You are on page 1of 13

1

2
3
4
5

A
B
07 Chapter model

8/10/2016 13:20

I
2/14/2006

Chapter 7. Bonds and Their Valuation


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.

8
9
10
11
12
13
14
15
16
17
18
19
20
21
22

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.

BOND VALUATION (Section 7.3)


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?

23
24
25
26
27
28
29
30
31
32
33
34

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

Refer to the Excel Tutorial for Data Table Instructions.

A
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52

53

54
55
56
57
58
59
60
61
62
63
64
65
66
67
68

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.

Interest Rate Sensitivity


$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%

YIELD TO MATURITY (YTM) (Section 7.4)


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

Going rate, rd =YTM:

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.

YIELD TO CALL (YTC) (Section 7.4)

69

70
71

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

72

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.)

73
74
75
76
77
78
79
80

Years to call:
Coupon rate:
Annual Pmt:
Current price:
Call price = FV
Par value

81

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

9
10%
$100.00
$1,494.93
$1,100.00
$1,000.00

YTC =

4.21%

82
83
84
85
86
87
88
89

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.

CURRENT YIELD (Section 7.4)


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?

90
91

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.

92
93
94
95
96
97

Par value
Coupon rate
Annual Payment
Current price

$1,000.00
10%
$100.00
$985.00

Current Yield =

10.15%

98

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.

99
100
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
102
addition, for each different-couponed bond, the corresponding current and capital gains yields are
calculated.
103
10%
104 YTM for all 3 bonds
Face
value
$1,000
105
106
107
BOND VALUES OVER TIME
Coupon rate =
7%
Coupon rate =
10%
Coupon rate =
108
N
Price
Curr yld Cap g yld
Price
Curr yld Cap g yld
Price
Curr yld
109
0
$771.82
9.1%
0.9%
$1,000.00
10.0%
0.0%
$1,228.18
10.6%
110
1
$779.00
9.0%
1.0%
$1,000.00
10.0%
0.0%
$1,221.00
10.6%
111
2
$786.90
8.9%
1.1%
$1,000.00
10.0%
0.0%
$1,213.10
10.7%
112
3
$795.59
8.8%
1.2%
$1,000.00
10.0%
0.0%
$1,204.41
10.8%
113
4
$805.15
8.7%
1.3%
$1,000.00
10.0%
0.0%
$1,194.85
10.9%
114
5
$815.66
8.6%
1.4%
$1,000.00
10.0%
0.0%
$1,184.34
11.0%
115
6
$827.23
8.5%
1.5%
$1,000.00
10.0%
0.0%
$1,172.77
11.1%
116
7
$839.95
8.3%
1.7%
$1,000.00
10.0%
0.0%
$1,160.05
11.2%
117
8
$853.95
8.2%
1.8%
$1,000.00
10.0%
0.0%
$1,146.05
11.3%
118
9
$869.34
8.1%
1.9%
$1,000.00
10.0%
0.0%
$1,130.66
11.5%
119
10
$886.28
7.9%
2.1%
$1,000.00
10.0%
0.0%
$1,113.72
11.7%
120
11
$904.90
7.7%
2.3%
$1,000.00
10.0%
0.0%
$1,095.10
11.9%
121
12
$925.39
7.6%
2.4%
$1,000.00
10.0%
0.0%
$1,074.61
12.1%
122
13
$947.93
7.4%
2.6%
$1,000.00
10.0%
0.0%
$1,052.07
12.4%
123
14
$972.73
7.2%
2.8%
$1,000.00
10.0%
0.0%
$1,027.27
12.7%
124
15
$1,000.00
7.0%
3.0%
$1,000.00
10.0%
0.0%
$1,000.00
13.0%
125

A
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143

Price of Bond Over Time


$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

11

13

15

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,
144 the bond will continue to sell at par. Note that the above graph assumes that interest rates stay
constant after the initial change. That is most unlikely--interest rates fluctuate, and so do the prices of
outstanding bonds.
145
146
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.
149
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%?
152
153
154
155
156
157
158
159
160

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.

A
B
C
D
E
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.
163
164 EXAMPLE
Compare the interest rate risk of two bonds, both of which have a 10% annual coupon and a $1,000 face
165
value. The first bond matures in 5 years, the second in 30 years.
166
10%
167 Coupon rate
$100.00
168 Payment
$1,000.00
169 Par value
Maturity
5
170
Going
rate
=
r
=
YTM
10%
171
d
172
$1,000.00
173 Value of bond:
174
175

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.

176
Value of the Bond Under Different Conditions
177
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
180
5%
$1,216.47 $1,386.09 $1,518.98 $1,623.11 $1,704.70 $1,768.62
181
10%
$1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00
182
15%
$832.39
$749.06
$707.63
$687.03
$676.79
$671.70
183
20%
$700.94
$580.75
$532.45
$513.04
$505.24
$502.11
184
185
We can show the sensitivity of bonds with different maturities by graphing the data shown in the data
186
table. The graph below does this. The lines for the 5-year and 30-year bonds are boldfaced.
187
188
189
Price sensitivity to changing rates
190
$4,000.00
191
192
$3,500.00
193
$3,000.00
194
5-year
195
$2,500.00
10-year
196
15-year
$2,000.00
197
20-year
198
$1,500.00
25-year
199
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

A
202
203

$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%

ANALYSIS OF A ZERO COUPON BOND


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%

2b Their current yield?


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