Debt Valuation and Interest

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 9
Debt Valuation and
Interest
Copyright © 2018, 2014, 2011 Pearson

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Rights Reserved
Learning Objectives (1 of 2)
1. Identify the key features of bonds and describe the
difference between private and public debt markets.
2. Calculate the value of a bond and relate it to the yield to
maturity on the bond.
3. Describe the four key bond valuation relationships.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning Objectives (2 of 2)
4. Identify the major types of corporate bonds.
5. Explain the effects of inflation on interest rates
and describe the term structure of interest rates.
Principles Applied in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 3: Cash Flows Are the Source of Value
9.1 OVERVIEW OF CORPORATE DEBT
Corporate Borrowings
• When a corporation borrows money to finance its
operations, it has two main sources:
1. Loan from a financial institution (known as private
debt since it involves only two parties)
2. Bonds (known as public debt since they can be
traded in the public financial markets)
Borrowing Money in the Private Financial
Market
Financial Institutions provide loans to finance
firm’s day-to-day operations (working capital
loans) or it might be used for the purchase of
equipment or property (transaction loans). Such a
loan is considered a private market transaction
because it involves only the two parties to the loan.
Private Debt Placements (1 of 2)
Firms can raise money by selling debt securities
directly to investors through a private placement.
The major investors in private placements are large
financial institutions, with the three most important
investor groups being (1) Life insurance companies,
(2) state and local retirement funds, and (3) private
pension funds.
Private Debt Placements (2 of 2)
• Advantages of Private Debt Placement
– Speed
– Reduced costs
– Financing flexibility
• Disadvantages of Private Debt Placement
– Interest costs
– Restrictive covenants
– The possibility of future SEC registration
Floating—Rate Loans (1 of 2)
• Loans made in the private financial market are
typically floating-rate loans, which means that every
month or every quarter the rate of interest charged by
the lender adjusts up or down depending on the
movement of an agreed-upon benchmark rate of
interest.
• The most popular benchmark rate of interest is the
London Interbank Offered Rate (LIBOR). This is the
daily rate that is based on the interest rates at which
banks offer to lend in the London wholesale or
interbank market.
Floating—Rate Loans (2 of 2)
For example, a corporation may get a 1-year loan
with a rate of 300 basis points (or 3%) over LIBOR
with a ceiling of 11% and a floor of 4%.
Table 9.1 Types of Bank Debt
Blank (Panel A) Types of Bank Loans—Classified by Intended Use
Working-capital Typically, these loans set up a line of credit based on an open-ended credit
Loans agreement whereby the firm has prior approval to borrow up to a set limit. This type
of credit agreement is similar to that of a personal credit card that provides a line of
credit up to an agreed-on limit. The credit is then used to provide cash needed to
support the firm’s day-to-day business needs.
Transaction Firms use this type of loan to finance a specific asset. These loans
loans typically call for installment payments designed to repay the principal
amount of the loan, plus interest, with fixed monthly or annual payments.
Home mortgage and automobile loans are examples of transaction loans
that require installment payments.
(Panel B) Types of Bank Loans—Classified by the Collateral Used to Secure
the Loan
Secured debt This type of debt acts as a promise to pay that is backed by granting the lender an
interest in a specific piece of property, known as collateral. The property used to
secure the loan can include virtually any tangible business asset, such as accounts
receivable, inventory, plant and equipment, or real estate.
Unsecured debt This type of debt acts as a promise to pay that is not supported by collateral, so the
lender relies on the creditworthiness and reputation of the borrower to repay the debt
when due.
CHECKPOINT 9.1: CHECK YOURSELF
Calculating the Rate of Interest on a Floating-Rate Loan
Consider the same loan period as above but change the spread over LIBOR from
.25% to .75%. Is the ceiling rate or floor rate violated during the loan period?
Step 1: Picture the Problem (1 of 2)
The graph on the next slide shows the LIBOR index
(series 1), LIBOR plus the spread of 75 basis points
(series 2), the ceiling rate (series 3), and the floor
rate (series 4).
Step 2: Decide on a Solution Strategy (1 of 2)
• We have to determine the floating rate for every
week and see if it exceeds the ceiling or falls
below the floor.
• Floating rate on Loan
= LIBOR for the previous week + spread of .75%
Step 2: Decide on a Solution Strategy (2 of 2)
The floating rate on loan cannot exceed the ceiling
rate of 2.5% or drop below the floor rate of 1.75%.
– If the floating rate falls below the floor, the rate will be
reset at the floor rate.
– If the floating rate exceeds the ceiling, the rate will be
reset at the ceiling rate.
Step 3: Solve (1 of 2)
Blank LIBOR LIBOR + Spread (.75%) Loan Rate
2/29/2008 1.98% Blank Blank
3/7/2008 1.66% 2.73% 2.50%
3/14/2008 1.52% 2.44% 2.41%
3/21/2008 1.35% 2.27% 2.27%

