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Valuation of Securities

**Chapters in this Part
**

Chapter 6 Interest Rates and Bond Valuation

Chapter 7 Stock Valuation

Integrative Case 3: Encore International

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 6

Interest Rates and Bond Valuation

Instructor’s Resources

Overview

This chapter begins with a thorough discussion of interest rates, yield curves, and their relationship to

required returns. Features of the major types of bond issues are presented along with their legal issues, risk

characteristics, and indenture convents. The chapter then introduces students to the important concept of

valuation and demonstrates the impact of cash flows, timing, and risk on value. It explains models for

valuing bonds and the calculation of yield-to-maturity using either an approximate yield formula or

calculator. Students learn how interest rates may affect their ability to borrow and expand business

operations or assets under personal control.

** Suggested Answers to Opener in Review Questions
**

a. With short-term interest rates near 0 percent in 2010, suppose the Treasury decided to replace

maturing notes and bonds by issuing new Treasury bills, thus shortening the average maturity of

U.S. debt outstanding. Discuss the pros and cons of this strategy.

**The U.S. Treasury would face many of the same considerations as those faced by a company that is
**

considering revision of its average debt maturity. Short-term rates are normally lower, reducing total

financing costs. However, if the U.S. Treasury relies on short-term rates and short-term rates rise, the

cost of financing the federal debt could end up being higher. Even more serious is the risk that the U.S.

Treasury may not be able to find buyers of new Treasury bills when old Treasury bills mature.

According to market segmentation theory, there is a limited amount of demand for short-term

securities. Excessive short-term demand might push up the cost of seasonal business loans higher,

hindering business and tax revenues.

**Another concern that the U.S. Treasury would have to face is whether the financing adjustment would
**

diminish the high regard with which Treasury bills are held. Currently, Treasury bills are as close as we

can get to a risk-free rate in the real world. If the amount of short-term financing becomes excessive,

the ability of the federal government to make good on its short-term repayment promises may come

into question, no longer make it a “risk-free” surrogate, and increase Treasury bill rates.

**b. The average maturity of outstanding U.S. Treasury debt is about 5 years. Suppose a newly issued
**

5-year Treasury note has a coupon rate of 2 percent and sells for par. What happens to the value

of this debt if the inflation rate rises 1 percentage point, causing the yield-to-maturity on the 5-

year note to jump to 3 percent shortly after it is issued?

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

this security is commonly considered the risk-free asset.e.71 The drop in Treasury values would be about 4. Assuming the Treasuries are priced at par. government. by how much would the market value of outstanding debt fall? What does this suggest about the incentives of government policy makers to pursue policies that could lead to higher inflation? Based on the information provided in the Opener. Division of the interest payment by the total debt results in an interest rate of 3. * For a 3-month U.044 × $13 trillion). $383 billion ÷ $12 trillion). 2. $13 trillion less more than $1 trillion accrued in 2009). alas. the nominal rate of interest can be stated as r1 = r + IP.20 The price of the Treasury would drop $45. Publishing as Prentice Hall .19. leading up to $1. or 4.90 per thousand being the annual payment needed to result in Treasuries being priced at par. political. If total U. the coupon payment is no longer sufficient. complicated.71.4 percent. The price would be N = 5.e. is assumed to be zero since the security is backed by the U.S. However. © 2012 Pearson Education. to $954.19 percent (i. and.9.. The nominal rate of interest for a security can be defined as r1 = r + IP + RP.58 percent.S. If interest rates rise by 1% to 4. This would decrease the size of the federal debt by $572 billion (0.19 percent. Assume that the “average” Treasury security outstanding has the features described in part b. and FV = $1. The nominal rate of interest is the actual rate of interest charged by the supplier and paid by the demander.000 at maturity. if one considers the size of the current federal budget deficit in isolation. debt is $13 trillion and an increase in inflation causes yields on Treasury securities to increase by 1 percentage point. making proper use of interest rates to properly manage the federal budget difficult. FV = 1. If the discount rate increases. the price of the federal debt would fall to $955. The term structure of interest rates is the relationship of the rate of return to the time to maturity for any class of similar-risk securities. it must be paying $20 annually.. I = 4. Chapter 6 Interest Rates and Bond Valuation 103 Debt priced at par provides a coupon payment sufficient to pay the required rate of return. the price would drop to create a one percent capital gain per year. The real rate of interest is the rate that creates an equilibrium between the supply of savings and demand for investment funds. if the required rate of return is 2%. Hence.80. N = 5. PMT = $20. Hence. PMT = 31.000 Solve for PV = $955. The graphic presentation of this relationship is the yield curve. there is an incentive for the government to pursue policies which will lead to higher inflation. The default * risk premium.20. The nominal rate of interest differs from the real rate of interest due to two factors: (1) a premium due to inflationary expectations (IP) and (2) a premium due to issuer and issue characteristic risks (RP). c.S. Answers to Review Questions 1. Inc. Treasury bill. Hence. a few calculations can lead us to an approximation for this complex and complicated question.000 Solve for PV = 954. higher prices will lead to higher future costs for goods and services purchased by the government and an increase in the cost of entitlements. as computed below. RP. I = 3%. one ends up with $31. We are informed that $383 billion is the 2009 interest expense and that the national debt was about $12 trillion in 2009 (i.

