return

PB PMT PVFAk, n + FV PVFk, n

Involves solving for k, which
is more complicated because
it involves both an annuity
and a FV

Use trial and error to solve

for k, or use a financial
calculator.

21

Example

Finding the Yield at a Given

PriceExample
Q: The Benson Steel Company issued a 30-year bond 14 years ago with a
face value of $1,000 and a coupon rate of 8%. The bond is currently
selling for $718. What is the yield to an investor who buys it today at
that price? (Assume semiannual interest.)
A: Since the bond is now selling below par we can make an educated
guess about the yield. As interest rates rise, bond prices fall, so the
yield must be above 8%. Using a guess of 10% and applying Equation
6.4 we obtain:

PB PMT PVFA k, n + FV PVFk, n

$40 PVFA 5, 32 + $1,000 PVF5, 32
$40 15.8027 + $1,000 0.2099
$842.01

Clearly, 10% is not

high enough.
Recalculating the
price of the bond at
14% gives us
$620.56, which means
that 14% is too high.
The correct answer is
12%.

22

Call Provisions

If interest rates have dropped substantially since a bond

was originally issued, a firm may wish to refinance, or
retire their old high interest bond issue
However, the issuing corporation would have to get all
the bondholders to agree to this

From the bondholders viewpoint, this could be a bad ideathey

would be giving up high coupon bonds and would have to
reinvest their cash in a market with lower interest rates

To ensure that the corporation can refinance their bonds

should they wish to do so, the corporation makes the
bonds callable

23

Call Provisions
Call provisions allow bond issuers to retire
bonds before maturity by paying a
premium (penalty) to bondholders
Many corporations offer a deferred call
period (meaning the bond wont be called
for at least x years after the initial issuing
date)

Known as the call-protected period

24

Call Provisions

The Effect of A Call Provision on Price

When valuing a bond that is probably going to

be called when the call-protected period is
over
Cannot use the traditional bond valuation
procedure
Cash flows will not be received through maturity
because bond will probably be called

25

Figure 6.5: Valuation of a

Bond Subject to Call

26

Call Provisions

Valuing the Sure-To-Be-Called Bond

Requires that two changes be made to bond

valuation formula
PB PMT[PVFA k, n ] + FV[PVFk, n ]
The future value
becomes the call
price (face value plus
call premium).

N now represents
the number of
periods until the
bond is likely to be
called.

27

The Refunding Decision

When current interest rates fall below the

coupon rate on a bond, company has to
decide whether or not to call in the issue

Compare interest savings of issuing a new

bond to the cost of making the call
Calling in the bond requires the payment of a call
premium
Issuing a new bond to raise cash to pay off the old
bond requires payment of administrative expenses
and flotation costs

28

Dangerous Bonds with

Surprising Calls

Some bonds have contingency call

features buried in the fine print

For instance, some issuers would like to retire

a portion of their bond issue periodically
Versus paying a huge principal repayment on the
entire issue at maturity

This feature does not require a call provision

Rather, those bondholders who must retire their
bond are determined by lottery

29

Risky Issues

Sometimes bonds sell for a price far below what

valuation techniques suggest

Investors are worried that company may not be able

to pay promised cash flows

Valuation model should determine a price

similar to the market price if the correct discount
rate is used

Riskier loans should be discounted at a higher

interest rate leading to a lower calculated price

30

Convertible Bonds

Unsecured bonds that are exchangeable for a fixed

number of shares of the companys stock at the
bondholder's discretion

Conversion ratio represents the number of shares of

stock that will be received for each bond
Conversion price is the implied stock price if bond is
converted into a certain number of shares

Allows bondholders to participate in a stocks price appreciation

should the firm be successful

Usually set 15-30% higher than the stocks market value at the
time the bond is issued

Can usually be issued at lower coupon rates

31

Convertible Bonds

The effect of conversion on financial statements

and cash flow

Upon conversion an accounting entry removes the

convertible bonds from long-term debt and places it
into the equity accounts
There is no immediate cash flow impact, but ongoing
cash flow implications exist
Interest payments will stop
If the firms stock pays a dividend the newly created shares
are entitled to those dividends

Improves debt management ratios

32

Advantages of Convertible
Bonds

To issuing companies

Convertible features are sweeteners that let the firm

pay a lower interest rate (coupon)
Can be viewed as a way to sell equity at a price
above market
Convertible bonds usually have few or no restrictions

To buyers

Offer the chance to participate in stock price

appreciation
Offer a way to limit risk associated with a stock
investment

33

Forced Conversion

A firm may want its bonds to be converted

because

Eliminates interest payments on bond

Strengthens balance sheet

Convertible bonds are always issued with call

features which can be used to force conversion
Issuers generally call convertibles when stock
prices rise to 10-15% above conversion prices