Ceiling
3/28/2008 1.60% 2.10% 2.10%
Violated
4/4/2008 1.63% 2.35% 2.35%
4/11/2008 1.67% 2.38% 2.38%
4/18/2008 1.88% 2.42% 2.42%
4/25/2008 1.93% 2.63% 2.50%
5/2/2008 Blank 2.68% 2.50%
The table shows the ceiling is violated during the
first week and last two weeks of the loan period.
The floor rate is never violated.
Step 4: Analyze
• The ceiling is the maximum rate charged on the
loan while floor is the minimum rate charged on
the loan. If the ceiling or floor rates are violated,
the loan rate is reset to the ceiling rate or the floor
rate.
• If there were no ceiling, the loan rate would have
been 2.73% during the first week of the loan, and
2.63% and 2.68% during the last two weeks of the
loan.
Borrowing Money in the Public Financial
Market
Corporations engage the services of an investment
banker while raising long-term funds in the public
financial market. The investment banker performs
three basic functions:
– Underwriting: assuming risk of selling a security
issued. The client is given the money before the
securities are sold to the public.
– Distributing or selling securities to ultimate investors
– Advising such as on source of capital, timing of the
sale of securities
Corporate Bonds
• Corporate bond is a security sold by corporation
that has promised future payments and a maturity
date.
• If the firm fails to make its promised interest and
principal payments, then the bond trustee can
classify the firm as insolvent and force it into
bankruptcy.
Basic Bond Features
• The basic features of a bond include the following:
– Bond indenture
– Claims on assets and income
– Par or face value
– Coupon interest rate
– Maturity and repayment of principal
– Call provision and conversion features
Table 9.2 Bond Terminology (1 of 2)
Indenture The indenture is the legal agreement between the firm issuing the bonds and the bond
trustee, who represents the bondholders. It lists the specific terms of the loan agreement,
including a description of the bonds, the rights of the bondholders, the rights of the issuing
firm, and the responsibilities of the trustee.
Priority of In the case of insolvency, claims of debt in general, including bonds, are honored before
claims those of both common stock and preferred stock. In addition, interest payments hold priority
on assets and over dividend payments for common and preferred stock.
income
Par value The par value of a bond, also known as its face value, is the principal that must be repaid to
the bondholder at maturity. In general, corporate bonds are issued with par values in
increments of $1,000. Also, when bond prices are quoted in the financial press, prices are
generally expressed as a percentage of the bond’s par value.
Maturity and The maturity date refers to the date on which the bond issuer must repay the principal or par
repayment of value to the bondholder.
principal
Coupon The coupon rate on a bond indicates the percentage of the par value of the bond that will be
interest paid out annually in the form of interest and is quoted as an APR.
Rate
Table 9.2 Bond Terminology (2 of 2)
Current yield The current yield on a bond refers to the ratio of the annual interest payment to the bond’s
current market price. If, for example, we have a bond with an 8% coupon interest rate, a par
value of $1,000, and a market price of $700, it has a current yield of 11.4%, calculated as
follows:
Annual Interest Payment
Current Yield =
Current Market Price of the Bond
0.08 × $1,000
=
$700
$80
= = 0.114, or 11.4% (9-1)
$700
Call provision The call provision provides the issuer of the bond with the right to redeem or retire a bond
before it matures.
Conversion Some bonds have a conversion feature that allows bondholders to convert their bonds into a
feature set number of shares of common stock.
Bond Ratings and Default Risk
Bond ratings indicate the default risk i.e. the
probability that the firm will make the bond’s
promised payments. Rating agencies use
borrower’s financial statements, financing mix,
profitability, variability of past profits, and make
judgments about the quality of the firm’s
management in order to determine ratings.
Table 9.3 Interpreting Bond Ratings
Bond Rating Category Standard & Moody’s Description
Poor’s
Investment Grade: Blank Blank Blank
Prime or AAA Aaa Highest quality; extremely strong capacity to pay

highest strong
High quality AA Aa Very strong capacity to pay
Upper medium A A-1, A Upper medium quality; strong capacity to pay
Medium BBB Baa-1, Baa Lower medium quality; changing circumstances

could impact the firm’s ability to pay
Not Investment Grade: Blank Blank Blank
Speculative BB Ba Speculative elements; faces uncertainties
Highly speculative B, CCC, CC B, Caa, Ca Extremely speculative and highly vulnerable to