corporation. the yield curve reflects investor expectations about future interest rates. Upward sloping: Short-term borrowing costs are lower than long-term borrowing costs. and contractual provisions. • Liquidity risk: The ease with which securities can be converted to cash without a loss in value. • Contractual provisions: Covenants included in a debt agreement or stock issue defining the rights and restrictions of the issuer and the purchaser. The market segmentation theory is another theory that can explain any of the three curve shapes.and * issue-related components: • Default risk: The possibility that the issuer will not pay the contractual interest or principal as scheduled. c. The trustee may be a paid individual. and thus a premium must be offered to attract adequate long-term investment. Both bond indentures and trustees are means of protecting the bondholders. The stated interest rate on a bond represents the percentage of the bond’s par value that will be paid out annually. Since the market for loans can be segmented based on maturity. Thirteenth Edition 3. r = r + IP + RP. The risks that are debt specific are default. The most commonly used class of securities is U. and vice versa.000 with maturities of 10 to 30 years. This theory states that long-term rates are generally higher than short-term rates due to the desire of investors for greater liquidity. For a given class of securities. If supply is greater than demand for short-term funds at a time when demand for long-term loans is higher than the supply of funding. thereby reducing the nominal rate of interest by an amount that brings the return into line with the after-tax return on a taxable issue of similar risk. In the Fisher equation. the reverse also holds true. 5. An upward-sloping curve is the result of increasing inflationary expectations. Obviously. • Maturity (interest rate) risk: The possibility that changes in the interest rates on similar securities will cause the value of the security to change by a greater amount the longer its maturity. and vice versa. 6. Downward sloping: Long-term borrowing costs are lower than short-term borrowing costs. with the differences based on inflation expectations. • Tax risk: Certain securities issued by agencies of state and local governments are exempt from federal. RP. maturity. sources of supply and demand for loans within each segment determine the prevailing interest rate. a. Treasury securities. The curve can take any of the three forms. b. The liquidity preference theory is an explanation for the upward-sloping yield curve. and in some cases state and local taxes. Inc. or commercial bank trust department that acts as a third-party “watch dog” on behalf of the bondholders to ensure that the issuer does not default on its contractual commitment to the bondholders. Flat: Borrowing costs are relatively similar for short. The upward-sloping yield curve has been the most prevalent historically. the yield curve would be upward sloping. b. the risk premium. According to the expectations theory. Most corporate bonds are issued in denominations of $1.S. a. The bond indenture is a complex and lengthy legal document stating the conditions under which a bond is issued. These can increase or reduce the risk of a security. consists of the following issuer. the slope of the curve reflects an expectation about the movement of interest rates over time. although the actual payments may be divided up and made quarterly or semiannually. 4. © 2012 Pearson Education.104 Gitman/Zutter • Principles of Managerial Finance.and long-term loans. Publishing as Prentice Hall . c.

The higher the rating. give the holder the right to purchase a certain number of shares of common stock at a specified price. bonds. bonds at a stated price prior to maturity. and the basic cost of money. This feature allows the issuer to retire outstanding debt prior to maturity and. A foreign bond. A call feature gives the issuer the opportunity to repurchase. or call. Eurobonds are bonds issued by an international borrower and sold to investors in countries with currencies other than that in which the bond is denominated. whereas the standard provisions (also called affirmative covenants) require the firm to operate in a respectable and businesslike manner. as measured by the safety of repayment of principal and interest. and other assets in view of their risk. The major factors affecting the cost of long-term debt (or the interest rate). corporate bond prices are effectively quoted in dollars and cents. Since the lender is committing funds for a long period of time.621% of par. on the other hand. he seeks to protect himself against adverse financial developments that may affect the borrower. The bond rating affects the rate of return on the bond. 12. Chapter 6 Interest Rates and Bond Valuation 105 7. However. the bondholders have the option of converting the bond into a certain number of shares of stock within a certain period of time. 8. paying taxes and liabilities when due. or Japanese investors. are loan size. which are sometimes included as part of a bond issue. waive the violation and renegotiate terms of the original agreement. Ratings are the result of detailed financial ratio and cash flow analyses of the issuing firm.21. or demand repayment. Bonds are quoted in percentage of par terms. Current yields are calculated by dividing the annual interest payment by the current price. and keeping accounting records in accordance with generally accepted accounting procedures (GAAP). Swiss. Standard provisions include such requirements as providing audited financial statements on a regular schedule. If a bond has a conversion feature. Short-term borrowing is normally less expensive than long-term borrowing due to the greater uncertainty associated with longer maturity loans. Publishing as Prentice Hall . Bonds are rated by independent rating agencies such as Moody’s and Standard & Poor’s with respect to their overall quality. 10. A financial manager must understand the valuation process in order to judge the value of benefits received from stocks. borrower risk. Violation of any of the standard or restrictive loan provisions gives the lender the right to demand immediate repayment of both accrued interest and principal of the loan. For example. The restrictive provisions (also called negative covenants) differ from the so-called standard debt provisions in that they place certain constraints on the firm’s operations. a dollar-denominated Eurobond issued by an American corporation can be sold to French. the lender does not normally demand immediate repayment but instead evaluates the situation in order to determine if the violation is serious enough to jeopardize the loan. return. in the case of convertibles. It provides extra compensation to bondholders for the potential opportunity losses that would result if the bond were called due to declining interest rates. maintaining all facilities in good working order. These constraints are intended to assure the lender that the borrowing firm will maintain a specified financial condition and managerial structure during the term of the loan. A quote of 98. Long-term lenders include restrictive covenants in loan agreements in order to place certain operating and/or financial constraints on the borrower. The lender’s options are: Waive the violation. is issued by a foreign borrower in a host country’s capital market and denominated in the host currency.621 means the bond is priced at 98. or $986. in addition to loan maturity. to force conversion. 11. An example is a French-franc denominated bond issued in France by an English company. Inc. German. and combined impact on share value. Hence. © 2012 Pearson Education. the less risk and the lower the yield. Stock purchase warrants. 9. to the thousandths place.

