Principles of Business Finance

Lecture 6: Interest Rates and

Bond Valuation

Learning Outcomes
By the end of this lecture, you should be
able to: Understand the importance of bond
features
Calculate bond values and yields
Understand the impact on inflation on
interest rates.
Comprehend the term structure of interest
rates and the determinants of bond yields.

Try this!

Bond

Bond Definition
Beck Corporation wants to borrow $1,000
for 30 years. The interest rate on similar
debt issued by similar corporation is 12%.
- Coupon
- Face value or par value
- Coupon rate
- Maturity

Types of Corporate Bonds

Vanilla Bonds
Zero Coupon Bonds
Convertible Bonds

Bond Valuation
How bonds are price?
1. Estimate the expected future cash
flows.
2. Determine the required rate of return.
3. Compute the discounted present value
of the future cash flows.

Bond Values and Yields

As time passes, interest rates change in the
marketplace.
Cash flows from a bond, stay the same.
As a result, the value of the bond will fluctuate.
When interest rates rise, the present value of the
bonds remaining cash flow declines, the bond is
worth less.
When interest rates fall, the bond is worth more.
This negative relation between changes in interest
rate and price of a bond is a very important relation
in corporate finance.

Think!
Your stockbroker is trying to sell you a
15-year bond with a 7 percent coupon,
and the interest, or yield, on similar
bonds is 10 percent. Is the bond selling
at premium, par or at a discount?

Bond Values and Yields

Interest rate required in the market on a bond
is called the bonds yield to maturity (YTM).
Bonds YTM should not be confused with its
current yield.
Current yield = annual coupon/price
Current yield is usually higher/lower than the
YTM in that it considers only the coupon
portion of the return and does not consider
the built-in gain/loss from the price of the
bond.

Yield To Maturity
Is the discount rate that makes the present
value of the coupon and principal payments
equal to the price of the bond.
YTM is viewed as a promised yield.
A bonds yield to maturity changes daily as
interest rates increase or decrease, but its
calculation is always based on the issuers
promise to make interest and principal
payments as stipulated in the bond contract.

Valuing a Discount Bond with Annual

Coupons
Consider a bond with a coupon rate of 10% and annual
coupons. The par value is $1,000, and the bond has 5
years to maturity. The yield to maturity is 11%. What
is the value of the bond?

Valuing a Premium Bond with Annual

Coupons
Suppose you are reviewing a bond that has a 10%
annual coupon and a face value of $1000. There are
20 years to maturity, and the yield to maturity is 8%.
What is the price of this bond?

Bond Price

Graphical Relationship Between Price and Yieldto-maturity (YTM)

Yield-to-maturity (YTM)

Bond Prices: Relationship Between

Coupon and Yield
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
Why? The discount provides yield above coupon rate
Price below par value, called a discount bond

If YTM < coupon rate, then par value < bond price
Why? Higher coupon rate causes value above par
Price above par value, called a premium bond

The Bond Pricing Equation

1
1
t

(1 r)
Bond Value C
r

FV

t
(1 r)

Example: Semiannual Coupons

An ordinary bond has a coupon rate of 14%,
the yield to maturity is quoted at 16% and the
bond matures in seven years.
Find present values based on the payment
period

How many coupon payments are there?

What is the semiannual coupon payment?
What is the semiannual yield?
B = 70[1 1/(1.08)14] / .08 + 1,000 / (1.08)14 =
917.56

7-17

Interest Rate Risk

Risk that arises for bond owners from
fluctuating interest rates is called rate risk.
How much interest rate risk a bond has
depends on how sensitive its price is to
interest changes.
This sensitivity directly depends on two
things:-
-

Interest Rate Risk

Two things to keep in mind:-

Interest Rate Risk

Exhibit 8.3: Relation between Bond

Price Volatility and Coupon Rate

Computing Yield to Maturity

Yield to Maturity (YTM) is the rate
implied by the current bond price.
Finding the YTM requires trial and
error if you do not have a financial
calculator and is similar to the process
for finding r with an annuity.
It can also be calculated using the
interpolation method.

Computing Yield to Maturity Annual

Coupons
Consider a bond with a 10% annual coupon
rate, 15 years to maturity and a par value of
$1,000. The current price is $928.09.
Will the yield be more or less than 10%?
B = 100[1 1/(1.10)15] / .11 + 1,000 / (1.10)15 =
928.09
YTM = 11%

Computing Yield to Maturity Semiannual Coupons

Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of
$1,000, 20 years to maturity and is selling for
$1,197.93.
Is the YTM more or less than 10%?
What is the semiannual coupon payment?
How many periods are there?
B = 50[1 1/(1.04)40] / .04 + 1,000 / (1.04)40 =
1,197.93
YTM = 4%*2 = 8%

Summary of Bond Valuation

Questions
Basic (page 254)
Q. 2: Suppose you buy a 7% coupon, 20-year
bond today when it is first issued. If
interest rates suddenly rise to 15%, what
happens to the value of your bond? Why?

Price and yield move in opposite directions; if interest

rates rise, the price of the bond will fall. This is
because the fixed coupon payments determined by the
fixed coupon rate are not as valuable when interest
rates risehence, the price of the bond decreases.

Questions
Q. 3 Staind, Inc., has 7.5% coupon bonds
on the market that have 10 years left to
maturity. The bonds makes annual
payments. If the YTM on these bonds is
8.75%, what is the current bond price?
P = $75(PVIFA8.75%,10) + $1,000(PVIF8.75%,10)
= $918.89

Questions
Q.4 Ackerman Co. has 9 percent coupon
bonds on the market with nine years left to
maturity. The bonds make annual payments.
If the bond currently sells for $934 , what
is its YTM?
P = $934 = $90(PVIFAR%,9) + $1,000(PVIFR%,9)
YTM = 10.15%