Rational investors will convert if the conversion value

is greater than the call value

34

Valuation (Pricing)
Convertibles

A convertibles price can depend on

Its value as a traditional bond or
The market value of the stock into which it
can be converted

At any stock price the convertible is worth

at least the larger of its value as a bond or
as stock

The market value will be greater due to the

possibility that the stocks price will rise

35

Figure 6.7: Value of a

Convertible Bond

36

Effect on Earnings Per Share

Diluted EPS

Upon conversion convertible bonds cause

dilution in EPS

EPS drops due to the increase in the number

of shares of stock

Thus convertible bonds have the potential

to dilute EPS

Therefore convertible bonds will impact the

calculation of Diluted EPS according to FASB
128

37

Example

Effect on Earnings Per Share

Diluted EPSExample
Q: Montgomery Inc. is a small manufacturer of mens clothing with
operations in Southern California. It issued 2,000 convertible
bonds in 1999 at a coupon rate of 8% and a par value of $1,000.
Each bond is convertible into Montgomerys common stock at
$40 per share. Management expected the stock price to rise
rapidly after the convertible was issued and lead to a quick
conversion of the bond debt into equity. However, a
recessionary climate has prevented that from happening, and
the bonds are still outstanding. In 2003 Montgomery had net
income of $3 million. One million shares of its stock were
outstanding for the entire year, and its marginal tax rate is 40%.
Calculate Montgomerys basic and diluted EPS.
A: Basic EPS is the firms net income divided by the number of
shares outstanding, or $3,000,000 1,000,000 = $3.00.
38

Effect on Earnings Per Share

Diluted EPSExample

Example

Diluted EPS assumes all convertible bonds

are converted at the beginning of the year.
Two adjustments need to be made:
Add

the number of newly converted shares to the

denominator:
Shares

exchanged: Bonds par Conversion price =

$1,000 $25 = 40
Since

each bond can be converted into 40 shares of stock

and there are 2,000 bonds, the newly converted shares
totals 80,000, or 40 x 2,000, bringing the total number of
shares outstanding to 1,080,000.

39

Effect on Earnings Per Share

Diluted EPSExample

Example

Adjust the net income figure in the numerator by the amount

of interest saved:

The 2,000 bonds pay 8% interest on a $1,000 par; therefore

the first will save $160,000 in interest, or .08 x $1,000 x 2,000.

However, the interest expense was tax deductible, so the firms

taxable income will now rise by $160,000, resulting in an
increase in taxes of $64,000, or $160,000 x 40%.

Thus the firms Net Income will rise by $96,000 resulting in a

new Net Income of $3,096,000.

The firms Diluted EPS will be: $3,096,000

1,080,000 = $2.87.

40

Institutional Characteristics of
Bonds

Registration, Transfer Agents, and Owners of

Record

A record of registered securities is kept by a transfer

agent
Payments are sent to owners of record as the dates
as of the dates the payments are made

Bearer bonds vs. registered bonds

Bearer bondsinterest payment is made to the

bearer of the bond
Registered bondsinterest payment is made to the
holder of record

41

Kinds of Bonds

Secured bonds and mortgage bonds

Debentures

Unsecured bonds

Subordinated debentures

Backed by collateral

Lower in priority than senior debt

Junk bonds

Issued by risky companies and pay high interest

rates

42

Bond RatingsAssessing
Default Risk
Bond rating agencies (such as Moodys,
S&P) evaluate bonds (and issuing firms)
and assign a rating to each bond issued
by a corporation
These ratings gauge the probability that
issuers will fail to meet their obligations

43

Bond RatingsAssessing
Default Risk

Why Ratings Are Important

Ratings are the primary measure of the
default risk associated with bonds
Thus, ratings play a big part in the interest
rate that investors demand

The rating a firms bonds receive basically

determines the rate at which the firm can borrow
A lower quality rating implies a higher borrowing rate

44

Bond RatingsAssessing
Default Risk

The differential between the yields on high and

low quality bonds is an indicators of the health
of the economy
The Differential Over Time

The quality differential tends to be larger when

interest rates are generally high
May indicate a recession and marginal firms are more likely
to fail, making them riskier

The Significance of the Investment Grade

Rating

Many institutional investors are prohibited from

trading below-investment-grade bonds
45

Table 6.2

46

Bond IndenturesControlling
Default Risk

As a bondholder, you would like to ensure that

you will receive your promised interest and
principal payments

Bond indentures attempt to prevent firms from

becoming riskier after the bonds are purchased, and
includes such protective covenants as:

Limits to managements salary

Limits to dividends
Maintenance of certain financial ratios
Restrictions on additional debt issues