Cash flows—the cash generated from ownership of the asset. 17. the higher the risk. Three key inputs to the valuation process are: a. The valuation process applies to assets that provide an intermittent cash flow or even a single cash flow over any time period. Inc. b. © 2012 Pearson Education. The disparity between the required rate and the coupon rate will cause the bond to be sold at a discount or premium. The value of any asset is the PV of future cash flows expected from the asset over the relevant time period. Required return—the interest rate used to discount the future cash flows to a PV.106 Gitman/Zutter • Principles of Managerial Finance. whereas the required return fluctuates with shifts in the cost of long-term funds due to economic conditions and/or risk of the issuing firm. The selection of the required return allows the level of risk to be adjusted. and c. The equation for value is: CF1 CF2 CFn V0 = + + (1 + r ) (1 + r ) 1 2 (1 + r )n where: V0 = value of the asset at time zero CF1 = cash flow expected at the end of year t r = appropriate required return (discount rate) n = relevant time period 16. Timing—the time period(s) in which cash flows are received. The number of years to maturity must be multiplied by two. and the timing of cash flows. The three key inputs in the valuation process are cash flows. the higher the required return (discount rate). Thirteenth Edition 13. the basic bond valuation equation is adjusted as follows to account for the more frequent payment of interest: a. The annual interest must be converted to semiannual interest by dividing by two. 14. The basic bond valuation equation for a bond that pays annual interest is: n 1 1 V 0 = I × t + M× n t = 1 (1 + rd ) (1 + rd ) where: V0 = value of a bond that pays annual interest I = interest n = years to maturity M = dollar par value rd = required return on the bond To find the value of bonds paying interest semiannually. Publishing as Prentice Hall . A bond sells at a discount when the required return exceeds the coupon rate. A bond sells at par value when the required return equals the coupon rate. the required rate of return. A bond sells at a premium when the required return is less than the coupon rate. b. c. The coupon rate is generally a fixed rate of interest. 15. The required return must be converted to a semiannual rate by dividing it by two.

To protect against the impact of rising interest rates. The YTM can be found precisely by using a hand-held financial calculator and using the time value functions.e. Because the bond has an inflation protection feature.8% = 1. $75.000). $1. and $10. If the required return on a bond is constant until maturity and different from the coupon interest rate. Spreadsheets include a formula for computing the yield to maturity. $5. the Treasury Department can issue the I-bond at slightly lower interest rates than comparable bonds. 20.23 − 0. Inc. Some suggest that the relationship between the agencies’ and the issuers is one of the factors that contributed to the subprime crisis.08 = 0. Have the calculator solve for the interest rate. and the I as the annual payment. The concern is that rating agencies might hesitate to give low ratings. Chapter 6 Interest Rates and Bond Valuation 107 18. the issuers) happy in order to secure future business. $500.43% © 2012 Pearson Education. $100. the bond’s value approaches its $1. fearing that bond issues would no longer pay to have their bonds rated.000. The responsiveness of the bond’s market value to interest rate fluctuations is an increasing function of the time to maturity. $200. This interest value is the YTM.000 par value as the time to maturity declines.000. The yield-to-maturity (YTM) on a bond is the rate investors earn if they buy the bond at a specific price and hold it until maturity. and the n as the number of periods until maturity. Suggested Answer to Focus on Practice Box: I-Bonds Adjust for Inflation What effect do you think the inflation-adjusted interest rate has on the cost of an I-bond in comparison with similar bonds with no allowance for inflation? The cost of the I-bond when issued is the face value ($50. Answers to Warm-Up Exercises E6-1. Suggested Answer to Focus on Ethics Box: Can We Trust the Bond Raters? What ethical issues may arise because the companies that issue bonds pay the rating agencies to rate their bonds? The rating agencies have an incentive to keep their customers (i. 19..23% − IP IP = 1. Enter the B0 as the PV. a risk-averse investor would prefer bonds with short periods until maturity. Using this feature will also obtain the YTM since the YTM and IRR are determined the same way. Publishing as Prentice Hall . Finding the real rate of interest Answer: r* = RF − IP 0. Many calculators are already programmed to solve for the internal rate of return (IRR).

