Corporate Finance: Laurence Booth - W. Sean Cleary

Prepared by
Ken Hartviksen and Robert Ironside

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary
CHAPTER 6
Bond Valuation and Interest
Rates
CHAPTER 6 Bond Valuation and Interest Rates 6 - 3
Lecture Agenda
Learning Objectives
Important Terms
Basic Structure of Bonds
Bond Valuation
Bond Yields
Interest Rate Determinants
Other Types of Bonds/Debt Instruments
Summary and Conclusions
Concept Review Questions
Learning Objectives
The basic features of different types of bonds
How to value bonds given an appropriate discount rate
How to determine the discount rate or yield given the market
value of a bond
How market interest rates or yields affect bond investors
How bond prices change over time
The factors (both domestic and global) that affect interest rates
Important Chapter Terms
Balloon payment
Bills
Bond indenture
Bullet payment
Call prices
Callable bonds
Canada Savings Bonds
Collateral trust bonds
Coupons
Current yield
Debentures
Debt ratings
Default free

Default risk
Discount (premium)
Duration
Equipment trust certificates
Expectations theory
Extendible bonds
Face value
Floating rate bonds
Interest payments
Interest rate parity (IRP) theory
Interest rate risk
Issue-specific premiums
Liquidity preference theory
Maturity value
Important Chapter Terms
Mortgage bonds
Nominal interest rates
Notes
Paper
Par value
Protective covenants
Purchase fund provisions
Real return bonds
Retractable bonds
Risk-free rate
Sinking fund provisions
Spread
Term structure of interest
rates
Term to maturity
Yield curve
Yield to maturity
Zero coupon bond
The Basic Structure of Bonds
What is a bond?
In its broadest sense, a bond is any debt instrument
that promises a fixed income stream to the holder
Fixed income securities are often classified
according to maturity, as follows:
Less than one year Bills or Paper
1 year < Maturity < 7 years Notes
< 7 years Bonds
A typical bond has the following characteristics:
A fixed face or par value, paid to the holder of the
bond, at maturity
A fixed coupon, which specifies the interest payable
over the life of the bond
Coupons are usually paid either annually or semi-annually
A fixed maturity date
Bonds may be either:
Bearer bonds
Registered bonds
Bond indenture - the contract between the issuer of
the bond and the investors who hold it
The market price of a bond is equal to the present
value of the payments promised by the bond

(See the basic pattern of cash flows from a traditional bond on the next slide)
Cash Flow Pattern for a Traditional Coupon-Paying Bond

0 1 2 3 n

I I I I I
F

FIGURE 6-1
I = interest payments, and F = principal repayment
Cash Flow Pattern of a Bond
The Purchase Price or Market Price of a bond is simply the present
value of the cash inflows, discounted at the bonds yield-to-maturity
0 2
3
4 n 1
Coupon Coupon Coupon Coupon Coupon +
Face Value
Purchase
Price
Cash Inflows
to the Investor
Cash Outflows
to the Investor
Bond indenture is the contract between the issuer
and the holder. It specifies:
Details regarding payment terms
Collateral
Positive and negative covenants
Par or face value (usually increments of $1,000)
Bond pricing usually shown as the price per $100 of
par value, which is equal to the percentage of the
bonds face value
Term-to-maturity the time remaining to the bonds
maturity date
Coupon rate the annual percentage interest paid
on the bonds face value; to calculate the dollar
value of the annual coupon, multiply the coupon rate
by the face value
If the coupon is paid twice a year, divide the annual
coupon by two
Example: A $1,000 bond with an 8% coupon rate will
have an $80 coupon if paid annually or a $40 coupon
if paid semi-annually

Security and Protective Provisions
Mortgage bonds secured by real assets
Debentures either unsecured or secured with a
floating charge over the firms assets
Collateral trust bonds secured by a pledge of
financial assets, such as common stock, other
bonds or treasury bills
Equipment trust certificates secured by a pledge
of equipment, such as railway rolling stock
Security and Protective Provisions
Covenants
Positive covenants things the firm agrees to do
Supply periodic financial statements
Maintain certain ratios
Negative covenants things the firm agrees not to
do
Restricts the amount of debt the firm can take on
Prevents the firm from acquiring or disposing of
assets
More Bond Features
Call feature allows the issuer to redeem or pay off
the bond prior to maturity, usually at a premium
Retractable bonds allows the holder to sell the
bonds back to the issuer before maturity
Extendible bonds allows the holder to extend the
maturity of the bond
Sinking funds funds set aside by the issuer to
ensure the firm is able to redeem the bond at
maturity
Convertible bonds can be converted into common
stock at a pre-determined conversion price
Bond Valuation
The value of a bond is a function of:
Par value
Term to maturity
Coupon rate
Investors required rate of return (discount rate is also
known as the bonds yield to maturity)
Bond Value
General Formula

