CHPT 4

Valuing Bonds
Chapter 4
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole
or in part.
What Companies Do
• Forrest Gump Bonds

Hotel Chocolat
1) issued its own promissory notes,
2) raising money from its existing customers
who were members of it “Tasting Club.”
What made these notes unique was that they did
not make interest payments in cash. Instead,
investors received a monthly box of chocolates.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole
or in part.
Valuation Basics
Present Value of Future Cash Flows
Link Risk & Return
Expected Return
on Assets
Valuation
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site,
in whole or in part.
The Fundamental Valuation Model
CF 1 CF 2 CF n
P0 = 1
+ 2
+ . . .+
(1 + r ) (1 + r ) (1 + r )n
P0 = Price of asset at time 0 (today)
CFt = Cash flow expected at time t
r = Discount rate (reflecting asset’s risk)
n = Number of discounting periods (usually years)
This model can express the price of any asset at

t = 0 mathematically.
Marginal benefit of owning the asset: right to receive
the cash flows
Marginal cost: opportunity cost of owning the asset
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Bond Vocabulary
Principal • The amount of money on which interest

is paid.
• The date when a bond’s life ends and

Maturity date the borrower must make the final
interest payment and repay the
principal.
Par value • The face value of a bond, which the
borrower repays at maturity.
Coupon • A fixed amount of interest that a bond

promises to pay investors.
Indenture • A legal document stating the conditions

under which a bond has been issued.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in
whole or in part.
Bond Vocabulary
Coupon rate • The rate derived by dividing the bond’s

annual coupon payment by its par value.
• The amount obtained by dividing the

Coupon yield bond’s coupon by its current market price
(which does not always equal its par
value). Also called current yield.
whole or in part.
Bond Valuation: The Basic Equation
• Bond Price = PV of coupons + PV of principal

Assuming annual interest:
C C C M
P0 = 1
+ 2
+ . . .+ n
+ n
(1 + r ) (1 + r ) (1 + r ) (1 + r )
C 1 M
P0 = X [1  n
]+
r (1 + r ) (1 + r )n
whole or in part.
Bond Features
• Bond - evidence of debt issued by a corporation or a

governmental body. A bond represents a loan made
by investors to the issuer. In return for his/her money,
the investor receives a legal claim on future cash
flows of the borrower. The issuer promises to:
• Make regular coupon payments every period until the
bond matures, and
• Pay the face/par/maturity value of the bond when it
matures.
• Default - since the abovementioned promises are
contractual obligations, an issuer who fails to keep
them is subject to legal action on behalf of the lenders
(bondholders).
Bond Valuation
• If a bond has 5 years to maturity, an $80 annual
coupon, and a $1000 face value, its cash flows would
look like this:
Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80
Face Value $ 1000
$______
• How much is this bond worth? It depends on the level

of current market interest rates. If the going rate on
bonds like this one is 10%, then this bond is worth
$924.18. Find it by TVM tables and Excel.
Valuation
• By financial calculator
PMT 80 ($924.18) PV
n 5
r 10%
FV 1000
• By TVM tables
PV of coupons: 80 x PVIFA (10%, 5 yrs)=
80x3.7908=303.264
PV of 1000 = 1000 x PVIF (10%, 5
yrs)=1000*0.6209=620.90
PV =$924.164
whole or in part.
Fig 4.1 Time Line for Bond Valuation
(Assuming Annual Interest Payments)
Worldwide
United
9.125% Coupon,
$1,000 Par
Value
Bond, Maturing
at
End of 2022;
Required Return
Assumed To Be
8%
whole or in part.
Yield to Maturity (YTM)
Estimate of return investors earn if they buy

the bond at P0 and hold it until maturity
The YTM on a bond selling at par will always equal

the coupon rate.
YTM is the discount rate that equates the

PV of a bond’s cash flows with its price.
whole or in part.
Bond Premiums and Discounts
What happens to bond values if the required
return is not equal to the coupon rate?
The bond's price will differ from its par value.
r > Coupon Interest Rate P0 < par value