80% 0. Maturity Yield Real Rate of Interest Inflation Expectation 3 months 1.5%} ÷ 5 = 26. To obtain a minimum 2% real return.80 1.3% exactly matching the CPI rate. market segmentation theory allows for additional interest rate increases arising from either limited availability of funds or greater demand for funds at longer maturities.71 0.80 2.51 0.25 0.80 3.108 Gitman/Zutter • Principles of Managerial Finance. Thirteenth Edition E6-2.01% × 3) − (2.36% = 3.88 3 years 3.68 0.51% × 10) − (3. long-term interest rates tend to be higher than short-term rates because longer-term debt has lower liquidity.6% ÷ 5 = 5.41% 0. and borrower willingness to pay a higher interest rate to lock in money for a longer period of time.80 0. The real return would be zero if the T-bill rate was 3. In addition to expectations theory and liquidity preference theory. {(4. Inc.21 5 years 3. higher responsiveness to general interest rate movements.90 10 years 4. Yield curves may slope up for many reasons beyond expectations of rising interest rates.71 30 years 5.1% − 18. Calculating inflation expectation Answer: The inflation expectation for a specific maturity is the difference between the yield and the real interest rate at that maturity.80 4. Yield curve b. (3. According to liquidity preference theory.67% d. the T-bill rate would have to be at least 5.68% × 2) = 9.70 0.3%.03% − 5. Real returns Answer: A T-bill can experience a negative real return if its interest rate is less than the inflation rate as measured by the CPI.80 2.01 0.32% c.45 E6-4.7% × 5)} ÷ 5 = {45.91 2 years 2. E6-3. © 2012 Pearson Education.61% 6 months 1. Publishing as Prentice Hall .

PV of interest: PMT = −1. Inc.12% 5.20 1.51% = 0. Student answers will vary but should be consistent with their answers to part a.82% − 4. plus the face value of the bond that will be received at the maturity of the bond (end of year 5). from each nominal interest rate.51%. Calculating the PV of a bond when the required return exceeds the coupon rate Answer: The PV of a bond is the PV of its future cash flows.5% the bond will sell at par.000 N = 5 periods I = 8%/year Solve for PV = $13. Set the calculator on 1 period/year. Security Nominal Interest Rate Risk Premium AAA 5.611. 4.611. © 2012 Pearson Education.91.10)3 E6-7.78% − 4. The present value is a cash outflow.10)2 (1. In the case of the 5-year bond. This answer is consistent with the knowledge that when interest rates rise. Publishing as Prentice Hall .500 $850 Asset 2: PV = + + = $2. Asset 1: PV = $500 ÷ 0. You may use the bond valuation formula found in your text or you may use a financial calculator.15 = $3. the values of previously issued bonds fall. the expected cash flows are $1. Any required rate of return below the coupon rate will cause the bond to sell at a premium.51% = 3.27% B 7.25 PV of the bond’s face value: FV = $20.402. Chapter 6 Interest Rates and Bond Valuation 109 E6-5.969.791. The solution presented below is derived using a financial calculator. E6-8.78 5. The basic valuation model Answer: Find the PV of the cash flow stream for each asset by discounting the expected cash flows using the respective required return.31% E6-6.33 $1.791.12% − 4. or cost to investor. b.200 $1.25 + $13.82 7. Calculating risk premium Answer: We calculate the risk premium of other securities by subtracting the risk-free rate.10 (1.61% BBB 5.200 at the end of each year for 5 years.51% = 1.333.200 I = 8%/year N = 5 periods Solve for PV = $4. Bond valuations using required rates of return Answer: a. Student answers will vary but any required rate of return above the coupon rate will cause the bond to sell at a discount.66 The PV of this bond is $4. while at a required return of 4.66 = $18.

Personal finance: Real and nominal rates of interest LG 1. The number of polo shirts in one year = $109 ÷ $26. 4 shirts b. The real rate of return is 9% − 5% = 4%. e.5% P6-2.0381).110 Gitman/Zutter • Principles of Managerial Finance. A change in the tax law causes an upward shift in the demand curve. which is shown on the graph as the intersection of lines for current suppliers and current demanders. The change in the number of shirts that can be purchased is determined by the real rate of return since the portion of the nominal return for expected inflation (5%) is available just to maintain the ability to purchase the same number of shirts. Inc. $100 + ($100 × 0. Real rate of interest LG 1.1524 ÷ 4 = 0. d.25 d. Basic Real rate of return = 5. Interest rate fundamentals: The real rate of return LG1.8% more shirts (4. Thirteenth Edition Solutions to Problems P6-1. Intermediate a.0% = 2. He can buy 3.09) = $109 c.25 = 4. r = 4%. b. Publishing as Prentice Hall . $25 + ($25 × 0. The real rate of interest creates an equilibrium between the supply of savings and the demand for funds. P6-3. See graph. c. Intermediate a. © 2012 Pearson Education. causing the equilibrium point between the supply curve and the demand curve (the real rate of interest) to rise from r0 = 4% to r0 = 6% (intersection of lines for current suppliers and demanders after new law).1524.5% − 3.05) = $26.

The yield curve for U.5% + 5% = 7. Publishing as Prentice Hall . Treasury issues. Obviously.0%.5% 5-year bond: RF = 2.S. However. P6-5. Chapter 6 Interest Rates and Bond Valuation 111 P6-4. The yield curve is slightly downward sloping. If the real rate of interest (r ) drops to 2.5% * b. Yield curve LG 1. a slowing economy may diminish the perceived need for funds and the resulting interest rate being paid for cash.S. The curve may reflect a general expectation for an economic recovery due to inflation coming under control and a stimulating impact on the economy from the lower rates. Intermediate a. Challenge a. b.5% 2-year note: RF = 2. Inc.5% + 9% = 11. rl = r* + IP + RP1 For U. c.5% + 8% = 10. the nominal interest rate in each case would decrease by 0. the second scenario is not good for business and highlights the challenge of forecasting the future based on the term structure of interest rates. © 2012 Pearson Education. reflecting lower expected future rates of interest.5% 3-month bill: RF = 2. RP = 0 rF = r + IP * 20-year bond: RF = 2. reflecting the prevailing expectation of higher future inflation rates. Treasury issues is upward sloping.5% point. Nominal interest rates and yield curves LG 1.5% + 6% = 8.