nonpayment
Default D C Income bond; doesn’t pay interest
9.2 VALUING CORPORATE DEBT
Valuing Corporate Debt
The value of corporate debt is equal to the present
value of the contractually promised principal and
interest payments (the cash flows) discounted back
to the present using the market’s required yield to
maturity on bonds of similar risk.
Valuing Bonds by Discounting Future
Cash Flows (1 of 3)
Step 1: Determine bondholder cash flows, which
are the amount and timing of the bond’s promised
interest and principal payments to the bondholders.
Annual Interest = Par value × coupon rate
• Example: The annual interest for a 10-year bond
with coupon interest rate of 7% and a par value of
$1,000 is equal to $70, (.07 × $1,000 = $70). This
bond will pay $70 every year and $1,000 at the
end of 10-years.
Cash Flows (2 of 3)
Step 2: Estimate the appropriate discount rate on a
bond of similar risk. Discount rate is the return the
bond will yield if it is held to maturity and all bond
payments are made.
Calculating a Bond’s Yield to Maturity
(YTM)
We can think of YTM as the discount rate that
makes the present value of the bond’s promised
interest and principal equal to the bond’s observed
market price.
Interest year 1 Interest year 2 Interest year 3 Interest year n Principal

Bond Price = + + + + +
(1 + YTM )1 (1 + YTM )2 (1 + YTM )3 (1 + YTM )n (1 + YTM )n
Cash Flows (3 of 3)
Step 3: Calculate the present value of the bond’s
interest and principal payments from Step 1 using
the discount rate in step 2.
 Present Value of the   Present Value of the 

Bond    
=  Bond's Coupon Interest  +  Principal Amount (par Value) 
Value    
 Payments   of the Bond Issue 
Calculating the Yield to Maturity on a Corporate Bond
Calculate the YTM on the Ford bond where the bond price rises to $900 (holding all
other things equal).
Step 1: Picture the Problem
YTM = ?
Years 0 1 2 3… Blank 11
Cash flow −$900 $65 $65 $65 Blank $1,065
Purchase price = $900

Interest payments = $65 per year for years 1-11
Final payment = $1,000 in year 11 of principal.
Step 2: Decide on a Solution Strategy
We can use equation 9-2a to find YTM. YTM is the
rate that makes the present value of all future
expected cash flows equal to the current market
price. We can also solve for YTM using a calculator
and a spreadsheet.
Using a Mathematical Equation
Interest year 1 Interest year 2 Interest year 3 Interest year n Principal

Bond Price = + + + + +
(1 + YTM )1 (1 + YTM )2 (1 + YTM )3 (1 + YTM )n (1 + YTM )n
• It is cumbersome to solve for YTM by hand using

the equation. It is more practical to use the
financial calculator or the spread sheet.
Using a Financial Calculator Using an Excel Spreadsheet

N = 11 = RATE(nper, pmt,pv,fv)
I/Y = 7.89 = RATE (11,65,−900,1000)
PV = −900 = 7.89%
PMT = 65
FV = 1,000
Step 4: Analyze
The yield to maturity on the bond is 7.89%. The
yield is higher than the coupon rate of interest of
6.5%. Since the coupon rate is lower than the yield
to maturity, the bond is trading at a price below
$1,000. We call this a discount bond.
Using Market—Yield—to—Maturity Data
(1 of 2)
Market-yield-to-maturity data are regularly reported

by a number of investor services and are often
quoted in terms of credit spread, or yield spread, or
spread over Treasury bonds. Table 9-4 contains
some example yield to maturity by credit rating –
this directly provides us with the yield to maturity on
bonds with different levels of risk.
Table 9.4 Corporate Bond Yields: Bond Yields by Bond
Rating and Term to Maturity (1 of 2)
Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years
Aaa/AAA 0.22 0.31 0.42 0.76 1.26 2.00 3.41
Aa1/AA+ 0.26 0.43 0.58 0.96 1.46 2.17 3.62
Aa2/AA 0.29 0.55 0.74 1.16 1.66 2.35 3.83
Aa3/AA– 0.31 0.58 0.77 1.20 1.70 2.39 3.88
A1/A+ 0.32 0.60 0.80 1.23 1.73 2.43 3.93
A2/A 0.55 0.80 0.98 1.40 1.89 2.57 4.03
A3/A– 0.62 0.95 1.18 1.66 2.19 2.92 4.51
Baa1/BBB+ 0.83 1.19 1.42 1.91 2.45 3.18 4.80
Baa2/BBB 1.00 1.39 1.65 2.17 2.73 3.48 5.17
Table 9.4 Corporate Bond Yields: Bond Yields by Bond
Rating and Term to Maturity (2 of 2)
Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years
Baa3/BBB– 1.49 1.87 2.11 2.62 3.16 3.91 5.56
Ba1/BB+ 2.27 2.64 2.90 3.41 3.98 4.75 6.37
Ba2/BB 3.04 3.41 3.68 4.21 4.79 5.58 7.19
Ba3/BB– 3.82 4.18 4.47 5.00 5.61 6.42 8.00
B1/B+ 4.60 4.95 5.25 5.79 6.42 7.26 8.82
B2/B 5.38 5.72 6.04 6.59 7.24 8.10 9.63
B3/B– 6.15 6.49 6.82 7.38 8.06 8.93 10.45
Caa/CCC+ 6.93 7.26 7.61 8.17 8.87 9.77 11.26
U.S. Treasury 0.18 0.25 0.32 0.60 1.00 1.59 2.76