= DISCOUNT
r < Coupon Interest Rate P0 > par value

= PREMIUM
whole or in part.
On Discount Rates
• Generally,
• the greater the uncertainty about an asset’s
future benefits,
• the higher the discount rate investors will apply
• when discounting those benefits to the
present.
whole or in part.
Bond premiums and discounts
• Bond prices are most impacted by changes in the

interest rate:
– if interest rates increase, bond prices decrease;
- if interest rates decrease, bond prices increase.
When you compare 2 identical bonds with differing
interest rates, same risk and maturity:
- the one with a coupon rate 10% and the other 12%,
the 12% bond will be more valuable, and will sell for a
higher price.
whole or in part.
Bond premiums and discounts
• Suppose you own the 10% bond. A year later, interest
rates increase to 12%.
• A new investor would invest either in your bond (10%)
or a new bond with a coupon of 12%. ???
• Your bond has become less valuable, compared to
the current market bonds with the same risk.
• If you wish to sell the bond, you can sell it at a
discount (less than FV).
• Similarly, if r decline to 8%, your bond is now
more valuable. Investors would want a security
paying 10% interest, when the going rate is only 8%.
Your bond will sell at a premium, > FV.
whole or in part.
Semiannual Compounding
C C C C
F
Price  2  2  2  ....  2
r 1 r 2 r 3 r 2n
(1  ) (1  ) (1  ) (1  )
2 2 2 2
An example....
Value a T-Bond $40 $40 $40 $40
Par value = $1,000  1,000
P0  2  2  2  2
Maturity = 2 years 1 2 3
 0.044   0.044   0.044   0.044 
4
Coupon rate = 4% 1   1   1   1  
 2   2   2   2 
r = 4.4% per year
= $992.43
$20 $20 $20 $1,020
    
(1.022) (1.022) 2 (1.022)3 (1.022) 4
How to calculate bonds (TVM&Excel)
• Most U.S.-issued bonds are semi-annual.

• To calculate bond value on a financial
calculator, the number of years is multiplied by
two;
• the interest rate is divided in half;
• the coupon payment is divided in half.
• The price (PV) and face value (FV) remain the
same and are not changed in semi-annual
bond calculations.
whole or in part.
Bond discount & premium
• Suppose a bond currently sells for $932.90; pays an annual coupon

of $70, and matures in 10 years. Its FV is $1000.
• What are its coupon rate, current yield, and yield to maturity
(YTM)?
– 1. The coupon rate (or just “coupon”) is the annual dollar coupon expressed as
a percentage of the face value:
Coupon rate = $70 /$_____ = ___%
– 2. The current yield is the annual coupon divided by the current market price of
the bond:
Current yield = $___ /_____ = 7.5%
Under what conditions will the coupon rate and current yield be the same?
whole or in part.
Bond discount & premium
3. The yield to maturity (or “YTM”) is the rate that makes the
price of the bond just equal to the present value of its future cash
flows. It is the unknown r in:
$932.90 = $_______ x [1 - 1/(1 + r)10]/r + $_______ /(1 +
r)10
The only way to find the YTM is trial and error:

a. Try 10%: $70 x [(1 - 1/(1.10)10]/.10 + $1000/(1.10)10 =
$816
b. Try 9%: $70 x [1 - 1/(1.09)10]/.09 + $1000/(1.09)10 =
$872
c. Try 8%: $70 x [1 - 1/(1.08)10]/.08 + $1000/(1.08)10 =
$933
( ) The yield to maturity is 8%
whole or in part.
Valuing a bond
• Assume you have the following

information:
Barnhart, Inc. bonds have a $1,000 face value

The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds
is 10%
whole or in part.
Solve the problem
– 1. Calculate the present value of the face

value
= $1,000 * [1/1.1020 ] = $1,000 * .14864 = $148.64
– 2. Calculate the present value of the coupon

payments
= $100 * [1 - (1/1.1020)]/.10 = $100 * 8.5136 = $851.36
– 3. The value of each bond = $148.64 +

851.36 = $1,000
– Find those by TVM and excel
– Next change the YTM to 12%
whole or in part.
Solve the problem
– 1. Calculate the present value of the face value

= $1,000 * [1/1.1220 ] = $1,000 * .10366 = $103.66

payments
= $100 * [1 - (1/1.1020)]/.10 = $100 * 7.4694 = $746.94
– 3. The value of each bond = $103.66 + 746.94 =

