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07 Chapter model

8/10/2016 13:20

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2/14/2006

The value of any financial asset is the present value of the asset's expected future cash flows. The key

inputs are (1) the expected cash flows and (2) the appropriate discount rate, given the bond's risk,

maturity, and other characteristics. The model developed here analyzes bonds in various ways.

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Bond valuation requires keen judgment with regard to assessing the riskiness of the bond, i.e., what is

the likelihood that the promised coupon and maturity payments will actually be made at the scheduled

times? Also, investing in bonds requires one to make implicit forecasts of future interest rates--you

don't want to buy long-term bonds just before a sharp increase in interest rates. We do not deal with

these important but subjective issues in this spreadsheet. Rather, we concentrate on the actual

calculations used, given the inputs.

A bond has a 15-year maturity, a 10% annual coupon, and a $1,000 par value. The required rate of return

(or the yield to maturity) on the bond is 10%, given its risk, maturity, liquidity, and other rates in the

economy. What is a fair value for the bond, i.e., its market price?

INPUT DATA

Years to Maturity

Coupon rate

Annual Payment

Par value

Going rate, rd

Value of bond =

15

10%

$100

$1,000

10%

$1,000.00 Thus, this bond sells at its par value. That situation always exists

if the going rate is equal to the coupon rate.

Suppose the going interest rate changed from 10%, falling to 5% or rising to 15%. How would those

changes affect the value of the bond?

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We could go to the input data section above and change the value for r d from 10% to 5% and then 15%,

and observe the change in value. Alternatively, we can set up a data table to show the bond's value at a

range of rates, i.e. to show the bond's sensitivity to changes in interest rates.

Bond

Going rate

Value

(r)

$1,000

0%

$2,500.00

5%

$1,518.98

10%

$1,000.00

15%

$707.63

20%

$532.45

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We can use the data table to construct a graph that shows the value of standard 10% annual coupon,

$1,000 face value bonds at a variety of interest rates.

$3,000.00

$2,500.00

$2,000.00

$1,500.00

$1,000.00

$500.00

$0.00

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

The YTM is the rate of return that a bond earns if the issuer makes all scheduled payments and the bond

is held to maturity. The YTM is the same as the total rate of return discussed in the chapter, and it can

also be interpreted as the "promised rate of return," or the return to investors if all promised payments

are made. The YTM for a bond that sells at par consists entirely of an interest yield. However, if the

bond sells at any price other than its par value, the YTM consists of the interest yield together with a

positive or negative capital gains yield.

EXAMPLE

Suppose that you are offered a 14-year, 10% annual coupon, $1,000 par value bond at a price of

$1,494.93. What is the YTM of the bond?

Use the Rate function to solve the problem.

Years to Maturity

Coupon rate

Annual Payment

Current price

Par value = FV

14

10%

$100.00

$1,494.93

$1,000.00

5.00%

The YTM is the same as the expected rate of return only if (1) the probability of default is zero, and (2)

the bond cannot be called. If there is any chance of default, then there is a chance some payments may

not be made. In this case, the expected rate of return will be less than the promised YTM.

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The YTC is the rate of return investors will receive if their bonds are called. If the issuer has the right to

call the bonds, and if interest rates fall, then it would be logical for the issuer to call the bonds and

replace them with new bonds that carry a lower coupon. The YTC is found similarly to the YTM. The

same formula is used, but years to maturity is replaced with years to call, and the maturity value is

replaced with the call price.

EXAMPLE

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Suppose you purchase a 15-year, 10% annual coupon, $1,000 par value bond with a call provision after

10 years at a call price of $1,100. One year later, interest rates have fallen from 10% to 5% causing the

value of the bond to rise to $1,494.93. What is the bond's YTC? (Note, this is the same bond as the

previous question except it is callable.)

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Years to call:

Coupon rate:

Annual Pmt:

Current price:

Call price = FV

Par value

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This bond's YTM is 5%, but its YTC is only 4.21%. Which would an investor be more likely to actually

earn?