Yield
Using Market Yield to Maturity Data (2 of 2)
• A credit or yield spread represents the difference
in the number of basis points (with 100 basis
points equal to 1 percent) that a corporate bond
yields over a U.S. Treasury security of the same
maturity as the corporate bond.
• For example, if the credit or yield spread for a 30-
year Aaa1/BBB1-rated corporate bond is 204
basis points, then this bond should yield 2.04
percent over the yield earned on a similar 30-year
U.S. Treasury bonds.
Promised versus Expected Yield to
Maturity
• The yield to maturity calculation assumes that the
bond performs according to the terms of the bond
contract or indenture. Since corporate bonds are
subject to risk of default, the promised yield to
maturity may not be equal to expected yield to
maturity.
• The financial press quotes promised yields and
not expected rates of return.
Valuing a Bond Issue
Calculate the present value of the AT&T bond if the market’s required yield to maturity
for comparable-risk bonds rises to 9% (holding all other things equal).
Step 1: Picture the Problem
i = 9%
Years 0 1 2 3… Blank 20
Cash flow $85 $85 $85 $1,085 Blank Blank
PV of all
Cash flows
=?
$85 annual $85 interest

interest + $1,000
Principal
• Here we know the following:
– Annual interest payments = $85
– Principal amount or par value = $1,000
– Time = 20 years
– YTM or discount rate = 9%
• We can use the above information to determine
the value of the bond by discounting future
interest and principal payment to the present.
Using a Mathematical Formula
 
Bond    
1 1
= Interest 1 −  + Principal 
n 
Value  (1 + YTMMarket )n   (1 + YTM Market ) 
 
 YTMMarket 
= $ 85{[1−(1/(1.09)20] ÷ (.20)} + $1,000/(1.09)20

= $85 (9.128) + $178.43
= $954.36
– N = 20 = PV (rate, nper, pmt, fv)
– 1/y = 9.0 = PV (.09,20,85,1000)
– PMT = 85 = $954.36
– FV = 1000
– PV = 954.36
Step 4: Analyze
• The value of AT&T bond falls to $954.36 when the
yield to maturity rises to 9%. The bonds are now
trading at a discount as the coupon rate on AT&T
bonds is lower than the market yield.
• An investor who buys AT&T bonds at its current
discounted price will earn a promised yield to
maturity of 9%.
Semiannual Interest Payments
In general, Corporate bonds pay interest on a
semiannual basis. We can adapt Equation (9-2a)
from annual to semiannual payments as follows:
 
 
   
   
Bond Value  1  1
= (Interest/2) 1 −  + Principal  
 YTMMarket  
2n 2n
(semiannual payments)   YTMMarket  
 1+    1+  
 2    2  
 
 YTMMarket 
 2 
Valuing a Bond Issue That Pays Semiannual Interest
Calculate the present value of the AT&T bond if the yield to maturity on comparable-
risk bonds rises to 9% (holding all other things equal).
Step 1: Picture the Problem 40
6-month
periods
i = 9%
Periods 0 1 2 3… Blank 40
Cash flow $42.5 $42.5 $42.5 $1,042.50 Blank Blank
PV=?
$42.50 $42.5 interest

Semiannual + $1,000
interest Principal
• Here we know the following:
– Semiannual interest payments = $42.50
– Principal amount or par value = $1,000
– Time = 20 years or 40 periods
– YTM or discount rate = 9% or 4.5% for 6-months
• We can use the above information to determine
the value of the bond by discounting future
interest and principal payment to the present.
Using a Mathematical Formula
 
 
   
   
Bond Value  1   1 
= (Interest/2) 1 −  + Principal 
 YTMMarket  
2n 2n
(semiannual payments)   YTMMarket  
 1+    1+  
 2    2  
 