$850.60
– Now solve for YTM 8%
whole or in part.
Solve the bond
– 1. Calculate the present value of the face value
= $1,000 * [1/1.0820 ] = $1,000 * .21455 = $214.55
payments
= $100 * [1 - (1/1.0820)]/.08 = $100 * 9.8181 = $981.81
– 3. The value of each bond = $214.55 + 981.81 =

$1,196.36
• Why do the bonds in this and the preceding example have prices
that are different from par?
whole or in part.
Bond Price Sensitivity to YTM
Bond price
$1,800
Coupon = $100
20 years to maturity
$1,600
$1,000 face value
$1,400 Notice: bond prices and YTMs are

inversely related.
$1,200
$1,000
$ 800
$ 600 Yields to maturity, YTM

4% 6% 8% 10% 12% 14% 16%
Interest Rate Risk and Time to
Maturity
Bond values ($)
2,000
$1,768.62
30-year bond Time to Maturity
1,500
Interest rate 1 year 30 years
5% $1,047.62 $1,768.62
$1,047.62 1-year bond 10 1,000.00 1,000.00
1,000
$916.67
15 956.52 671.70
20 916.67 502.11
500 $502.11
Interest rates (%)

5 10 15 20
Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
Bond prices theorem
The following statements about bond pricing are always true.

1. Bond prices and market interest rates move in opposite directions.
2. When a bond’s coupon rate is (greater than / equal to /less than)
the market’s required return, the bond’s market value will be (greater
than / equal to / less than) its par value.
3. Given two bonds identical but for maturity, the price of the longer-
term bond will change more than that of the shorter-term bond, for a
given change in market interest rates.
4. Given two bonds identical but for coupon, the price of the lower-
coupon bond will change more than that of the higher-coupon bond,
for a given change in market interest rates.
whole or in part.
Economic Forces Affecting Bond Prices
Time to maturity: bond prices converge to par

value (plus final coupon) with passage of time.
Interest rates: bond prices and interest rates

move in opposite directions.
Changes in interest rates have larger impact on

long-term bonds than on short-term bonds.
whole or in part.
Fig 4.2 The Relationship Between
Bond Prices and Required Returns
6% coupon rate
for both
whole or in part.
Interest Rate Risk
• The risk that changes in market interest
Interest Rate rates will cause fluctuations in a bond’s
Risk price. Also, the risk of suffering losses as
a result of unanticipated changes in
market interest rates.
• Approximately, the difference between an

Real return investment’s stated or nominal return and
the inflation rate.
Nominal • The stated return offered by an

return investment unadjusted for the effects of
inflation.
whole or in part.
Fig 4.3 Treasury Bond Yields and Inflation
Rates 1955- 2010
whole or in part.
What Companies Do Globally
Belgian CFOs Find Bond Issues Attractive
whole or in part.
Primary versus Secondary Markets
Primary market: the initial sale of bonds by issuers

to large investors or syndicates
Secondary market: the market in which investors

trade with each other
Trades in the secondary market do not raise any

capital for issuing firms.
whole or in part.
Types of Bonds: By Issuer
• Usually with par $1000 and semi-annual
Corporate coupon
Bonds • Bonds if maturity > 10 years; notes if
maturity < 10 years
Municipal • Issued by local and state government

Bonds • Interest on municipal bonds tax-free
• If maturity < 1 year: Treasury Bills
• If 1 year < maturity < 10 years: Treasury
Treasury Notes
Bonds • Maturity > 10 years: Treasury Bonds
• Used to fund budget deficits
Agency • Issued by government agencies: FHLB,
FNMA (Fannie Mae), GNMA (Ginnie Mae),
Bonds FHLMC (Freddie Mac)
whole or in part.
Types of Bonds: By Features
• Floating-rate bonds: coupon tied to

Fixed vs. prime rate, LIBOR, Treasury rate or
other interest rate
Floating • Floating rate = benchmark rate + spread
Rates • Floating rate can also be tied to the
inflation rate: TIPS, for example
• Unsecured bonds (debentures) are

backed only by general faith and credit
Secured vs. of issuer
Unsecured • Secured bonds are backed by specific
assets (collateral)
Bonds • Mortgage bonds, collateral trust bonds,
equipment trust certificates
whole or in part.
• Zero-coupon bonds pay no interest

• Also known as Discount bonds or pure
Zero-Coupon discount bonds
Bonds • Sell below par value
• Treasury Bills (Tbills)
• Treasury STRIPs
• Convertible bonds, in addition to paying

Convertible coupon, offers the right to convert the
and bond into common stock of the issuer of
the bond
Exchangeabl • Exchangeable bonds are convertible in
e Bonds shares of a company other than the
issuer’s
whole or in part.
Fig 4.4 Bonds Yields and Inflation
Expections
The figure shows yields on ordinary
and inflation indexed Treasury bonds
from 2003–2010. The difference in
yields between these two instruments
provides a measure of investors’
inflation expectations
whole or in part.
Table 4.1 Zero-Coupon Bond Prices and
Taxable Income
whole or in part.
• Callable bonds: bond issuer has the right

to repurchase the bonds at a specified
Callable and price (call price).
• Firms could retire and reissue debt if
Putable interest rates fall.
Bonds • Putable bonds: the investors have the
right to sell the bonds to the issuer at
the put price.
• Sinking fund provisions: the issuer is

Protection required to gradually repurchase
outstanding bonds.
from Default • Protective covenants: requirements the
Risk bond issuer must meet
• Positive and negative covenants
whole or in part.
Treasury • Notes and bonds issued by

Inflation- the federal government that
Protected make coupon payments that
vary with the inflation rate.
Securities
(TIPS)
whole or in part.
Bond Markets
whole or in part.
U.S. Treasury Bond Quotations
MATURITY ASK
RATE BID ASKED CHG
MO/YR YLD
Government Bonds & Notes
5.500 May 09n 107:13 107:14 3 3.83
Rate Coupon rate of 5.5%
Bid price: the price traders receive if

they sell a bond to the dealer. Quoted in
Bid prices increments of 32nds of a dollar
Ask prices
Ask price: the price traders pay to the
(percentage of
dealer to buy a bond
par value)
Bid-ask spread: difference between ask
and bid prices.
Ask Yield Yield to maturity on the ask price

Corporate Bond Quotations
Company Estimated Est $ Vol
Coupon Maturity Last Price Last Yield UST
(Ticker) Spread (000s)
SBC
Comm Aug
5.875 107.161 4.836 80 10 73,867
15,2012
(SBC)
Corporate prices are quoted as percentage of par, without

the 32nds of a dollar quoting convention
Yield spread: the difference in yield-to-maturities between

a corporate bond and a Treasury bond with same maturity
The greater the default risk, the higher

the yield spread
whole or in part.
Bond Ratings
Bond ratings: grades assigned to bond issues based

on degree of default risk
Investment- • Moody’s Aaa to Baa3 ratings

grade bonds • S&P and Fitch AAA to BBB-
ratings
Junk bonds • Moody’s Ba1 to Caa1 or lower

• S&P and Fitch BB to CCC+ or
lower
whole or in part.
Table 4.2 Bond Ratings
whole or in part.
Table 4.3 The Relationship Between Bond Ratings
and Spreads at Different Maturities at a Point in
Time, Expressed in Basis Points
whole or in part.
Term Structure of Interest Rates
• Relationship between yield and maturity is called

the Term Structure of Interest Rates
– Graphical depiction called a Yield Curve
– Usually, yields on long-term securities are higher than on short-
term securities.
– Generally look at risk-free Treasury debt securities
• Yield curves normally upwards-sloping

– Long yields > short yields
– Can be flat or even inverted during times of financial stress
What do you think a Yield Curve would look like

graphically?
whole or in part.
Fig 4.6
Yield Curves for US Government Bonds
whole or in part.
Fig 4.7 The Expectations Theory
whole or in part.
Advanced Bond Valuation
• States that the slope of the yield curve is