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10%

$100.00

$1,494.93

$1,100.00

$1,000.00

YTC =

4.21%

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This company could call the old bonds, which pay $100 per year, and replace them with bonds that pay

somewhere in the vicinity of $50 (or maybe even only $42.10) per year. It would want to save that

money, so it would in all likelihood call the bonds. In that case, investors would earn the YTC, so the

YTC is the most-likely, or expected, yield on the bonds.

The current yield is the annual interest payment divided by the bond's current price. The current yield

provides information regarding the amount of cash income that a bond will generate in a given year.

EXAMPLE

What is the current yield on a $1,000 par value, 10% annual coupon bond that is currently selling for

$985?

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Simply divide the annual interest payment by the price of the bond. Even if the bond made semiannual

payments, we would still use the annual interest.

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Par value

Coupon rate

Annual Payment

Current price

$1,000.00

10%

$100.00

$985.00

Current Yield =

10.15%

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The current yield provides information on a bond's cash return, but it gives no indication of the bond's

total return. To see this, consider a zero coupon bond. Since zeros pay no coupon, the current yield is

zero because there is no interest income. However, the zero appreciates through time, and its total

return clearly exceeds zero. ZERO COUPON BONDS ARE DISCUSSED MORE FULLY IN WEB APPENDIX

7A AND THE NEXT TAB IN THIS EXCEL WORKBOOK.

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101 CHANGES IN BOND VALUES OVER TIME (Section 7.5)

Sudden changes in interest rates (as suggested above) are rare. Instead, the more worthwhile exercise

is to examine how different bonds (identical but for their coupon rates) will behave over time. In

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addition, for each different-couponed bond, the corresponding current and capital gains yields are

calculated.

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10%

104 YTM for all 3 bonds

Face

value

$1,000

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BOND VALUES OVER TIME

Coupon rate =

7%

Coupon rate =

10%

Coupon rate =

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N

Price

Curr yld Cap g yld

Price

Curr yld Cap g yld

Price

Curr yld

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0

$771.82

9.1%

0.9%

$1,000.00

10.0%

0.0%

$1,228.18

10.6%

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1

$779.00

9.0%

1.0%

$1,000.00

10.0%

0.0%

$1,221.00

10.6%

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2

$786.90

8.9%

1.1%

$1,000.00

10.0%

0.0%

$1,213.10

10.7%

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3

$795.59

8.8%

1.2%

$1,000.00

10.0%

0.0%

$1,204.41

10.8%

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4

$805.15

8.7%

1.3%

$1,000.00

10.0%

0.0%

$1,194.85

10.9%

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5

$815.66

8.6%

1.4%

$1,000.00

10.0%

0.0%

$1,184.34

11.0%

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6

$827.23

8.5%

1.5%

$1,000.00

10.0%

0.0%

$1,172.77

11.1%

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$839.95

8.3%

1.7%

$1,000.00

10.0%

0.0%

$1,160.05

11.2%

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$853.95

8.2%

1.8%

$1,000.00

10.0%

0.0%

$1,146.05

11.3%

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$869.34

8.1%

1.9%

$1,000.00

10.0%

0.0%

$1,130.66

11.5%

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10

$886.28

7.9%

2.1%

$1,000.00

10.0%

0.0%

$1,113.72

11.7%

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$904.90

7.7%

2.3%

$1,000.00

10.0%

0.0%

$1,095.10

11.9%

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$925.39

7.6%

2.4%

$1,000.00

10.0%

0.0%

$1,074.61

12.1%

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13

$947.93

7.4%

2.6%

$1,000.00

10.0%

0.0%

$1,052.07

12.4%

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14

$972.73

7.2%

2.8%

$1,000.00

10.0%

0.0%

$1,027.27

12.7%

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15

$1,000.00

7.0%

3.0%

$1,000.00

10.0%

0.0%

$1,000.00

13.0%

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$1,300.00

Coupon = 13%

$1,200.00

$1,100.00

Coupon = 10%

$1,000.00

$900.00

Coupon = 7%

$800.00

$700.00

$600.00

-1

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If rates fall, the bond goes to a premium, but it moves toward par as maturity approaches. The reverse

holds if rates rise and the bond sells at a discount. If the going rate remains equal to the coupon rate,

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constant after the initial change. That is most unlikely--interest rates fluctuate, and so do the prices of

outstanding bonds.