 YTMMarket 
 2 
= $ 42.5{[1−(1/(1.045)40] ÷ (.20)} + $1,000/(1.045)40

= $42.5 (18.40) + $171.93
= $954
– N = 40 = PV (rate, nper, pmt, fv)
– 1/y = 4.50 = PV (.045,40,42.5,1000)
– PMT = 42.50 = $954
– FV = 1000
– PV = 954
Step 4: Analyze
Using semi-annual compounding we get a value of
$954 for AT&T bonds. This is very close to the value
of $954.26 found using annual compounding.
However, for a large investor buying thousands of
bonds, this can certainly add up over time.
9.3 BOND VALUATION: FOUR KEY RELATIONSHIPS
Relationship 1
• First Relationship The value of bond is inversely
related to changes in the market’s required yield
to maturity.
Blank YTM = 12% YTM rises to 15%
Par value $1,000 $1,000
Coupon rate 12% 12%
Maturity date 5 years 5 years
Bond Value $1,000 $899
Bond
Value
Drops
Figure 9-1 Bond Value and the Market’s Required Yield to
Maturity (5—Year Bond, 12% Coupon Rate)
Relationship 2
The market value of a bond will be less than the par
value (discount bond) if the market’s required yield
to maturity is above the coupon interest rate and will
be more than the par valued if the market’s required
yield to maturity is below the coupon interest rate.
Relationship 3
As the maturity date approaches, the market value
of a bond approaches its par value.
Figure 9.2 clearly demonstrates the value of a bond,
whether a premium or a discount bond, approaches
its par value as the maturity date becomes closer in
time.
Table 9-5 Bond Prices Relative to Maturity Date
Blank Blank Blank Years to Blank Blank Blank Blank

Maturity
Blank 12% Coupon Bond 5 4 3 2 1 0
Blank 12% yield scenario $1,000.00 $1,000.00 $1,000.0 $1,000.0 $1,000. $1,000.0
0 0 00 0
Discount 15% yield scenario $ 899.44 $ 914.35 $ 931.50 $ 951.23 $ $1,000.0

bond 973.91 0
Premium 9% yield scenario $1,116.69 $1,097.19 $1,075.9 $1,052.7 $1,027. $1,000.0

