Chapter

Fundamentals of
Corporate Finance
Fourth Edition

Valuing Bonds

Slides by
Matthew Will

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 2

Topics Covered
Bond Characteristics
reading

the financial pages

Bond Prices and Yields

Bond

prices and interest rates

YTM vs. current yield
Rate of Return
Interest Rate Risk
The Yield Curve
Nominal and Real Rates of Interest
Default Risk
Variations in Corporate Bonds
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 3

Bonds
Terminology
Bond - Security that obligates the issuer to
make specified payments to the bondholder.
Coupon - The interest payments made to the
bondholder.
Face Value (Par Value or Maturity Value) - Payment
at the maturity of the bond.
Coupon Rate - Annual interest payment, as a
percentage of face value.
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 4

Bonds
WARNING
The coupon rate IS NOT the discount rate
used in the Present Value calculations.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 5

Bonds
WARNING
The coupon rate IS NOT the discount rate
used in the Present Value calculations.
The coupon rate merely tells us what cash flow the
bond will produce.
Since the coupon rate is listed as a %, this
misconception is quite common.
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 6

Bond Pricing
The price of a bond is the Present Value of
all cash flows generated by the bond (i.e.
coupons and face value) discounted at the
required rate of return.

cpn
cpn
(cpn par )
PV

....
1
2
t
(1 r ) (1 r )
(1 r )

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 7

Bond Pricing
Example
What is the price of a 6.5 % annual coupon bond,
with a $1,000 face value, which matures in 3
years? Assume a required return of 3.9%.

65
65
1,065
PV

1
2
(1.039) (1.039) (1.039) 3
PV $1,072.29

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 8

Bond Pricing
Example (continued)
What is the price of the bond if the required rate
of return is 6.5 %?

65
65
1,065
PV

1
2
3
(1.065) (1.065) (1.065)
PV $1,000

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 9

Bond Pricing
Example (continued)
What is the price of the bond if the required rate
of return is 15 %?

65
65
1,065
PV

1
2
(1.15) (1.15) (1.15) 3
PV $805.93

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 10

Bond Pricing
Example (continued)
What is the price of the bond if the required rate
of return is 6.0% AND the coupons are paid
semi-annually?

32.50
32.50
32.50
1,032.50
PV

...

1
2
5
(1.0195) (1.0195)
(1.0195) (1.0195) 6
PV $1,072.94

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 11

Bond Pricing
Example (continued)
Q: How did the calculation change, given semiannual coupons versus annual coupon payments?

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 12

Bond Pricing
Example (continued)
Q: How did the calculation change, given semiannual coupons versus annual coupon payments?
Time Periods

Discount Rate

Paying coupons twice a

year, instead of once
doubles the total number of
cash flows to be discounted
in the PV formula.

Since the time periods are

now half years, the
discount rate is also
changed from the annual
rate to the half year rate.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 13

Bond Yields
Current Yield - Annual coupon payments
divided by bond price.
Yield To Maturity - Interest rate for which
the present value of the bonds payments
equal the price.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 14

Bond Yields
Calculating Yield to Maturity (YTM=r)
If you are given the price of a bond (PV)
and the coupon rate, the yield to maturity
can be found by solving for r.

cpn
cpn
(cpn par )
PV

....
1
2
t
(1 r ) (1 r )
(1 r )

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 15

Bond Yields
Example
What is the YTM of a 6.5 % annual coupon bond,
with a $1,000 face value, which matures in 3
years? The market price of the bond is $1,072.29.

65
65
1,065
PV

1
2
3
(1 r ) (1 r ) (1 r )
PV $1,072.29
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 16

Bond Yields
WARNING
Calculating YTM by hand can be very
tedious.
It is highly recommended that you learn to
use the IRR or YTM or i functions on
a financial calculator.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 17

Bond Yields
Rate of Return - Earnings per period per
dollar invested.
total income
Rate of return =
investment
Coupon income + price change
Rate of return =
investment
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 18

Bond Valuation Spreadsheet

Valuing bonds using a spreadsheet
6.5 % coupon
maturing May 2005
Settlement date
Maturity date
Annual coupon rate
Yield to maturity
Redemption value (% of face value)
Coupon payments per year
Bond price (% of par)

5/15/02
5/15/05
0.065
0.039
100
1
107.229

6% coupon
10-year maturity
1/1/00
1/1/10
0.06
0.07
100
1
92.976

=PRICE(B7,B8,B9,B10,B11,B12)

Esc and Double click on spreadsheet to access

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 19

Bond Yield Spreadsheet

Finding yield to maturity using a spreadsheet
May 2005 maturity bond, coupon rate = 6.5%, maturity = 3 years

Annual coupons
Settlement date
Maturity date
Annual coupon rate
Bond price
Redemption value (% of face value)
Coupon payments per year
Yield to maturity (decimal)

5/15/02
5/15/05
0.065
107.229
100
1
0.04

Semiannual coupons
5/15/02
5/15/05
0.065
107.229
100
2
0.0392

=YIELD(B7,B8,B9,B10,B11,B12)

Esc and Double click on spreadsheet to access

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 20

Interest Rate Risk

1,080

Price path for

Premium Bond

1,060
1,040

Bond Price

1,020
1,000
980
960
940

Today

900

Maturity

Price path for

Discount Bond

920

880
0

10

15

20

25

Time to Maturity
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

30

5- 21

Interest Rate Risk

3,000

When the interest rate equals

the 6.5% coupon rate, both
bonds sell at face value

2,500

30 yr bond
$ Bond Price

2,000

1,500

1,000

3 yr bond

500

YTM

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 22

Nominal and Real rates

16
14

Yield on UK
nominal bonds

12

Percent

10
8

Yield on UK
indexed bonds

6
4
2

2000

97

94

91

88

85

82

Year
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 23

Default Risk
Credit risk
Default premium
Investment grade
Junk bonds

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 24

Default Risk
Moody' s

Standard
& Poor's

Aaa

AAA

Aa

AA

Baa

BBB

Ba
B

BB
B

Caa
Ca
C

CCC
CC
C

Irwin/McGraw Hill

Safety

The strongest rating; ability to repay interest and principal

is very strong.
Very strong likelihood that interest and principal will be
repaid
Strong ability to repay, but some vulnerability to changes in
circumstances
Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Considerable uncertainty about ability to repay.
Likelihood of interest and principal payments over
sustained periods is questionable.
Bonds in the Caa/CCC and Ca/CC classes may already be
in default or in danger of imminent default
C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 25

Corporate Bonds
Zero coupons
Floating rate bonds
Convertible bonds

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 26

The Yield Curve

Term Structure of Interest Rates - A listing of
bond maturity dates and the interest rates
that correspond with each date.
Yield Curve - Graph of the term structure.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

5- 27

Web Resources
Click to access web sites
Internet connection required
www.investinginbonds.com
www.moodys.com/cust/default.asp
www.standardandpoor.com
http://gozips.uakron.edu/~drd/ratings.html
www.smartmoney.com/bonds
www.ustreas.gov
www.ustreas.gov/offices/domestic-finance/debt-management/interestrate/index.html
www.bondmarkets.com
www.publicdebt.treas.gov/sec/sec.htm
www.bondsonline.com/asp/research/glossary.asp
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights