Fundamentals of

Chapter Corporate Finance

Fourth Edition

Valuing Bonds

Slides by
Matthew Will

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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

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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.

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Bonds

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

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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.

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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  r ) (1  r )
1 2
(1  r ) t

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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
 3
(1.039) (1.039) (1.039)
PV  $1,072.29

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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

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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

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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
 ...  
(1.0195) (1.0195) (1.0195) (1.0195) 6
5

PV  $1,072.94

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

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

Time Periods Discount Rate

Paying coupons twice a Since the time periods are
year, instead of once now half years, the
doubles the total number of discount rate is also
cash flows to be discounted changed from the annual
in the PV formula. rate to the half year rate.
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Bond Yields

Current Yield - Annual coupon payments

divided by bond price.
Yield To Maturity - Interest rate for which
the present value of the bond’s payments
equal the price.

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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  r ) (1  r )
1 2
(1  r ) t

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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  r ) (1  r ) (1  r )3
1 2

PV  $1,072.29

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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.

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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

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Bond Valuation Spreadsheet

Valuing bonds using a spreadsheet

6.5 % coupon 6% coupon

maturing May 2005 10-year maturity

Settlement date 5/15/02 1/1/00

Maturity date 5/15/05 1/1/10
Annual coupon rate 0.065 0.06
Yield to maturity 0.039 0.07
Redemption value (% of face value) 100 100
Coupon payments per year 1 1

Bond price (% of par) 107.229 92.976

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

Esc and Double click on spreadsheet to access

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Bond Yield Spreadsheet

Finding yield to maturity using a spreadsheet

May 2005 maturity bond, coupon rate = 6.5%, maturity = 3 years

Annual coupons Semiannual coupons

Settlement date 5/15/02 5/15/02

Maturity date 5/15/05 5/15/05
Annual coupon rate 0.065 0.065
Bond price 107.229 107.229
Redemption value (% of face value) 100 100
Coupon payments per year 1 2

Yield to maturity (decimal) 0.04 0.0392

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

Esc and Double click on spreadsheet to access

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Interest Rate Risk

1,080
Price path for
1,060 Premium Bond
1,040

1,020

1,000
Bond Price

980

960

940

920 Price path for Maturity

Today Discount Bond
900

880
0 5 10 15 20 25 30
Time to Maturity

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Interest Rate Risk

3,000

When the interest rate equals

2,500
the 6.5% coupon rate, both
30 yr bond bonds sell at face value
2,000
$ Bond Price

1,500

1,000
3 yr bond

500

-
0 2 4 6 8 10
YTM
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Nominal and Real rates

16

14

12
Yield on UK
nominal bonds
10
Percent

6 Yield on UK
4
indexed bonds

0
82

85

88

91

94

97

2000
Year

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Default Risk

Credit risk
Default premium
Investment grade
Junk bonds

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Default Risk
Standard
Moody' s & Poor's Safety

Aaa AAA The strongest rating; ability to repay interest and principal
is very strong.
Aa AA Very strong likelihood that interest and principal will be
repaid
A A Strong ability to repay, but some vulnerability to changes in
circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over
sustained periods is questionable.
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be
Ca CC in default or in danger of imminent default
C C C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.

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Corporate Bonds

Zero coupons
Floating rate bonds
Convertible bonds

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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.

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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/interest-
rate/index.html
www.bondmarkets.com
www.publicdebt.treas.gov/sec/sec.htm
www.bondsonline.com/asp/research/glossary.asp

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