) k (
F
k
) k (
I B
n
b b
n
b
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-1]
Where:
I = interest (or coupon ) payments
k
b
= the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
Bond Valuation: Example
What is the market price of a ten-year, $1,000 bond with a
5% coupon, if the bonds yield-to-maturity is 6%?
( )
( )
( )
( )
10
10
1 1
1
1 1.06
1, 000
50
0.06
1.06
$926.40
n
b
n
b
b
k
F
B I
k
k
(
+
= + (
+
(

(
= + (
(

=
Calculator Approach:
1,000 FV
50 PMT
10 N
I/Y 6
CPT PV 926.40
Factors Affecting Bond Prices
Bond Price-Yield Curve
Market Yield (%)
FIGURE 6-2
Price
($)
When interest rates increase, bond prices fall
The relationship between the coupon rate and the bonds
yield-to-maturity (YTM) determines if the bond will sell at a
premium, at a discount, or at par
If Then Bond Sells at a:
Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium
Bond Valuation: Semi-Annual Coupons
So far, we have assumed that all bonds have annual
pay coupons. While this is true for many
Eurobonds, it is not true for most domestic bond
issues, which have coupons that are paid semi-
annually
To adjust for semi-annual coupons, we must make
three changes:
Size of the coupon payment (divide by 2)
Number of periods (multiply by 2)
Yield-to-maturity (divide by 2)
Bond Valuation: Semi-Annual Coupons
For example, suppose you want to value a five-year,
$10,000 Government of Canada bond with a 4% coupon,
paid twice a year, given a YTM of 6%.
2
2
2 5
2 5
1 1
2
2
1
2
2
.06
1 1
400 10, 000
2
0.06
2
.06
1
2
2
$9,146.98
n
b
n
b
b
x
x
k
I F
B
k
k
(
| |
+
(
|
\ .
(
= +
(
| |
+
(
|
(
\ .

(
| |
+
(
|
\ .
(
= +
(
| |
+
(
|
\ .

=
Calculator Approach:
10,000 FV
400 2 = PMT
5 x 2 = N
6 2 = I/Y
CPT PV 926.40
There are three factors that affect the price volatility
of a bond
Yield to maturity
Time to maturity
Size of coupon
Yield to maturity
Bond prices go down when the YTM goes up
Bond prices go up when the YTM goes down
Look at the graph on the next slide. It shows how
the price of a 25 year, 10% coupon bond changes
as the bonds YTM varies from 1% to 30%
Note that the graph is not linear instead it is said
to be convex to the origin
Price and Yield: 25 Year Bond, 10% Coupon
Price/Yield Relationship
0
50
100
150
200
250
300
350
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Percent YTM
P
r
i
c
e

p
e
r

$
1
0
0

o
f

F
a
c
e

V
a
l
u
e
The convexity of the price/YTM graph reveals two
important insights:
The price rise due to a fall in YTM is greater than the
price decline due to a rise in YTM, given an identical
change in the YTM
For a given change in YTM, bond prices will change
more when interest rates are low than when they are
high
Bond Convexity
Time to maturity
Long bonds have greater price volatility than short
bonds
The longer the bond, the longer the period for which the
cash flows are fixed
Size of coupon
Low coupon bonds have greater price volatility
than high coupon bonds
High coupons act like a stabilizing device, since a greater
proportion of the bonds total cash flows occur closer to
today & are therefore less affected by a change in YTM
Interest Rate Risk & Duration
The sensitivity of bond prices to changes in interest
rates is a measure of the bonds interest rate risk
A bonds interest rate risk is affected by:
Yield to maturity
Term to maturity
Size of coupon
These three factors are all captured in one number
called duration
Duration
Duration is a measure of interest rate risk
The higher the duration, the more sensitive the bond
is to changes in interest rates
A bonds duration will be higher if its:
YTM is lower
Term to maturity is longer
Coupon is lower
Bond Quotations
Issuer Coupon Maturity Price Yield
Canada 5.500 2009-Jun-01 103.79 4.16
Cash Versus Quoted Prices
The quoted price is the price reported by the media
The cash price is the price paid by an investor
The cash price includes both the quoted price plus
any interest that has accrued since the last coupon
payment date
Cash Versus Quoted Price: Example
Assume you want to purchase a $1,000 bond with a 5%
coupon, paid semi-annually. Today is July 15
th
. The last
coupon was paid June 30
th
. If the quoted price is $902,
how much is the cash price?
Solution: The cash price is equal to:
Quoted price of $902
Plus 15 days of interest
( )( )
15
902 1, 000 0.05
365
902 2.05
$904.05
Cash price=Quoted Price+Accrued Interest
| |
= +
|
\ .
= +
=
Bond Yields
Yield-to-maturity (YTM) the discount rate used to
evaluate bonds
The yield earned by a bond investor who:
Purchases the bond at the current market price
Held the bond to maturity
Reinvested all of the coupons at the YTM
Is the bonds Internal Rate of Return (IRR)
Bond Yield to Maturity

