BU7300 Corporate Finance

Cost of Debt: Bond Valuation

Week 4
Cost of Debt

• The cost of debt is the required return on our company’s debt.

• We usually focus on the cost of long-term debt or bonds.

• The required return is best estimated by computing the yield-

to-maturity on the existing debt.

• We may also use estimates of current rates based on the bond

rating we expect when we issue new debt.

• The cost of debt is NOT the coupon rate.

Valuation fundamentals

• Value of asset = PV of expected cash flows

• Depends on timing of cash flows – earlier returns more valuable than later
returns

Required return
• Discount rate used to calculate PV
• Depends on expected inflation rate and perceived risk of asset
• For risk averse investors, higher perceived risk results in higher required return
and lower asset market values

3
General features of debt instruments
Bond
• Debt security obliging the borrower (issuer) to make contractual
payments of interest and principal to the lender (bondholder)
Coupon
• Periodic interest paid to bondholder at the contract interest rate
Coupon rate
• Contract interest rate = % of bond’s par value that will be paid
annually

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General features of debt instruments

Principal
• Amount borrowed and owed to bond holder at maturity

Maturity date
• Time at which bond becomes due and principal must be repaid

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Interest rates
Interest rate
• Compensation paid by borrower to lender expressed as
percentage

Required rate of return

• Lender’s expected rate of return

Nominal interest rate (k)

• Rate on money

Real interest rate (k*) k  k*  IP  RP

• Annual percentage increase in purchasing power of an asset

6
 Term structure of interest rates

• Relationship between interest rates and terms to maturity

• Yield to maturity is annual rate of return earned by a debt security held to
maturity

Yield curve
• Graph showing relationship between remaining term to maturity and yield to
maturity
• Normal yield curve – upward-sloping
• Inverse yield curve – downward-sloping
• Flat yield curve – non-sloping

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Model of bond

• Price B0 paid for bond

B0 = PV0
1 2 3 N
0 annuity
I I I I+M
bond price  PV of future cash flows
 PV of annuity  PV of maturity payment
• Buyer of bond has claim
over future cash flows
• Coupons (interest, I) from
• M is future value arising
from redeeming bond when
it matures

M
B0  I[PVIFA(N, k d )] 
( 1  k d )N
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Yield to maturity
• Discount rate that makes the PV of the future cash flows equal to the
price paid for the bond
• Return on bond bought at specific price and held to maturity
• YTM measures compound annual return to investor considering all
bond cash flows

NOTE
• If bond value is different from par, YTM different from coupon rate
• If YTM = coupon rate, B0 = M
• If YTM < coupon rate, B0 > M
• If YTM > coupon rate, B0 < principal

M
B0  PMT[PVIFA(N, YTM)] 
(1  YTM) N
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Approximate yield to maturity
 (M-V) 
I  N 
YTM 
( M  2V)
3

• M - maturity value (principal)

• I - interest per period
• N – number of periods to maturity
• V - bond proceeds
• YTM - period rate - must be annualised

NOTE:
• This formula is different from the usual one quoted
in books but is a better approximation
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 Actual rate of return
• When bonds sold before maturity, prices and returns vary – interest rate risk
• Actual rate of return depends on coupon paid and price change over holding
period
• YTM assumes that bond is held to maturity
• In general, actual rate of return and YTM differ

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Example

• Yield to maturity The Salem Company bond currently sells for $955, has a 12%
coupon interest rate and a $1,000 par value, pays interest annually, and has 15
years to maturity.

• Calculate the yield to maturity (YTM) on this bond.

Answer

 (M-V) 
• V= 955  I
N 
YTM   
• Coupon rate = 12% ( M  2V)
3
• M = 1,000 120  
 1000 - 955 

 15 

• Annual interest 1,000  2(955) 
3
• I = $120 per year 123

970
• N = 15  12.7%

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Example

• Yield to maturity The Salem Company bond currently sells for $955, has a 12%
coupon interest rate and a $1,000 par value, pays interest every 6 months, and
has 15 years to maturity.

• Calculate the yield to maturity (YTM) on this bond.

Answer
 (M-V) 
• V= 955 I  N 
YTM 
( M  2V)
• Coupon rate = 12%
3
• M = 1,000 60  
 1000 - 955 

 30 
• Interest paid every 6 
1,000  2(955) 
months 3
61.50
• I = $60 per 6-months 
970
• N = 30  6.34%
EAR  (1.0634) 2 - 1
 13.1%

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Cookbook for solving valuation problems

• Identify the cash flows involved

• Sort the known variables from the unknown variables
• Draw the cash flow diagram
• Identify the correct formula to be used to find the unknown variable
• Calculate the unknown variable

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Example
• Basic bond valuation Complex Systems has an outstanding issue of $1,000-par
value bonds with a 12% coupon interest rate. The issue pays interest annually and
has 16 years remaining to its maturity date.
• If bonds of similar risk are currently earning a 10% rate of return, how much
should the Complex Systems bond sell for today?
 Answer

• No compounding periods/yr =1
• Maturity value = $1,000
• Coupon rate = 12% per year
• Annual interest = 0.12($1,000) = $120
• No years to redemption = 16
• Discount rate = 10% per year

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Solution
B0 = PV0
1 2 3 16

0
120 120 120 + 1,000

M
B0  I[PVIFA(N,k d )] 
(1  k d ) N
1,000
 120[ PVIFA (16,10%)] 
1.1016
 120(7.823)  217.63
 938.85  217.63
 1,156.47

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 Compounding within a year

• Interest is compounded m times in a year

• N years to maturity
• Interest per period I = annual coupon/m
• The discount rate (required rate of return) kd= k/m
• Number of periods = Nm

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Example

Basic bond valuation Complex Systems has an outstanding issue of $1,000-parvalue

bonds with a 12% coupon interest rate. The issue pays interest semi annually and
has 16 years remaining to its maturity date.
c. If the required return were at 12% instead of 10%, what would the current value
of Complex Systems’ bond be?
 Answer

• No compounding periods/yr ═2
• Maturity value ═$1,000
• Coupon rate ═12% per year
• Annual interest ═0.12($1,000) = $120
• Period interest ═120/2 = $60
• No years to redemption ═16
• No periods to redemption ═16(2)= 32
• Discount rate ═10% per year
• Discount rate per period ═10%/2 = 5% per 6-months

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Answer
B0 = PV0
1 2 3 32

0
60 60 60 + 1,000

M
B0  I[PVIFA(N, k d )] 
(1  k d ) N
1,000
 60[PVIFA (32, 5%)] 
1.0532
 60(15.803)  209.87
 948.16  209.87
 1,158.03

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