Thirteenth Edition d.0% D 11.0% – 10. or changes in tax legislation.1% B 11.2% – 8. Market segmentation theorists would argue that the upward slope is due to the fact that under current economic conditions there is greater demand for long-term loans for items such as real estate than for short-term loans such as seasonal needs. Followers of the liquidity preference theory would state that the upward sloping shape of the curve is due to the desire by lenders to lend short term and the desire by business to borrow long term.5% = 3. general expectation for an economic recovery due to inflation coming under control and a stimulating impact on the economy from the lower rates.1% = 2. c.6% – 9. d. The real rate of interest decreased from January to March. a federal government budget deficit.0% C 13. ignoring the other yield curve theories. The dashed line in the part c graph shows what the curve would look like without the existence of liquidity preference. reflecting lower expected future rates of interest. Forces that may be responsible for a change in the real rate of interest include changing economic conditions such as the international trade balance. The yield curve is slightly downward sloping. Challenge Real rate of interest (r* ): ri = r + IP + RP * RP = 0 for Treasury issues r = ri − IP * a. remained stable from March through August. Nominal Real Rate of Security Rate (rj) – IP = Interest (r* ) A 12.0% = 3. Inc.3% = 3. © 2012 Pearson Education.1% b.4% – 8.9% E 11.0% – 8. The curve may reflect a current.112 Gitman/Zutter • Principles of Managerial Finance. P6-6. e.2% = 3. Nominal and real rates and yield curves LG 1. and finally increased in December. Publishing as Prentice Hall .

investors must have expected the current 5-year rate to be 9. Five years ago. the total return over ten years would have been the same on a 10-year bond and on two consecutive 5-year bonds. According to the expectations theory. which could be due to a decline in the expected level of inflation. d. or a total of 46. the 10-year bond was paying 9.7% because at that rate. Chapter 6 Interest Rates and Bond Valuation 113 P6-7. Five years ago.5%. Basic Risk-free rate: RF = r + IP * a. Intermediate a. reflecting higher expected future rates of interest. the 5-year bond was paying just 9. b. {(9. Security r* + IP = RF A 3% + 6% = 9% B 3% + 9% = 12% C 3% + 8% = 11% D 3% + 5% = 8% E 3% + 11% = 14% © 2012 Pearson Education. Term structure of interest rates LG 1. the yield curve was relatively flat.5%} ÷ 5 = 48.7% P6-8. the yield curve is upward sloping. Inc. Risk-free rate and risk premiums LG 1. which would result in approximately 95% in interest over the coming decade. reflecting lower expected interest rates.3%. At the same time.5% × 10) − (9. Today. Two years ago. the yield curve was downward sloping. The numbers are given below. and c. Publishing as Prentice Hall . reflecting expectations of stable interest rates.5% over the five years.6% ÷ 5 = 9.3% × 5)} ÷ 5 = {95% − 46.

Risk premiums LG 1.5% = 6% ri = r + IP + RP or r1 = rF + risk premium * c.97708 × $1. c. Basic a.000 = $977. Total interest expense = $70. Thirteenth Edition b.08 = $57.000 Interest expense tax savings (0.5% = 3% Security B: RP = 2% + 1. 0. Bond interest payments before and after taxes LG 2.07) = $70.000) 61. RFt = r* + IPt Security A: RF3 = 2% + 9% = 11% Security B: RF15 = 2% + 7% = 9% b.250 Net after-tax interest expense $113.500. Nominal rate: r = r + IP + RP * Security r* + IP + RP = r A 3% + 6% + 3% = 12% B 3% + 9% + 2% = 14% C 3% + 8% + 2% = 13% D 3% + 5% + 4% = 12% E 3% + 11% + 1% = 15% P6-9. it is probable that the maturity of each security differs.750 P6-11. Risk premium: RP = default risk + maturity risk + liquidity risk + other risk Security A: RP = 1% + 0.00 b. Total before tax interest $175.000 ÷ $977. 2017 bond maturity.07] = ($1.35 × $175. The yield to maturity is higher than the current yield.000 par value. Inc.5% + 1% + 1.05700 × $1.0583 = 5.000) ÷ $977. Security A: r1 = 11% + 3% = 14% Security B: r1 = 9% + 6% = 15% Security A has a higher risk-free rate of return than Security B due to expectations of higher near- term inflation rates. Intermediate a. Yearly interest = [($2. d.000 × 0. Bond prices and yields LG 4. (0. The issue characteristics of Security A in comparison to Security B indicate that Security A is less risky.5% + 1% + 0. P6-10.000/2500) × 0.000 c.00 per bond × 2. The bond is selling at a discount to its $1.08 b. Since the expected inflation rates differ.92 in price appreciation between today and the May 15. because the former includes $22.83% c. Publishing as Prentice Hall . © 2012 Pearson Education. Intermediate a.500 bonds = $175.08 = 0.114 Gitman/Zutter • Principles of Managerial Finance.