bond 4 7 52 0
Figure 9-2 Value of a 12% Coupon Bond during the Life of
the Bond
Relationships 4
• Long term bonds have greater interest-rate risk
than short-term bonds.
• While all bonds are affected by a change in
interest rates, the prices of longer-term bonds
fluctuate more when interest rates change than do
the prices of shorter-term bonds (see Table 9.6)
Table 9.6 Bond Price Fluctuations for Bonds with Different
Maturities
Blank Blank Blank Years to Blank Blank Blank
Maturity
Blank 5 10 15 20 25 30
15% (increased yield) $899.44 $849.44 $824.58 $812.22 $806.08 $803.02
% price decrease −10.1% −15.1% −17.5% −18.8% −19.4% −19.7%
% price decrease $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00
% price increase 11.7% 19.3% 24.2% 27.4% 29.5% 30.8%
9% (decreased yield) $1,116.69 $1,192.53 $1,241.82 $1,273.86 $1,294.68 $1,308.21
9.4 TYPES OF BONDS
Types of Bonds
Table 9.7 contains a list of the major types of
corporate bonds. The differences among the
various types of bonds are a function of how each
of the following bond attributes are defined:
– Secured versus unsecured
– Priority of claims
– Initial offering market
– Abnormal risk
– Coupon level
– Amortizing or non-amortizing
– Convertibility
Table 9.7 Types of Corporate Bonds (1 of 3)
Debentures A debenture is any unsecured debt instrument. Because they are unsecured, the earning
ability of the issuing corporation is of great concern to the bondholder. They are riskier than
secured bonds and as a result must provide investors with a higher yield than secured
bonds provide. Often the issuing firm attempts to provide some protection to the holder of
the bond by committing not to issue more secured long-term debt that would further tie up
the firm’s assets and leave the bondholders less protected. To the issuing firm, the major
advantage of debentures is that no property has to be committed to secure them. This
allows the firm to issue debt and still preserve some future borrowing power.
Subordinated The claims of subordinated debentures are honored only after the claims of secured debt
debentures and unsubordinated debentures have been satisfied.
Mortgage A mortgage bond is secured by a lien on real property. Typically, the value of the real
bonds property is greater than that of the bonds issued. This provides the mortgage bondholders
with a margin of safety in the event the market value of the secured property declines. In
the case of foreclosure, the bondholders get the proceeds from the sale of the secured
property. If the proceeds from this sale do not cover the bonds, the bondholders become
general creditors, similar to debenture bondholders, for the unpaid portion of the debt.
Eurobonds Eurobonds are bonds issued in a country different from the one in whose currency the
bonds are denominated. For example, a bond that is issued in Europe or Asia by an
American company and that pays interest and principal to the lender in U.S. dollars is
considered a Eurobond. Thus, a Eurobond does not have to be issued in Europe; it
merely needs to be issued in a country different from the one in whose currency it is
denominated to be considered a Eurobond.
Zero-coupon These bonds require either no coupon interest payments (these are called zeroes) or very
and very-low- low coupon interest payments. Consequently, bondholders receive all or most of their
coupon bonds return at maturity. Because these bonds pay little or no interest, they must sell at a deep
discount. For the investor, a zero-coupon bond is like a U.S. savings bond. The obvious
appeal of zero-coupon bonds is to those investors who need a lump sum of money at
some future date but don’t want to be concerned about reinvesting interest payments.
Today, zero-coupon bonds are infrequently issued by corporations. The dominant player
in this market is the U.S. government, with the government’s zero-coupon bonds called
STRIPS.
Junk (high-yield) Junk bonds are high-risk debt that has a below-investment-grade bond rating (see the
bonds earlier discussion of bond ratings). They are also called high-yield bonds because they
pay interest rates that are 3 to 5% higher than those of the highest-rated bonds.
Floating-rate A floating- or variable-rate bond is simply one whose coupon rate fluctuates according
bonds to the level of current market interest rates. These bonds are quite popular with
municipalities and foreign governments but are far less common among corporations.
Convertible bonds Convertible bonds are debt securities that can be converted to a firm’s stock at a
prespecified price.
9.5 DETERMINANTS OF INTEREST RATES
Determinants of Interest Rates
Bond prices vary inversely with interest rates;
therefore, we need to understand what determines
interest rates if we want to understand how bond
prices fluctuate.
Inflation and Real versus Nominal Interest
Rates
• Interest rate quotes in the financial press are
commonly referred to as the nominal (or quoted)
interest rates and are the interest rates
unadjusted for inflation.
• Real rate of interest adjusts for the expected
effects of inflation.
Fisher Effect: The Nominal and Real Rate
of Interest
The relationship between the nominal rate of
interest, rnominal , the anticipated rate of inflation,
rinflation , and the real rate of interest is known as the
Fisher effect.
(1 + rnominal ) = (1 + rreal ) (1 + rinflation )
Solving for the Real Rate of Interest
Assume now that you expect that inflation will be 5% over the coming year and want to
analyze how much better off you will be if you place your savings in an account that
also earns just 5%. What is the real rate of return in this circumstance?
• Let us assume that the prices of goods and
services today is $1.00 per unit.
• With a 5% inflation, these goods and services will
cost $1.05.
• Thus, $10,500 expected in the savings account at
the end of the year will buy you only 10,000 units
(10,500/1.05) at the end of the year.
Blank Year 0 Year 1
Savings Account Balance $10,000.00 $10,500.00
Price Index (5% inflation) $1.00 $1.05
Purchasing Power (units) 10,000.00 10,000.00
Step 3: Solve
We can estimate the real rate of interest by using
equation 9-4b.
(1 + rnominal )
rreal = −1
(1 + rinflation )
rreal = {(1+.05) ÷ (1+.05)} – 1 = 0%
Step 4: Analyze
Here the nominal rate of interest is equal to the
expected rate of inflation. Therefore, the real rate of
return is equal to zero i.e. there is no increase in
purchasing power from investing the savings at 5%.
Solving for the Nominal Rate of Interest
If you anticipate that the rate of inflation will now be 4% next year, holding all else the
same, what rate of return will you need to earn on your savings in order to achieve a
2% increase in purchasing power?
• Let us assume that the prices of goods and
services today is $1.00 per unit.
• If the expected rate of inflation is 4% and you want
to be able to purchase 2% more, you will need to
earn a nominal rate of interest on your savings
that will allow you to buy 10,200 units at $1.04
each.
Blank Year 0 Year 1
Savings Account Balance $10,000.00 $10,608
Price Index (5% inflation) $1.00 $1.04
Purchasing Power (units) 10,000.00 10,200.00
Real rate (% increase in purchasing Blank 2%

power)
Interest rate of
6.08% solved
in step 3
Step 3: Solve
We can use the Fisher model found in equation
9-4a to determine the nominal rate of interest.
rnominal = (1 + rreal )(1 + rinflation ) − 1

= rreal + rinflation + (rreal  rinflation )
Step 4: Analyze
In order to achieve a 2% increase in purchasing
power in the face of a 4% rate of inflation, you must
earn a 6.08% rate on your savings.
Interest—Rate Determinants (1 of 3)
We can think of the interest rate for a particular note
or bond as being composed of five basic
components:
Nominal Rate Real Risk-free Rate Inflation Default-risk Maturity-risk Liquidity-risk