Sinking funds provide money for the

repayment of bond principal
47

Appendix 6-A: Lease Financing

A lease is a contract giving one party

(lessee) the right to use an asset owned
by another (lessor) for a periodic payment
Individuals may lease houses, apartments
and automobiles
Corporations may lease equipment and real
estate

Approximately 30% of all equipment today is

leased

48

Appendix 6-A: Leasing and

Financial Statements

Originally leasing allowed the lessee to

use the asset without ownership
Lease payments were recognized as
expenses on the income statement
Had no impact on balance sheet

Led to large use of lease financing

Became the leading form of off balance sheet

financing

49

Appendix 6-A: Misleading Results

Off balance sheet financing makes

financial statements misleading
Missed lease payments can cause the firm to
fail just like a missed interest payment on
debt
Thus long-term leases are effectively the
same as debt
Not having leases appear on the balance
sheet can mislead investors to think a firm is
stronger than it is

50

Appendix 6-A: Misleading Results

By the early 1970s concerns led to FASB

13
Prior to FASB 13 an asset was owned by
whoever held its title regardless of who used
the asset
FASB 13 stated that the real owner of an
asset is whoever enjoys its benefits and deals
with the risks and responsibilities

51

Appendix 6-A: Operating and

Capital (Financing) Leases

Under FASB 13 lessees must capitalize

financing leases

Puts the value of leased assets and liabilities

on the balance sheet
Makes the balance sheet similar to what it would
have been had the asset been purchased with
borrowed money

Operating leases can still be listed off the

balance sheet

52

Appendix 6-A: Operating and

Capital (Financing) Leases

Rules that must be met for a lease to be

classified as an operating lease

Lease must not transfer legal ownership to the lessee

at its end
Must not be a bargain purchase option at the end of
the lease
Lease term must be < 75% of the assets estimated
economic life
Present value of the lease payments must be < 90%
of the assets fair market value at the beginning of the
lease

53

Appendix 6-A: Financial Statement

Presentation of Leases by Lessees

Operating leases

No balance sheet entries

Lease payments are treated as an expense
Details must be listed in footnotes

Financing leases

Lessee must record an asset on balance sheet

Lessee must record an offsetting liability
Both of the above amounts are usually the present value of
the stream of committed lease payments
The interest rate is generally the rate the lessee would pay if
it were borrowing money at the time the lease begins

The asset is depreciated while the Lease Obligation

is treated like a loan
54

Appendix 6-A: Leasing from the

Perspective of the Lessor

Lessors are usually banks, finance companies

and insurance companies

Lease payments are calculated to offer the

lessor a given return

Companies buy the equipment and lease it to

customer

The interest rate is called the lessors return or the

rate implicit in the lease

Lessor holds legal titlecan repossess assets if

lessee defaults
Lessors get better treatment in bankruptcy
proceedings than lenders
55

Appendix 6-A: Residual Values

Residual valuethe value of an asset at

the end of the lease term
Lessee may buy the equipment
Lessor may sell it to someone else
Asset may be re-leased (usually only with
operating leases)

Makes lease pricing and return

calculations more complex
Often are important negotiating points
between lessee and lessor

56

Appendix 6-A: Lease Vs. BuyThe

Lessees Perspective

Broad financing possibilities

Equity
Debtavailable through bonds or banks
Leasingavailable through leasing
companies

Should conduct a lease vs. buy

comparison

Choose the lowest cost in a present value

sense
57

Appendix 6-A: The Advantages of

Leasing

No money down

Restrictions

Lenders typically require some downpayment;

whereas lessors usually do not
Lenders usually require covenants/indentures,
whereas lessors have few, if any, restrictions

Easier credit with manufacturers/lessors

Equipment manufacturers sometimes lease their own

products and will lease to marginally creditworthy
customers
58

Appendix 6-A: The Advantages of

Leasing

Avoiding the risk obsolescence

Tax deducting the cost of land

If real estate is leased the lease payment can be

deducted as an expense, whereas if the land is
owned it is not depreciable

Increasing liquiditythe sale and leaseback

Short leases transfer this risk to lessors

A firm may sale an asset (to generate cash) and

lease the same asset backused to free up cash
invested in real estate

Tax advantages for marginally profitable

companies
59

Appendix 6-A: Leveraged Leases

The ability to depreciate an asset reduces taxes

If a company is not making a profit (and not
paying taxes) then depreciation is not saving the
firm any money
A lessor buys equipment but finances a portion
of the price of the equipment (hence, the term
leveraged) and is allowed to depreciate the
leased assets and gain the tax benefits
The lessor passes along some of the benefits to
the lessee in the form of lower lease payments
60