6- 1

Fundamentals
of Corporate Chapter 5
Finance
Valuing Bonds
Sixth Edition

Richard A. Brealey
Stewart C. Myers
Alan J. Marcus

Slides by
Matthew Will

McGraw
McGraw Hill/Irwin
Hill/Irwin Copyright ©Copyright
2009 by The McGraw-Hill
© 2009 Companies, Inc.
by The McGraw-Hill All rights
Companies, reserved
Inc. All rights reserved
6- 2

Topics Covered
 The Bond Market
 Interest Rates and Bond Prices
 Current Yield and Yield to Maturity
 Bond Rates and Returns
 The Yield Curve
 Corporate Bonds and the Risk of Default
6- 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 Principal Value) - Payment
at the maturity of the bond.
 Coupon Rate - Annual interest payment, as a
percentage of face value.
6- 4

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.
6- 5

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
6- 6

Bond Cash Flows

6- 7

Bond Pricing
Example
What is the price of a 5.0 % annual coupon bond,
with a $1,000 face value, which matures in 3 years?
Assume a required return of 2.15%.

50 50 1,050
PV   
(1.0215) (1.0215) (1.0215) 3
1 2

PV  $1,081.95
6- 8

Bond Pricing
Example (continued)
Q: How did the calculation change, given semi-annual
coupons versus annual coupon payments?
6- 9

Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 2.15% AND the coupons are paid semi-
annually?

25 25 25 1,025
PV  1
 2
 ...  
(1.01075) (1.01075) (1.01075) (1.01075) 6
5

PV  $1,082.37
 6- 10

Yield %

0
2
4
6
8
10
12
14
16
1900
1905

1910

1915
1920

1925
1930

1935

1940
1945

1950

1955

Year
1960

1965

1970
1975

1980

1985
1990
Treasury Yields

1995

2000
2005
 The interest rate on 10-year U.S. Treasury bonds
6- 11

Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 5.0 %?

50 50 1,050
PV  1
 2
 3
(1.050) (1.050) (1.050)
PV  $1,000
6- 12

Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 8 %?

50 50 1,050
PV   
(1.08) (1.08) (1.08) 3
1 2

PV  $922.69
6- 13

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.
6- 14

Interest Rate Risk

 The value of the 5% bond falls as interest rates rise

1,200

1,100
Bond price ($)

1,000

900

800

700
0 2 4 6 8 10 12 14 16
Interest rate (%)
6- 15

Interest Rate Risk

3,000

When the interest rate equals

2,500
the 5.0% 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
6- 16

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.
6- 17

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
6- 18

Bond Yields
Example
What is the YTM of a 5.0 % annual coupon bond,
with a $1,000 face value, which matures in 3 years?
The market price of the bond is $1,081.95.

50 50 1,050
PV   
(1  r ) (1  r ) (1  r )
1 2 3

PV  $1,081.95
YTM = 2.15%
6- 19

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.
6- 20

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
6- 21

Bond Valuation Spreadsheet

Valuing bonds using a spreadsheet

5.0 % coupon 6.0% coupon

maturing Feb 2011 10-year maturity

Settlement date 2/15/08 1/1/00

Maturity date 2/15/11 1/1/10
Annual coupon rate 0.05 0.06
Yield to maturity 0.0215 0.07
Redemption value (% of face value) 100 100
Coupon payments per year 1 1

Bond price (% of par) 108.195 92.976

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

Esc and Double click on spreadsheet to access

6- 22

Interest Rate Risk

1,400
Price path for
1,300
Premium Bond

1,200

1,100
Bond Price

1,000

900
Price path for
Discount Bond
800
Today Maturity
700

600
0 5 10 15 20 25 30
Time to Maturity
6- 23

Bond Yield Spreadsheet

Finding yield to maturity using a spreadsheet

Feb 2011 maturity bond, coupon rate = 5.0%, maturity = 3 years

Annual coupons Semiannual coupons

Settlement date 2/15/08 2/15/08

Maturity date 2/15/11 2/15/11
Annual coupon rate 0.05 0.05
Bond price 108.195 108.195
Redemption value (% of face value) 100 100
Coupon payments per year 1 2

Yield to maturity (decimal) 0.0215 0.0216

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

Esc and Double click on spreadsheet to access

6- 24

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.

6- 25

The Yield Curve

Treasury strips are bonds that make a single payment. The yields on Treasury
strips in February 2008 show that investors received a higher yield on longer
term bonds.

6
5

4
Yield %

3
2

1
0
1
3
5
7
9
11
13
15
17
19
21
23
25
27
29
Maturity (years)
6- 26

Corporate Bonds
 Zero coupons
 Floating rate bonds
 Convertible bonds
6- 27

Nominal and Real rates

14

12

10
Yield on UK
nominal bonds
8
Percent

6
Yield on UK
indexed bonds
4

Year
6- 28

Default Risk
 Credit risk
 Default premium
 Investment grade
 Junk bonds
6- 29

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.
6- 30

Default Risk
Yield spreads between corporate and 10-year Treasury bonds

12
10
Yield spread %

8 Junk bonds

6
4 Baa-rated
bonds
2
Aaa-rated bonds
0
6- 31

Web Resources