I = 6.000 PMT = $5.000 3 5. PMT = $1.06)5 1 2 3 4 V0 = $8.000 D 1–5 $ 1.791.06) (1 + 0.27 Worksheet 2 3. you would be receiving less than your required 6% return.36 2 $ 5.200 $1.200 $1.53 6 8. Publishing as Prentice Hall .200.000 Use Cash Flow $14.000 N = 3.15 $2. Cash flows: CF1 − 5 $1. Basic a.000 E 1 $ 2. since if you paid more than that amount.06) (1 + 0. Personal finance: Valuation fundamentals LG 4.500 N = 6.871.115.000 5 4.000 C 1 0 N = 5. FV = $5.713. Chapter 6 Interest Rates and Bond Valuation 115 P6-12.06) (1 + 0. I = 16 $16.000 Required return: 6% CF1 CF2 CF3 CF4 CF5 b.200 $1.000 3 0 4 0 5 $35.200 V0 = + + + + (1 + 0.06) (1 + 0.500 PMT = $1. P6-13.791 Using Calculator: N = 5.000 6 1. $9. I = 18 $10. Valuation of assets LG 4.000 Solve for PV: $8791 The maximum price you should be willing to pay for the car is $8.000 © 2012 Pearson Education.000 B 1–∞ $ 300 1 ÷ 0. I = 12. V0 = + + + + (1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r )5 1 2 3 4 $1.200 CF5 $5. Inc.500 FV = $7.000 4 7.200 $6.663.000 3 $ 5.96 2 0 FV = $35. Basic Present Value of Asset End of Year Amount Cash Flows A 1 $ 5.

Since Complex Systems’ bonds were issued. Basic Bond Calculator Inputs Calculator Solution A N = 20.39 B N = 16.000 $1.000 $ 9.000 9. Basic bond valuation LG 5. I = 8. Bond valuation—annual interest LG 5.030.122.030. I = 12. which reduces the value of the asset. FV = $1.156.42 $16. Publishing as Prentice Hall .510 $ 8. I = 18.481 CF5 15. if the required return is less than the coupon rate. PMT = 0. PMT = 0.000 Solve for PV: $1. FV = $500 $ 450.10 × $100 = $10.59 $13. In contrast to part a above.455 5.314 7.565 $ 7. Intermediate a.000 = $140.16 × $500 = $80. therefore assuming the highest risk. N = 16. I = 13.000 = $120.90 E N = 10. I = 12%.000 Solve for PV = $1. Thirteenth Edition P6-14.00 C N = 8. PMT = 0.000 When the required return is equal to the coupon rate. the required rate of return increases. P6-16.91 b. I = 10.14 × $1.823. PMT = 0.550 Calculator solutions: $18.92.12 × $1. the bond value is equal to the par value. c.60 D N = 13. FV = $1.000 $1.08 × $1.000 $1. N = 16. P6-15. By increasing the risk of receiving cash flow from an asset. PMT = 0. FV = $1. The maximum price Laura should pay is $13. PMT = $120.116 Gitman/Zutter • Principles of Managerial Finance. FV = $1. there may have been a shift in the supply- demand relationship for money or a change in the risk of the firm.149.47 b. Inc. c. the bond will sell at a premium (its value will be greater than par). FV = 1. Unable to assess the risk. PMT = $120.000 = $80. Laura would use the most conservative price. I = 10%.89 © 2012 Pearson Education.000.022. Intermediate a. @ 10% @ 15% @ 22% N PMT Low Risk Average Risk High Risk CF1–4 $3. FV = $100 $ 85. Personal finance: Asset valuation and risk LG 4.

Intermediate a.000 $953. PMT = $120. PMT = $110.46 © 2012 Pearson Education.79 (3) N = 9. Bond value and time—constant required returns LG 5.000 $1. Chapter 6 Interest Rates and Bond Valuation 117 P6-17. The required return on the bond is likely to differ from the coupon interest rate because either (1) economic conditions have changed. I = 14%. c.000 $877.18 (3) N = 12. PMT = $120.000 $886. Bond value and changing required returns LG 5. FV = $1. Bond Calculator Inputs Calculator Solution (1) N = 12. I = 15%. P6-18. causing a shift in the basic cost of long-term funds. d. PMT = $120.000 $1. PMT = $120. PMT = $120. I = 8%.000 $982. FV = $1. PMT = $110.07 (4) N = 6. PMT = $120. FV = $1. PMT = $110. the market value is less than the par value. I = 14%. the bond therefore sells at a discount. Publishing as Prentice Hall .000 $901. When the required return is less than the coupon rate.000 $922. I = 14%. FV = $1.23 (5) N = 3. I = 14%.00 (2) N = 12. I = 11%.226. I = 14%. or (2) the firm’s risk has changed. Bond Calculator Inputs Calculator Solution (1) N = 15.000.16 (2) N = 12. FV = $1. FV = $1.08 b. FV = $1.57 (6) N = 1. I = 14%. Inc. FV = $1. FV = $1.000 $ 783. When the required return is greater than the coupon rate. Intermediate a. the market value is greater than the par value and the bond sells at a premium.