The yield to maturity is that discount rate that causes the sum
of the present value of promised cash flows to equal the
current bond price.

YTM) (
F
YTM
YTM) (
I B
n
n
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-2]
Solving for YTM
To solve for YTM, solve for YTM in the following formula:

Problem: cant solve for YTM algebraically; therefore, must
either use a financial calculator, spreadsheet, trial and
error, or approximation formula.
( )
( )
1 1
1
n
n
YTM
F
B I
YTM
YTM
(
+
= +
(
+
(

Solving for YTM
Example: What is the YTM on a 10 year, 5% coupon bond
(annual pay coupons) that is selling for $980?
( )
( )
( )
( )
10
10
1 1
1
1 1
1, 000
980 50
1
5.26%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM
(
+
= + (
+
(

(
+
= + (
+
(

=
Financial Calculator
1,000 FV
980 +/- PV
50 PMT
10 N
I/Y 5.26%
Solving for YTM: Semi-annual Coupons
When solving for YTM with a semi-annual pay
coupon, the yield obtained must be multiplied by two
to obtain the annual YTM
Example: What is the YTM for a 20 year, $1,000
bond with a 6% coupon, paid semi-annually, given a
current market price of $1,030?
Solving for YTM: Semi-annual Coupons
( )
( )
( )
( )
40
40
1 1
1
1 1
1, 000
1, 030 30
1
2.87 2 5.74%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM x
(
+
= + (
+
(

(
+
= + (
+
(

= =
1,000 FV
1,030 +/- PV
30 PMT
40 N
I/Y 2.87 x 2
= 5.746%
The Approximation Formula
Where
F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity

1 YTM) annual - semi (1 YTM
YTM annual - semi 2 YTM
2
n
B - F
Maturity to Yield annual - Semi
2
+ =
=
+
+
=
B F
I
Example
Find the yield-to-maturity of a 5 year 6% coupon
bond that is currently priced at $850. (Always
assume the coupon interest is paid semi-annually.)
Therefore there is coupon interest of $30 paid
semi-annually
There are 10 semi-annual periods left until maturity
Solution
The actual answer is 9.87%...so of course, the
approximation approach only gives us an approximate
answerbut that is just fine for tests and exams.
% 97 . 9 1 ) 0486 . 1 ( 1 YTM) annual - semi (1 YTM
9.3% 0.09273 2 0.0486 YTM annual - semi 2 YTM
0486 . 0
925 $
30 $ 15 $
2
850 , 1 $
30 $
10
850 $ 000 , 1 $
2
n
B - F
Maturity to Yield annual - Semi
2 2
= = + =
= = = =
=
+
=
+
=
+
+
=
B F
I
The Logic of the Equation
Approximation Formula for YTM
The numerator simply represents the average semi-annual
returns on the investment; it is made up of two components:
The first component is the average capital gain (if it is a discount
bond) or capital loss (if it is a premium priced bond) per semi-
annual period.
The second component is the semi-annual coupon interest
received.
The denominator represents the average price of the bond.
Therefore the formula is basically, average semi-annual return
on average investment.
Of course, we annualize the semi-annual return so that we
can compare this return to other returns on other investments
for comparison purposes.
Yield to Call
If a bond has a call feature, the issuer can call the
bond prior to its stated maturity
To calculate the yield to call, replace the maturity
date with the first call date
Yield to Call
The yield to call is that discount rate that causes the present
value of all promised cash flows including the call price (CP)
to equal the current bond price.