= + + + +
of Interest, rnominal of Interest, rreal risk -free Premium Premium Premium Premium
• The inflation premium = premium for the expected
rate of increase in the prices of goods and
services in the economy over the terms of the
bond or note.
• Default–risk premium = a premium to reflect the
risk of default by the borrower.
• Maturity-risk premium = a premium that reflects
the additional return required by investors in
longer-term securities to compensate them for the
greater risk of price fluctuation on those securities
caused by interest rate changes.
• Liquidity-risk premium = a premium required by
investors for securities that cannot quickly be
converted to cash at a reasonably predictable
price
The Maturity—Risk Premium and the Term
Structure of Interest Rates
• The relationship between interest rates and time
to maturity, with default risk held constant is
known as the term structure of interest rates or
the yield curve.
• Figure 9.3 illustrates a hypothetical term structure
of U.S. Treasury Bonds. We observe that the rate
of interest on a 5-year note or bond is 11.5
percent, and the comparable rate on a 20-year
bond is 13 percent. Generally, the yield curve rises
for longer maturities.
Figure 9.3 The Term Structure of Interest Rates or Yield
Curve
The Shape of the Yield Curve (1 of 2)
By reviewing equation 9-4, we can gain an
understanding of why a yield curve takes on one
shape or another. For example, for Treasury
security, the default-risk premium and the liquidity-
risk premium would both be zero. Accordingly, the
shape of the yield curve is driven by real risk-free
rate of interest, inflation premium and maturity risk
premium.
The Shape of the Yield Curve (2 of 2)
During periods when inflation is expected to
subside, the inflation premium should decrease
over longer maturities, resulting in a downward
sloping Treasury yield curve as shown in Figure 9.5.
The reverse is also true as shown in Figure 9.4
Figure 9.4 Treasury Yield Curve during Period of Increasing
Inflation
Maturity Real Risk-Free Rate Inflation Premium Maturity-Risk Premium Yield
90 days 1.00% 1.75% 0.01% 2.76%
2 years 1.00% 2.15% 0.11% 3.26%
5 years 1.00% 2.56% 0.57% 4.13%
10 years 1.00% 3.05% 0.97% 5.02%
20 years 1.00% 3.42% 1.32% 5.74%
30 years 1.00% 3.60% 1.50% 6.10%
Figure 9.5 Treasury Yield Curve during Period of Decreasing
Inflation
Maturity Real Risk-Free Rate Inflation Premium Maturity-Risk Premium Yield

90 days 1.00% 3.80% 0.01% 4.81%
2 years 1.00% 3.71% 0.08% 4.79%
5 years 1.00% 3.42% 0.25% 4.67%
10 years 1.00% 2.85% 0.42% 4.27%
20 years 1.00% 2.38% 0.63% 4.01%
30 years 1.00% 2.19% 0.75% 3.94%
Shifts in the Yield Curve (1 of 2)
• The term structure of interest rates, or the yield
curve, changes over time as expectations
regarding each of the four factors that underlie
interest rates.
• Figure 9.6 shows the yield curve one day before
911 attack and again two weeks later. Investors
shifted their funds to the safety of short-term
Treasury securities, which pushed up prices and
pushed down yields on short-term securities
relative to long-term securities.
Figure 9-6 Changes in the Term Structure of Interest Rates
around September 11, 2001
Shifts in the Yield Curve (2 of 2)
• The yield curve is most often upward-sloping but
it can assume different shapes i.e. downward
sloping or flat.
• Figure 9-7 illustrates different shapes of yield
curves at different dates, observed within a span
of only 13 months.
Key Terms (1 of 6)
• Amortizing bond
• Basis point
• Bond indenture
• Bond rating
• Call provision
• Clean price
• Collateral
• Conversion feature
Key Terms (2 of 6)
• Convertible bond
• Corporate bond
• Coupon interest rate
• Credit spread
• Current yield
• Debenture
• Default-risk premium
Key Terms (3 of 6)
• Dirty price
• Discount bond
• Eurobonds
• Fisher effect
• Floating rate
• Floating-rate bond
• Inflation premium
• Interest rate risk
Key Terms (4 of 6)
• Junk (high-yield) bond
• London Interbank Offered Rate (LIBOR)
• Liquidity-risk premium
• Maturity-risk premium
• Mortgage bond
• Nominal (or quoted) interest rate
• Non-amortizing bond
Key Terms (5 of 6)
• Par or face value of a bond
• Private market transaction
• Premium bond
• Real rate of interest
• Recovery rate
• Secured bond
• Spread over Treasury bonds or yields
Key Terms (6 of 6)
• Subordinated debentures
• Syndicate
• Term structure of interest rates
• Transaction loan
• Unsubordinated debenture
• Yield curve
• Yield to maturity
• Yield Spread
• Zero-coupon bond
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Debt Valuation and Interest