Liquidity influenced not only by expected interest
Preference rate changes, but also by the liquidity
Theory premium that investors require on long-
term bonds.
• A theory that recognizes that the shape

of the yield curve may be influenced by
Preferred
investors who prefer to purchase bonds
Habitat having a particular maturity regardless of
Theory the returns those bonds offer compared
to returns available at other maturities.
whole or in part.
Valuing Bonds
• Bond price = present value of coupons +

present value of principal
• Bond prices are inversely related to interest
rates.
• Bonds can have features like convertibility and
callability.
whole or in part.
Yield Curve/Normal
• The yield curve plots the relationship between the

interest rates and time to maturity of the entire
spectrum of U.S. Treasury securities. A normal yield
curve slopes gently upward, reflecting a gradual
increase in interest rates as maturities lengthen out.
• In a steep yield curve environment, yields climb much
more rapidly than normal. This can occur when the
economy is starting to pick up speed and investors’
inflation concerns cause them to sell longer-term
Treasury securities, depressing the prices of those
bonds and driving their yields higher.
whole or in part.
Flat Yield Curve
• A flat yield curve exists when the yields on short- and

long-term securities are nearly identical–often an early
warning sign that the economy is moving into
recession. With their inflation fears quelled by the
threat of recession, investors will often buy long-term
bonds to capture higher yields. This causes prices of
these bonds to appreciate and their yields to move
down closer to short-term rates, resulting in a flattened
yield curve. A flat curve can also occur following an
inverted-curve environment (see below), when short
rates are heading back to normal levels.
whole or in part.
Inverted Yield Curve
• An inverted yield curve exists when short-term

rates are significantly higher than long-term
rates. It is often a harbinger of recession. It
reflects investors’ beliefs that the Fed is
keeping short-term rates too high, squeezing
the money supply and increasing the likelihood
of an economic downturn.
whole or in part.

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CHPT 4

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Valuing Bonds

• Forrest Gump Bonds

Present Value of Future Cash Flows

Link Risk & Return

This model can express the price of any asset at

Principal • The amount of money on which interest

• The date when a bond’s life ends and

Coupon • A fixed amount of interest that a bond

Indenture • A legal document stating the conditions

Coupon rate • The rate derived by dividing the bond’s

• The amount obtained by dividing the

• Bond Price = PV of coupons + PV of principal

• Bond - evidence of debt issued by a corporation or a

• How much is this bond worth? It depends on the level

Estimate of return investors earn if they buy

The YTM on a bond selling at par will always equal

YTM is the discount rate that equates the

The bond's price will differ from its par value.

r > Coupon Interest Rate P0 < par value

r < Coupon Interest Rate P0 > par value

• Bond prices are most impacted by changes in the

• Most U.S.-issued bonds are semi-annual.

• Suppose a bond currently sells for $932.90; pays an annual coupon

The only way to find the YTM is trial and error:

• Assume you have the following

Barnhart, Inc. bonds have a $1,000 face value

– 1. Calculate the present value of the face

– 2. Calculate the present value of the coupon

– 3. The value of each bond = $148.64 +

– 1. Calculate the present value of the face value

– 2. Calculate the present value of the coupon

– 3. The value of each bond = $103.66 + 746.94 =

– 3. The value of each bond = $214.55 + 981.81 =

$1,400 Notice: bond prices and YTMs are

$ 600 Yields to maturity, YTM

Interest rates (%)

The following statements about bond pricing are always true.

Time to maturity: bond prices converge to par

Interest rates: bond prices and interest rates

Changes in interest rates have larger impact on

• Approximately, the difference between an

Nominal • The stated return offered by an

Belgian CFOs Find Bond Issues Attractive

Primary market: the initial sale of bonds by issuers

Secondary market: the market in which investors

Trades in the secondary market do not raise any

Municipal • Issued by local and state government

• Floating-rate bonds: coupon tied to

• Unsecured bonds (debentures) are

• Zero-coupon bonds pay no interest

• Convertible bonds, in addition to paying

• Callable bonds: bond issuer has the right

• Sinking fund provisions: the issuer is

Treasury • Notes and bonds issued by

Rate Coupon rate of 5.5%

Bid price: the price traders receive if

Ask Yield Yield to maturity on the ask price

Corporate prices are quoted as percentage of par, without

Yield spread: the difference in yield-to-maturities between

The greater the default risk, the higher

Bond ratings: grades assigned to bond issues based

Investment- • Moody’s Aaa to Baa3 ratings

Junk bonds • Moody’s Ba1 to Caa1 or lower