YTC) (
CP
YTC
YTC) (
I B
n
n
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-3]
Solving for YTC: Semi-Annual Coupons
1,050 FV
1,030 +/- PV
30 PMT
10 N
I/Y 3.081 x 2
= 6.16%
YTC on a 20-year 6 percent bond that is callable in five years at a call price of
$1,050. The bond pays semi-annual coupons and is selling for $1,030.
% 16 . 6 2 % 081 . 3
% 081 . 3
1
050 , 1 $ 1
1
1
30 $ 030 , 1 $
1
1 1
1
1
10
10
= =
=
+
+
(
(
(
(
=
+
+
(
(
(
(
=
YTC
annually semi YTC
YTC) ( YTC
YTC) (

YTC) (
CP
YTC
YTC) (
I B
n
n
Current Yield
The current yield is the yield on the bonds current market
price provided by the annual coupon
It is not a true measure of the return to the bondholder because it
does not consider potential capital gain or capital losses based
on the relationship between the purchase price of the bond and
its par value.

B
interest Annual
CY = [ 6-4]
Current Yield
Example
The current yield is the yield on the bonds current market
price provided by the annual coupon
Example: If a bond has a 5.5% annual pay coupon and the
current market price of the bond is $1,050, the current yield is:
55
1, 050
5.24%
Annual Coupon
Current Yield =
Current Market Price
=
=
Interest Rate Determinants
Interest is the price of money
Basis points 1/100 of 1%
Interest rates go:
Up when the demand for loanable funds rises
Down when the demand for loanable funds falls
Risk-free Interest Rate
Usually use the yield on short federal government
treasury bills as a proxy for the risk-free rate (RF)
The risk-free rate is comprised of two components:
Real rate compensation for deferring consumption
Expected inflation compensation for the expected
loss in purchasing power

(See Figure 6-3 to see rates of inflation and yields on long Canada bonds since 1961)
Inflation and Yields over Time
FIGURE 6-3
Fisher Equation
If we call the risk-free rate the nominal rate, then the
relationship between the real rate, the nominal rate and
expected inflation is usually referred to as the Fisher
Equation (after Irving Fisher)
inflation Expected rate Real RF + = [ 6-5]
Fisher Equation
When inflation is low, can safely use the approximation
formula:

When inflation is high, use the exact form of the Fisher
Equation:
Nominal Real
R = R +Expected Inflation
( ) ( )( )
1 1 1
Nominal Real
R = R Expected Inflation + + +
Fisher Equation
Example
If the real rate is 3% and the nominal rate is 5.5%, what is
the approximate expected future inflation rate?
5.5 3
2.5%
Nominal Real
R = R +Expected Inflation
Expected Inflation
Expected Inflation
= +
=
Global Influences on Interest Rates
Canadian domestic interest rates are heavily
influenced by global interest rates
Interest rate parity (IRP) theory states that FX
forward rates will be established that equalize the
yield an investor can earn, whether investing
domestically or in a foreign jurisdiction
A country with high inflation and high interest rates
will have a depreciating currency
Term Structure of Interest Rates
Is that set of rates (YTM) for a given risk-class of
debt securities (for example, Government of Canada
Bonds) at a given point in time.
When plotted on a graph, the line is called a Yield
Curve

The Yield Curve is the graph created by putting term
to maturity on the X axis, YTM on the Y axis and
then plotting the yield at each maturity.
The four typical shapes of yield curves:
Upward sloping (the most common shape)
Downward sloping
Flat
Humped

(See Figure 6-4 for Yield curves that existed at various times in Canada)
Historical Yield Curves
1990, 1994, 1998, 2004
P
e
r
c
e
n
t

Term Left to Maturity
16

14

12

10

8

6

4

2

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
FIGURE 6-4
1990 1994 1998 2004
Theories of the Term Structure
Three theories are used to explain the shape of the
term structure
Liquidity preference theory
Investors must be paid a liquidity premium to hold less
liquid, long-term debt
Expectations theory
The long rate is the average of expected future short interest
rates
Market segmentation theory
Distinct markets exist for securities of different maturities
Risk Premiums