000. Bond Table Values Calculator Solution (1) N = 15. PMT = $110. I = 11%.000 $ 815.119. PMT = $110.73 c. I = 8%.00 1.000 $1. Thirteenth Edition b.00 14% 897. If Lynn wants to minimize interest rate risk in the future. the more responsive the market value of the bond to changing required returns.119.78 (2) N = 5.118 Gitman/Zutter • Principles of Managerial Finance.000 $ 897. FV = $1. Bond Calculator Inputs Calculator Solution (1) N = 5.256. FV = $1.256. PMT = $110. I = 11%.000 $1. FV = $1. P6-19. PMT = $110.000. PMT = $110. she would choose Bond A with the shorter maturity. and vice versa.01 b. I = 8%.00 (3) N = 5.78 $1. FV = $1. © 2012 Pearson Education. Value Required Return Bond A Bond B 8% $1. The bond value approaches the par value. Any change in interest rates will impact the market value of Bond A less than if she held Bond B. Publishing as Prentice Hall . Challenge a. c.000 $1.000 $1.000. I = 14%.75 11% 1.01 815. d.00 (3) N = 15.78 (2) N = 15. I = 14%. FV = $1.000. Personal finance: Bond value and time—changing required returns LG 5. Inc. FV = $1.73 The greater the length of time to maturity. PMT = $110.

the YTM is 12. Publishing as Prentice Hall .000 + $900) ÷ 2] b. Bond D is selling at a discount to par. P6-21. FV = $1.77% 8.71% [($1.22% [($500 + $560) ÷ 2] $150 + [($1. Intermediate a. I = 12. Chapter 6 Interest Rates and Bond Valuation 119 P6-20. the coupon interest rate equals the yield to maturity (regardless of the number of years to maturity). The yield to maturity approaches the coupon interest rate as the time to maturity declines.000 + $1.000 + $820) ÷ 2] B = 12. The correctness of this number is proven by putting the YTM in the bond valuation model. © 2012 Pearson Education.000 − $900) ÷ 3] E = = 8.685%. Bond B is selling at par value.000 − $1. LG 6: Yield to maturity LG 6. Basic Bond A is selling at a discount to par.95% [($1. P6-22.00 Since PV is $955. The market value of the bond approaches its par value as the time to maturity declines. Intermediate a. b.38% 10.00% 12.00% $60 + [($500 − $560) ÷ 12] C = = $10. Calculator Bond Approximate YTM Solution $90 + [($1. the YTM is equal to the rate derived on the financial calculator.120) ÷ 10] D = = 13. Bond C is selling at a premium to par.36% 12. Case B highlights the fact that if the current price equals the par value. The yield-to-maturity approaches the coupon interest rate as the time to maturity declines. Inc.81% [($1. Bond E is selling at a premium to par. This proof is as follows: N = 15.120 ÷ 2] $50 + [($1.02% 12.000 Solve for PV = $955.00 and the market value of the bond is $955. Using a financial calculator. Yield to maturity LG 6. The market value of the bond approaches its par value as the time to maturity declines. PMT = $120.000 − $820) ÷ 8] A = = 12.685%. Yield to maturity LG 6.

Challenge a. N = 5. I = 6%. FV = $1.120 Gitman/Zutter • Principles of Managerial Finance.152. I = 4%. The reasoning behind this result is that for both bonds the principal is priced to yield 12%.000.77% and the yield to maturity of Bond B is 11.249. I = 5%. the yield to maturity of Bond A is 11.59% with the 10% reinvestment rate for the interest payments.000 Solve for PV = $ $841. I = 7%. The difference is due to the differences in interest payments received each year.531.000 ÷ 2 = $50. 5.31 Total future cash flows: $366.000 ÷ $1072.655 bonds × $140 = $2. Intermediate Bond Computer Inputs Calculator Solution A N = 24. PMT= $60. Personal finance: Bond valuation and yield to maturity LG 2. I = 10%.000 Solve for PV = $783.000 $1.15 P6-25. Solve for FV = $366. Publishing as Prentice Hall . I = 14 ÷ 2 = 7%.366. Interest income of A = 25. FV = $1. Solve for FV = $854.24 E N = 8.47 B N = 40. PMT = 0. PMT = $30.000 = $1. I = 12%. Bond B is more dependent upon the reinvestment of the large coupon payment at the yield to maturity to earn the 12% than is the lower coupon payment of Bond A. However.000 $1.71 e. Intermediate N = 6 × 2 = 12.000 $1.70 d. N = 5. PMT = $3.000 Solve for PV = $ 1. FV = $500 $ 464. FV = $1.71 = 25. FV = $100 $ 76.655 c.000 = $60.20 Interest income of B = 18. FV = $1. Using the calculator.000 = $1.31 N = 5.11 © 2012 Pearson Education.10 × $1. PMT = $50. I = 10%.31 + $1. FV = $1. PMT = $60.000 = $140.06 × $1. I = 12%. PMT = $70.854.14 × $1.000 ÷ $783. 6.520 Number of Bond B bonds = $20. P6-24.71 + $1. Mark would be better off investing in Bond A. Inc. Bond valuation—semiannual interest LG 6. Bond valuation—semiannual interest LG 6. Number of Bond A bonds = $20.71 N = 5. The principal payments at maturity will be the same for both bonds.71 Total future cash flows: $854. I = 7%.10 = 18.072. PMT = 0.00 C N = 10.10 b.88 D N = 20.611. FV = $1. PMT = 0.520 bonds × $60 = $1.000. At the end of the 5 years both bonds mature and will sell for par of $1. PMT = $140. Thirteenth Edition P6-23.