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147 BONDS WITH SEMIANNUAL COUPONS (Section 7.6)

Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds. We

148 must make three modifications to our original valuation model: (1) divide the coupon payment by 2, (2)

multiply the years to maturity by 2, and (3) divide the nominal interest rate by 2.

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150 EXAMPLE

151 What is the price of a 15-year, 10% semiannual coupon, $1,000 par value bond if the nominal YTM is 5%?

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Periods to maturity = 15 2 =

Coupon rate:

Semiannual pmt = $100/2 =

Current price:

Periodic rate = 5%/2 =

30

10%

$50.00

$1,000.00

2.5%

PV =

$1,523.26

Note that the bond is now more valuable, because interest payments come in faster.

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161 ASSESSING A BOND'S RISKINESS (Section 7.7)

Interest rate risk is the risk of a decline in a bond's price due to an increase in interest rates. Price

sensitivity to interest rates is greater (1) the longer the maturity and (2) the smaller the coupon payment.

162 Thus, if two bonds have the same coupon, the bond with the longer maturity will have more interest

rate sensitivity, and if two bonds have the same maturity, the one with the smaller coupon payment will

have more interest rate sensitivity.

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164 EXAMPLE

Compare the interest rate risk of two bonds, both of which have a 10% annual coupon and a $1,000 face

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value. The first bond matures in 5 years, the second in 30 years.

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10%

167 Coupon rate

$100.00

168 Payment

$1,000.00

169 Par value

Maturity

5

170

Going

rate

=

r

=

YTM

10%

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d

172

$1,000.00

173 Value of bond:

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First, we solve for the value of the 5-year bond, and then set up a 2-variable Data Table, where we let

both r and Years change, as shown below.

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Value of the Bond Under Different Conditions

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Years to Maturity

178 Going rate, r

5

10

15

20

25

30

179 $1,000.00

0%

$1,500.00 $2,000.00 $2,500.00 $3,000.00 $3,500.00 $4,000.00

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5%

$1,216.47 $1,386.09 $1,518.98 $1,623.11 $1,704.70 $1,768.62

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10%

$1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00

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15%

$832.39

$749.06

$707.63

$687.03

$676.79

$671.70

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20%

$700.94

$580.75

$532.45

$513.04

$505.24

$502.11

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We can show the sensitivity of bonds with different maturities by graphing the data shown in the data

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table. The graph below does this. The lines for the 5-year and 30-year bonds are boldfaced.

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Price sensitivity to changing rates

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$4,000.00

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$3,500.00

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$3,000.00

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5-year

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$2,500.00

10-year

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15-year

$2,000.00

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20-year

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$1,500.00

25-year

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30-year

200

$1,000.00

201

$500.00

$0.00

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

$2,500.00

10-year

$2,000.00

15-year

20-year

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$1,500.00

25-year

$1,000.00

30-year

$500.00

$0.00

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Vandenburg Corporation needs to issue $50 million to finance a project, and it has decided to

raise the funds by issuing $1,000 par value, zero coupon bonds. The going interest rate on

such debt is 6%, and the corporate tax rate is 40%. Find the issue price of Vandenburg's

bonds, construct a table to analyze the cash flows attributable to one of the bonds, and

determine the after-tax cost of debt for the issue. Then, indicate the total par value of the

issue.

Set up the cash flow table as shown below. Then, use Excel's IRR function to find the

after-tax cost of debt.

