Bond Market and Alternative

Investment Rules
3.1 Valuation of Bonds
3.2 The Term Structure of Interest Rates
3.3 Alternative Investment Rules
(1) The Payback Period Rule
(2) The Average Accounting Return
(3) The Internal Rate of Return
(4) The Profitability Index
3.4 Why Use Net Present Value?
(RWJ Ch.5,6)
© Professor Ho-Mou Wu Corporate Finance 3-1
3.1 Valuation of Bonds
Example 1 ：
Suppose we observe the following bond prices for default-free zero coupon bonds
(pure discount bond, with face value $1,000) ：

i1 i2 ? i 3? i4 ?
y1
1 year zero: Price = 926 1 year bond y2
2 year zero: Price = 842 2 year bond
y3
3 year zero: Price = 758 3 year bond
y4
4 year zero: Price = 683 4 year bond
(maturity date)

How are the bond prices related with interest rates?

© Professor Ho-Mou Wu Corporate Finance 3-2

The Present Value Formulas for Bonds
Pure Discount Bonds
F
PB  PV  , ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥(3.1)
1  yT T

for T-maturity bonds with face value F.

Level Coupon Bonds

PB  PV   C   C 2    C T  F T ‥ ‥(3.2)
1 y  1 y 
 
1 y 
 
1 y 
 
     
Consols  
C
PB  PV  ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥ ‥(3.
y
3)
Such a rate y is known as the yield to maturity (YTM). The yield to
maturity is a complicated average of different rates of interest. It can be a
useful summary measure.

© Professor Ho-Mou Wu Corporate Finance 3-3

Yield to Maturity
Example 1.(continued): we can convert bond prices into “yield to
maturity” ( yn )
1000 y1  8% (i1  y1 )
926 
(1  y1 ) hence,
1000
842 
(1  y 2 ) 2 y 2  9%

1000
758  y 3  9.66%
(1  y 3 ) 3
1000
683  y 4  10%
(1  y 4 ) 4
yn= yield of bonds with n periods as time to maturity, also called
“spot rates.” Plot yn against time to maturity (n) ” yield curve” to
summarize information about bond prices (diagram 1).

© Professor Ho-Mou Wu Corporate Finance 3-4

3.2 The Term Structure of Interest Rates
From bond prices, we can compute yields yn , plot the “yield
curve”, and compute the implied forward rates, f n .
%
implied
10 “forward rates”

8
yield curve or
“spot rates”
6

Maturity
1 2 3 4
Yield Curve
© Professor Ho-Mou Wu Corporate Finance 3-5
Forward Rates
f n is the “break-even” interest rate that equates the returns on a n-
period bond to that of a (n – 1) period bond rolled over into a one-
year bond in year n. 2



1 y1  1 f 2   1 y2  ,
2 3



1 y2  1 f 3   1 y3  ,
3 4



1 y3  1 f 4   1 y4  .

(1. 09 ) 2
For example, 1  f 2  (1.08)
 1.1 , f 2  10% (geometric mean) or

y2  1
2
 y1  f 2  f 2  10%
, 1so as an approximation (arithmetic mean).
y3  ( y1  f 2  f 3 ), so f 3  11 % .
3
Similarly, 1
y 4  ( y1  f 2  f 3  f 4 ), so f 4  11% .
3
© Professor Ho-Mou Wu Corporate Finance 3-6
Forecast of Future Interest
Can we use forward rates fn to forecast future short-term interest rates
in, also called “short rates” ？ Assume that the investment horizon is
one year, and investors are risk neutral.
Example 2: Consider two investment alternatives ：
(A) buy 1-year zero-coupon bond (safe, no risk).
(B) buy 2-year zero-coupon bond and sell it at the end of 1st year
(risky, subject to price risk at the end of 1st year.)
926 1000
(A)
842 ? 1000
(B)
i2=?
1000
PB 
(1  i2 )
© Professor Ho-Mou Wu Corporate Finance 3-7
Pure Expectation Hypothesis
Expected return of (A)  E 1000926  E 1  y1   1  y1 or 1  i1
 1000
    1 y 2   1 

Expected return of (B)  E 
1  i2 
 E  2 
  1  y 2

2
E 
 842   1  i 1  i 
 2
   2 
Assume that investors are risk-neutral. These two expected returns should
be the same (do not worry about different risks involved in (A) and (B)) ：
2
 1  1  y 
1  y1  1  y 2 2 E   1  f 2 
 and we know 2
1  i  1  y1
 2 
1  1 
So  E  , hence 1  f  E 1  i  or f  E (i )
1  f 2   1  i2  2 2 2 2