Some students may argue that such a policy decreases the reliability of the rating agency’s bond ratings since the rating is not purely based on the quantitative and nonquantitative factors that should be considered. I = 10%. I = 12% ÷ 4 = 3. Case Case studies are available on www.com. N = 25. Evaluating Annie Hegg’s Proposed Investment in Atilier Industries Bonds This case demonstrates how a risky investment can affect a firm’s value.000 Solve for PV = $1. and then draw some conclusions about the value of the firm in this situation. ratings are a way to generate additional business for the rating firm.257. Other students may argue that. The value of the stock if the bond is converted is: 50 shares × $30 per share = $1.000 Solve for PV = $1.080 b. Annie should convert the bonds.255.30 The bond would be at a premium.46 The bond would be at a discount. 3. Publishing as Prentice Hall . c. Intermediate Student answers will vary. students will see the relationship between risk and valuation. PMT = 0. FV = $1.myfinancelab. FV = $5. I = 3%. I = 8%. I = 6%. FV = $1.000 ÷ 4 = $125. like a loss leader. N = 50. PMT = $40. In addition to gaining experience in valuation of bonds.422. First. © 2012 Pearson Education.67 The bond would be at a premium.000 Solve for PV = $818. Chapter 6 Interest Rates and Bond Valuation 121 P6-26. Current value of bond under different required returns – semiannual interest 1. students must calculate the current value of Atilier’s bonds. N = 25. Bond valuation—quarterly interest LG 6. 2. Inc.000 Solve for PV = $999. FV = $1. Ethics problem LG 6. Current value of bond under different required returns – annual interest 1. a. rework the calculations assuming that the firm makes the risky investment. One of the goals of the new law is to discourage such a practice.500 while if the bond was allowed to be called in the value would be on $1. Challenge N = 4 × 10 = 40.000 Solve for PV = $4. N = 25.0%. PMT = $80. PMT = 3.13 P6-27. PMT = $80.92 The bond would selling at about its par value. PV = $80. FV = $1.10 × $5.

© 2012 Pearson Education. FV = $1.0813.61 would be earned by Annie. and is priced at $983. Thirteenth Edition 2.091. When the change is made from annual to semiannual payments the value of the premium and par value bonds increase while the value of the discount bond decreases. An increase in interest rates is likely due to the possibility of higher inflation. PMT = $40. I = 8. N = 22. Annie should probably not invest in the Atilier bond. Using the calculator the YTM on this bond assuming annual interest payments of $80.08 The bond is more sensitive to interest rate changes when the time to maturity is longer (22 years) than when the time to maturity is shorter (15 years). I = 9%. I = 4%. FV = $1.00 The bond would be at par value. d.000 Solve for PV = $1. Hence.77.80 would be 8.000. I = 5%.000 Solve for PV = $817.000 Solve for PV = $901. N = 25. PMT = $80. When the required return and coupon are equal the bond sells at par. This amount is the maximum Annie should pay for the bond. or about 8. PMT = $40. 4. I = 7%.15%. 3.75%. N = 25. Bond value at 7% and 15 years to maturity.000 Solve for PV = $1. PMT = $80.77 e. thus driving the price down. When the required return is above (below) the coupon the bond sells at a discount (premium). If expected inflation increases by 1% the required return will increase from 8% to 9%. h. Inc. 1.122 Gitman/Zutter • Principles of Managerial Finance. and the bond price would drop to $901. The term to maturity is long and thus the maturity risk is high.80 = 0.13%.61 g. Maturity risk decreases as the bond gets closer to maturity.80 (0.08 would be earned by Annie. FV = $1. and a current price of $983. 25 years to maturity. Antilier Industries provides a yield of 8% ($80). i. Publishing as Prentice Hall . the current yield is 80/983. The bond would increase in value and a gain of $110. FV = $1. 2. N = 15. An increase in interest rates is likely due to the potential downgrading of the bond. 3.000 Solve for PV = $924.77 assuming an increase in interest rates of 1%.75 is well above her minimum price of $901.81 due to the higher required return and the inverse relationship between bond yields and bond values. PMT = $80. The bond would increase in value and a gain of $91. PMT = $80.98380 × 1. N = 50.81 f. The price of $983. This difference is due to the higher effective return associated with compounding frequency more often than annual.000). FV = $1.110. I = 7%.44 The bond would be at a discount. There are several reasons for this conclusion. Under all three required returns for both annual and semiannual interest payments the bonds are consistent in their direction of pricing. thus driving the price down. N = 50.000 Solve for PV = $1. The value of the bond would decline to $924. PV = $1.

Group Exercise Group exercises are available on www. Using the current yield on a comparable Treasury. any recent filing will suffice. the risk premium can then be calculated. This chapter is concerned with credit ratings. © 2012 Pearson Education. Each group is asked to use current information from their shadow firm to flesh out the details for their fictitious firm. as this is the firm they will be living with for another two months. The first lesson students will learn is the lack of transparency in the bond market. Since a recent debt issuance is needed the assignment can be redirected from publicly-accessed websites to the most recent filings with the SEC. For many firms there will be multiple offerings. Publishing as Prentice Hall . however the details of the project are entirely up to the discretion of the group. particularly when compared to the stock market. Each group is asked to retrieve the interest rate of a recent debt issuance. Students should be encouraged to get creative. The final step for the group is to address a potential capital investment.com. Inc.com/irc under the Instructor’s Manual. Students should realize the same firm can be given different ratings on different offerings according to each offering’s covenants. The interest rate will be derived from the information of the shadow firm.myfinancelab. This information on rates is then combined with the credit rating of the offering. The steps for the assignment are very straightforward. Chapter 6 Interest Rates and Bond Valuation 123 Spreadsheet Exercise The answer to Chapter 6’s CSM Corporation spreadsheet problem is located on the Instructor’s Resource Center at www. Updated information is not as easily compared across multiple sites and details are often sketchy.pearsonhighered.

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