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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson

2/29/2008 1.98% Blank Blank

3/7/2008 1.66% 2.73% 2.50%

3/14/2008 1.52% 2.44% 2.41%

3/21/2008 1.35% 2.27% 2.27%

4/11/2008 1.67% 2.38% 2.38%

4/18/2008 1.88% 2.42% 2.42%

4/25/2008 1.93% 2.63% 2.50%

5/2/2008 Blank 2.68% 2.50%

Prime or AAA Aaa Highest quality; extremely strong capacity to pay

Upper medium A A-1, A Upper medium quality; strong capacity to pay

Medium BBB Baa-1, Baa Lower medium quality; changing circumstances

Speculative BB Ba Speculative elements; faces uncertainties

Highly speculative B, CCC, CC B, Caa, Ca Extremely speculative and highly vulnerable to

Interest year 1 Interest year 2 Interest year 3 Interest year n Principal

 Present Value of the   Present Value of the 

Cash flow −$900 $65 $65 $65 Blank $1,065

Purchase price = $900

Interest year 1 Interest year 2 Interest year 3 Interest year n Principal

• It is cumbersome to solve for YTM by hand using

Using a Financial Calculator Using an Excel Spreadsheet

Market-yield-to-maturity data are regularly reported

Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years

Aaa/AAA 0.22 0.31 0.42 0.76 1.26 2.00 3.41

Aa1/AA+ 0.26 0.43 0.58 0.96 1.46 2.17 3.62

Aa2/AA 0.29 0.55 0.74 1.16 1.66 2.35 3.83

Aa3/AA– 0.31 0.58 0.77 1.20 1.70 2.39 3.88

A1/A+ 0.32 0.60 0.80 1.23 1.73 2.43 3.93

A2/A 0.55 0.80 0.98 1.40 1.89 2.57 4.03

A3/A– 0.62 0.95 1.18 1.66 2.19 2.92 4.51

Baa1/BBB+ 0.83 1.19 1.42 1.91 2.45 3.18 4.80

Baa2/BBB 1.00 1.39 1.65 2.17 2.73 3.48 5.17

Rating 1 year 2 years 3 years 5 years 7 years 10 years 30 years

Baa3/BBB– 1.49 1.87 2.11 2.62 3.16 3.91 5.56

Ba1/BB+ 2.27 2.64 2.90 3.41 3.98 4.75 6.37

Ba2/BB 3.04 3.41 3.68 4.21 4.79 5.58 7.19

Ba3/BB– 3.82 4.18 4.47 5.00 5.61 6.42 8.00

B1/B+ 4.60 4.95 5.25 5.79 6.42 7.26 8.82

B2/B 5.38 5.72 6.04 6.59 7.24 8.10 9.63

B3/B– 6.15 6.49 6.82 7.38 8.06 8.93 10.45

Caa/CCC+ 6.93 7.26 7.61 8.17 8.87 9.77 11.26

U.S. Treasury 0.18 0.25 0.32 0.60 1.00 1.59 2.76

Cash flow $85 $85 $85 $1,085 Blank Blank

$85 annual $85 interest

= $ 85{[1−(1/(1.09)20] ÷ (.20)} + $1,000/(1.09)20

Cash flow $42.5 $42.5 $42.5 $1,042.50 Blank Blank

$42.50 $42.5 interest

= $ 42.5{[1−(1/(1.045)40] ÷ (.20)} + $1,000/(1.045)40

Par value $1,000 $1,000

Coupon rate 12% 12%

Maturity date 5 years 5 years

Bond Value $1,000 $899

Blank Blank Blank Years to Blank Blank Blank Blank

Blank 12% Coupon Bond 5 4 3 2 1 0

Discount 15% yield scenario $ 899.44 $ 914.35 $ 931.50 $ 951.23 $ $1,000.0

Premium 9% yield scenario $1,116.69 $1,097.19 $1,075.9 $1,052.7 $1,027. $1,000.0

15% (increased yield) $899.44 $849.44 $824.58 $812.22 $806.08 $803.02

% price decrease −10.1% −15.1% −17.5% −18.8% −19.4% −19.7%

% price decrease $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00

% price increase 11.7% 19.3% 24.2% 27.4% 29.5% 30.8%

9% (decreased yield) $1,116.69 $1,192.53 $1,241.82 $1,273.86 $1,294.68 $1,308.21

(1 + rnominal ) = (1 + rreal ) (1 + rinflation )