More risky bonds (i.e.. BBB rated Corporate Bonds) will have
their own yield curve and it will plot at higher YTM at every
term to maturity because of the default risk that BBBs carry
The difference between the YTM on a 10-year BBB corporate
bond and a 10-year Government of Canada bond is called a
yield spread and represents a default-risk premium investors
demand for investing in more risky securities.
Spreads will increase when pessimism increases in the
economy
Spreads will narrow during times of economic expansion
(confidence)
Yield Curves for Different Risk Classes
Risk Premiums (Yield Spreads)
P
e
r
c
e
n
t

Term Left to Maturity
16

14

12

10

8

6

4

2

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
BBB Corporates Government of Canada Bonds
Yield
Spread
Risk Premiums
The YTM on a corporate bond is comprised of:

The maturity yield differential is explained by the term
structure
Spread is the additional yield due to default risk
Spread al differenti yield Maturity - / RF k
b
+ + = =YTM
[ 6-6]
Debt Ratings
All publicly traded bonds are assigned a risk rating
by a rating agency, such as Dominion Bond Rating
Service (DBRS), Standard & Poors (S&P), Moodys,
Fitch, etc.
Bonds are categorized as
Investment grade top four rating categories (AAA,
AA, A & BBB)
Junk or high yield everything below investment
grade (BB, B, CCC, CC, D, Suspended)

Why Do Bonds Have Different Yields?
Default risk the higher the default risk, the higher
the required YTM
Liquidity the less liquid the bond, the higher the
required YTM
Call features increase required YTM
Extendible feature reduce required YTM
Retractable feature reduce required YTM

Treasury Bills
Treasury bills are short-term obligations of government with
an initial term to maturity of one year or less
Issued at a discount and mature at face value
The difference between the issue price and the face value is
treated as interest income
To calculate the price of a T-bill, use the following formula
1
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
Where:
P = market price of the T Bill
F = face value of the T Bill
BEY = the bond equivalent yield
n = the number of days until maturity
B = the annual basis (365 days in Canada)
Treasury Bills: Example
What is the price of a $1,000,000 Canadian T bill with 80
days to maturity and a BEY of 4.5%?
1
1, 000, 000
80
1 .045
365
$990, 233.32
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
=
| |
+
|
\ .
=
Solving for Yield on a T Bill
To solve for the yield on a T bill, rearrange the previous
formula and solve for BEY.
Example: What is the yield on a $100,000 T bill with 180 days
to maturity and a market price of $98,200?
100, 000 98, 200 365
98, 200 180
3.72%
F P B
BEY
P n
| |
=
|
\ .
| |
=
|
\ .
=
Zero Coupon Bonds
A zero coupon bond is a bond issued at a discount
that matures at par or face value
A zero coupon bond has no reinvestment rate risk,
since there are no coupons to be reinvested
To calculate the price of a zero coupon bond, solve
for the PV of the face amount
Zero Coupon Bonds
Example: What is the market price of a $50,000 zero
coupon bond with 25 years to maturity that is currently
yielding 6%?

( )
( )
25
F
1
50, 000
1.06
$11, 649.93
n
b
B
k
=
+
=
=
Floating Rate & Real Return Bonds
Floating rate bonds have a coupon that floats with
some reference rate, such as the yield on T bills
Because the coupon floats, the market price will
typically be close to the bonds face value
Real return bonds are issued by the Government of
Canada to protect investors against unexpected
inflation
Each period, the face value of the bond is grossed up
by the inflation rate. The coupon is then paid on the
grossed up face value.
Canada Savings Bonds
A Canada Savings Bond (CSB) is a special type of
bond issued by the Government of Canada
It is issued in two forms:
Regular interest interest is paid annually
Compound interest interest compounds over the life
of the bond
CSBs are redeemable at any chartered bank in
Canada at their face value
There is no secondary market for CSBs
Summary and Conclusions
In this chapter you have learned:
About the nature of bonds as an investment
How to value a bond using discounted cash flow
concepts
About the determinants of interest rates and theories
used to explain the term structure of interest rates
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved.
Reproduction or translation of this work beyond that permitted by Access
Copyright (the Canadian copyright licensing agency) is unlawful.
Requests for further information should be addressed to the Permissions
Department, John Wiley & Sons Canada, Ltd. The purchaser may make
back-up copies for his or her own use only and not for distribution or
resale. The author and the publisher assume no responsibility for errors,
omissions, or damages caused by the use of these files or programs or
from the use of the information contained herein.

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