Basic data

Par value

Going rate, rd

Yrs to maturity

Corp. Tax Rate

$1,000

6%

5

40%

Issue price =

$747.26

Time period

Accrued value

Int. Deduction

Tax savings

CF to issuer

0

$747.26

A-T rd (IRR)

$747.26

1

$792.09

$44.84

$17.93

$17.93

2

$839.62

$47.53

$19.01

$19.01

3

$890.00

$50.38

$20.15

$20.15

4

5

$943.40 $1,000.00

$53.40

$56.60

$21.36

$22.64

$21.36 -$977.36

3.60%

The after-tax cost of the bonds is found by taking the IRR of the pertinent cash flows. The IRR,

or "Internal Rate of Return," is discussed in detail in Chapter 11, but it is simply the interest

rate that forces the net present value of a series of cash flows to zero. The IRR can be

calculated by accessing the function wizard, fx. The IRR function can be found in the list of

Financial functions. You must enter the range for the cash flows. If you want, you can make a

guess as to the IRR, but that is not necessary. The completed IRR menu is shown below.

=IRR(C19:H19,.12)

The after-tax cost of debt, 3.6%, as calculated with the IRR function is the same as the after-tax

cost of debt found by multiplying the before-tax cost of debt times one minus the tax rate,

(6%*(1-.4) = 3.6%). This shows us that the after-tax cost of debt for regular coupon bonds,

including zero coupons, can be found with this formula:

After-tax cost of debt = A-T rd = B-T rd *(1T).

Illustration:

3.60%

The A-T cost of debt is used extensively in finance, as we shall see in Chapter 10.

SECTION 7.3

SOLUTIONS TO SELF-TEST QUESTIONS

1 A bond that matures in eight years has a par value of $1,000, an annual coupon payment of

$70, and a market interest rate of 9%. What is its price?

Years to Maturity

Annual Payment

Par value

Going rate, rd

Value of bond =

8

$70

$1,000

9%

$889.30

2 A bond that matures in 12 years has a par value of $1,000, an annual coupon of 10%, and a

market interest rate of 8%. What is its price?

Years to Maturity

Coupon rate

Annual Payment

Par value

Going rate, rd

Value of bond =

12

10%

$100

$1,000

8%

$1,150.72

SECTION 7.4

SOLUTIONS TO SELF-TEST QUESTIONS

2a Halley Enterprises bonds currently sell for $975. They have a seven-year maturity, an

annual coupon of $90, and a par value of $1,000. What is their yield to maturity?

Years to Maturity

Annual Payment

Current price

Par value = FV

Going rate, rd =YTM:

7

$90.00

$975.00

$1,000.00

9.51%

Annual Payment

Current price

Current yield:

$90.00

$975.00

9.23%

3a The Henderson Companys bonds currently sell for $1,275. They pay a $120 annual coupon

and have a 20-year maturity, but they can be called in 5 years at $1,120. What is their YTM and

their YTC?

Years to Maturity

Annual Payment

Current price

Par value = FV

YTM

20

$120

$1,275

$1,000

8.99%

Years to Call

Annual Payment

Current price

Call price

YTC

5

$120

$1,275

$1,120

7.31%

3b Which is more relevant in the sense that investors should expect to earn it?

YTM

YTC

Most likely yield

8.99%

7.31%

7.31%

SECTION 7.5

SOLUTIONS TO SELF-TEST QUESTIONS

2a Last year a firm issued 20-year, 8% annual coupon bonds at a par value of $1,000. Suppose

that one year later the going rate had dropped to 6%. What is the new price of the bonds,

assuming that they now have 19 years to maturity?

Years to Maturity

Coupon rate

Annual Payment

Par value

Going rate, rd

Value of bond =

19

8%

$80

$1,000

6%

$1,223.16

2b Suppose that one year after issue the going interest rate had been 10% (rather than 6%).

What would the price have been?

Years to Maturity

Coupon rate

Annual Payment

Par value

Going rate, rd

Value of bond =

19

8%

$80

$1,000

10%

$832.70

SECTION 7.6

SOLUTIONS TO SELF-TEST QUESTIONS

2 Hartwell Corporation bonds have a 20-year maturity, an 8% semiannual coupon, and a face

value of $1,000. The going interest rate (rd) is 7%, based on semiannual compounding. What

is the bond's price?

Coupons per year

Years to Maturity

Coupon rate

Annual Payment

Par value

Going rate, rd

Value of bond =

2

20

8%

$40

$1,000

7%

$1,106.78

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