Chapter 3

VALUING BONDS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS

C1 C2 1,000 C N
PV ...
(1 r ) (1 r )
1 2
(1 r ) N

3-2
3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
Example
Today is October 1, 2010; what is the value of the
following bond? An IBM bond pays $115 every
September 30 for five years. In September 2015 it
pays an additional $1,000 and retires the bond. The
bond is rated AAA (WSJ AAA YTM is 7.5%).

115 115 115 115 1,115

PV
1.075 1.075 1.075 1.075 1.0755
2 3 4

$1,161.84

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3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
Example: France
In October 2011 you purchase 100 euros of
bonds in France which pay a 5% coupon every
year. If the bond matures in 2016 and the YTM
is 2.4%, what is the value of the bond?

5 5 5 5 105.0
PV
1.024 1.024 2 1.024 3 1.024 4 1.024 5
112.11

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3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
Another Example: Japan
In July 2010 you purchase 200 yen of bonds in
Japan which pay an 8% coupon every year. If
the bond matures in 2015 and the YTM is
4.5%, what is the value of the bond?

16 16 16 16 216
PV
1.045 1.0452
1.045 1.045 1.0455
3 4

243.57

3-5
3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
Example: USA
In February 2012 you purchase a three-year
U.S. government bond. The bond has an annual
coupon rate of 11.25%, paid semiannually. If
investors demand a 0.085% semiannual return,
what is the price of the bond?

56.25 56.25 56.25 56.25 56.25 1056.25

PV
1.00085 1.000852 1.000853 1.000854 1.000855 1.000856
$1,331.40

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3-2 HOW BOND PRICES VARY WITH INTEREST
RATES
Example, Continued: USA
Take the same three-year U.S. government
bond. If investors demand a 4.0% semiannual
return, what is the new price of the bond?

PV 56.25 56.25 56 .25 56.25 56.25 1056 .25

5
1.04 1.04 1.04 1.04 1.04
2 3 4
1.046

$1203.05

3-7
FIGURE 3.1 INTEREST RATE ON 10-YEAR
TREASURIES
16

14

12

10
Yield, %

Year
3-8
3-2 HOW BOND PRICES VARY WITH INTEREST
RATES
115.00

110.00

105.00
Bond price

100.00

95.00

90.00

85.00

80.00

Interest rate, %

3-9
FIGURE 3.2 MATURITY AND PRICES
5000

4500

4000
When interest rate =
3500
11.25% coupon, both
bonds sell for face
Bond price

3000
value
2500

2000

1500

1000

500

0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Interest rate, %
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BOND DURATION
Full name: Macaulay duration
It is the weighted average of the times to each of
the cash payments.
The times are future years 1, 2, 3, until the
maturity date.
The weight is the percentage of the bonds PV
received in each year.
Modified Duration is commonly used to find
price change when there is a 1% change in
yield.
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3-2 HOW BOND PRICES VARY WITH INTEREST
RATES

1 PV(C1 ) 2 PV(C2 ) 3 PV(C3 ) T PV(CT )

Duration ...
PV PV PV PV

duration
Modified duration volatility (%)
1 yield

Modified duration measures the percentage change in bond price for a 1%

change in yield.

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3-2 DURATION CALCULATION
Year Payment PV(Ct) at Fraction of Total Year fraction of
Ct 4.0% Value total value
[PV(Ct)/V] [t PV(Ct)/PV]

1 $90 $86.54 0.0666 0.0666

2 90 83.21 0.0640 0.1280
3 90 80.01 0.0615 0.1846
4 90 76.93 0.0592 0.2367
5 90 73.97 0.0569 0.2845
6 90 71.13 0.0547 0.3283
7 1090 828.31 0.6371 4.4598

PV = Total = duration =
$1300.10 5.60

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3-3 TERM STRUCTURE OF INTEREST RATES
Short- and long-term rates are not always parallel
September 1992April 2000: U.S. short-term
rates rose sharply while long-term rates declined

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3-3 TERM STRUCTURE OF INTEREST RATES

YTM (r)

1981
1987 & Normal

1976
1 5 10 20 30 Year

Spot Rate: Actual interest rate today (t = 0)

Forward Rate: Interest rate, fixed today, on future loan at
fixed time
Future Rate: Spot rate expected in future

Yield To Maturity (YTM): IRR on interest-bearing instrument

3-15
3-3 YIELD TO MATURITY

Example
$1,000 Treasury bond expires in 5
years. Pays coupon rate of 10.5%.
What is YTM if market price is 107.88?

C0 C1 C2 C3 C4 C5
1078.80 105 105 105 105 1105

Calculate IRR = 8.5%

3-16
3-5 INFLATION AND INTEREST RATES
Classical theory of interest rates was
developed by Irving Fisher:
(1+R) = (1+r)(1+h)
Roughly: Nominal Interest Rate = real rate + expected
inflation
What determine expected inflation? Real rate?

r
Supply

Real r

Demand
$ Qty

3-17
 Annual inflation, %

10
15
20
25

0
5

-5

-15
-10
1900
1904
1908
1912
1900-2011

1916
1920
1924
1928
1932
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
FIGURE 3.5 ANNUAL U.S. INFLATION RATES,

1996
2000
2004
2008
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 Average inflation, %

10
12

0
2
4
6
8
Switzerland

Netherlands

U.S.

Canada

Sweden

New Zealand

Norway

Australia

Denmark

U.K.

Ireland

Average

South Africa
Germany ex
1922/23
Belgium

Spain

France

Finland

Japan

Italy
FIGURE 3.6 GLOBAL INFLATION RATES, 1900-2011

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3-5 DEBT AND INTEREST RATES

Nominal r = Real r + expected

inflation (approximation)
Real r theoretically somewhat stable
Inflation is a large variable
Term structure of interest rates shows
cost of debt

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3-5 DEBT AND INTEREST RATES

Debt and Interest Formula:

1 rnominal (1 rreal) (1 h)

3-21
3-6 THE RISK OF DEFAULT

Corporate Bonds and Default Risk

Payments promised to bondholders
represent best-case scenario
Most bonds safety judged by bond ratings

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TABLE 3.6 PRICES AND YIELDS OF CORPORATE
BONDS, 01/2011

Price, % of Yield to
Issuer Coupon Maturity S&P Rating Face Value Maturity
Johnson &
Johnson 5.15% 2017 AAA 122.88% 1.27%
Walmart 5.38 2017 AA 117.99 1.74
Walt Disney 5.88 2017 A 121.00 2.07
Suntrust Banks 7.13 2017 BBB 109.76 4.04
U.S. Steel 6.05 2017 BB 97.80 6.54
American
Stores 7.90 2017 B 97.50 8.49
Caesars
Entertainment 5.75 2017 CCC 41.95 25.70

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TABLE 3.7 BOND RATINGS

Standard & Poor's

Moody's
and Fitch
Investment grade bonds
Aaa AAA
Aa AA
A A
Baa BBB
Junk bonds
Ba BB
B B
Caa CCC
Ca CC
C C

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3-6 THE RISK OF DEFAULT

Sovereign Bonds and Default Risk

Sovereign debt is generally less risky than
corporate debt
Inflationary policies can reduce real value
of debts

3-25
3-6 THE RISK OF DEFAULT

Sovereign Bonds and Default Risk

Foreign Currency Debt
Default occurs when foreign government
borrows dollars
If crisis occurs, governments may run out of
taxing capacity and default
Affects bond prices, yield to maturity

3-26
3-6 THE RISK OF DEFAULT

Sovereign Bonds and Default Risk

Own Currency Debt
Less risky than foreign currency debt
Governments can print money to repay bonds

3-27