The forward rates are market expectations of future short-term interest

rates in . This is called the Pure Expectations Hypothesis ：
f n  E  in  …… .…….. .……. ……..(3.4)

© Professor Ho-Mou Wu Corporate Finance 3-8

Liquidity Preference Hypothesis
Assume investors are Risk averse. Still with one-year investment
horizon (preference for “liquidity”).
Since (B) is riskier, (B) should have higher expected return to attract

 1 
investors ： (1  y 2 ) E 2
  (1  y1 ) .
 1  i2 
1  1 
Hence  E    f 2  E (i2 ) .
1  f2  1  i2 

The Liquidity Preference Hypothesis: E i2  + risk premium = f2 .

 
In general, fn - risk premium = E in  .…………………….……..(3.5)

© Professor Ho-Mou Wu Corporate Finance 3-9

3.3 Alternative Investment Rules
(1) The Payback Period Rule
• How long does it take the project to “pay back” its
initial investment?
• Payback Period = number of years to recover
initial costs
• Minimum Acceptance Criteria:
– set by management
• Ranking Criteria:
– set by management

© Professor Ho-Mou Wu Corporate Finance 3-10

(1) The Payback Period Rule (continued)
• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
– A project accepted based on the payback criteria may
not have a positive NPV
• Advantages:
– Easy to understand
– Biased toward liquidity

© Professor Ho-Mou Wu Corporate Finance 3-11

The Discounted Payback Period Rule
• How long does it take the project to “pay back” its
initial investment taking the time value of money
into account?
• By the time you have discounted the cash flows,
you might as well calculate the NPV.

© Professor Ho-Mou Wu Corporate Finance 3-12

(2) The Average Accounting Return Rule

• Another attractive but fatally flawed approach.

• Ranking Criteria and Minimum Acceptance Criteria
set by management
• Disadvantages:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values
• Advantages:
– The accounting information is usually available
– Easy to calculate
© Professor Ho-Mou Wu Corporate Finance 3-13
(3) The Internal Rate of Return (IRR) Rule
• IRR: the discount that sets NPV to zero
• Minimum Acceptance Criteria:
– Accept if the IRR exceeds the required return.
• Ranking Criteria:
– Select alternative with the highest IRR
• Reinvestment assumption:
– All future cash flows assumed reinvested at the IRR.
• Disadvantages:
– Does not distinguish between investing and borrowing.
– IRR may not exist or there may be multiple IRR
– Problems with mutually exclusive investments
• Advantages:
– Easy to understand and communicate

© Professor Ho-Mou Wu Corporate Finance 3-14

(3) The Internal Rate of Return: Example
Example 3
Consider the following project:
$50 $100 $150

0 1 2 3
-$200

The internal rate of return for this project is 19.44%

© Professor Ho-Mou Wu Corporate Finance 3-15

The NPV Payoff Profile for This Example
If we graph NPV versus discount rate, we can see the IRR as
the x-axis intercept.
Discount Rate NPV $120.00
0% $100.00 $100.00
4% $71.04 $80.00
8% $47.32
$60.00
12% $27.79
$40.00
NPV
16% $11.65
20% ($1.74) $20.00
IRR = 19.44%
24% ($12.88) $0.00
28% ($22.17)
($20.00)-1% 9% 19% 29% 39%
32% ($29.93)
36% ($36.43) ($40.00)
40% ($41.86) ($60.00)
Discount rate

© Professor Ho-Mou Wu Corporate Finance 3-16

Problems with the IRR Approach
• Multiple IRRs.
• Are We Borrowing or Lending?
• The Scale Problem.
• The Timing Problem.

© Professor Ho-Mou Wu Corporate Finance 3-17

Multiple IRRs
Example 4: There are two IRRs for this project:
$200 $80 Which one should
0 we use?
0 1 2 3
-$200 - $800
NPV

$100.00
100% = IRR2
$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00)
0% = IRR1 Discount rate
($100.00)

($150.00)
© Professor Ho-Mou Wu Corporate Finance 3-18
The Scale Problem

Would you rather make 100% or 50% on your

investments?
What if the 100% return is on a $1 investment while
the 50% return is on a $1,000 investment?

© Professor Ho-Mou Wu Corporate Finance 3-19

The Timing Problem
Example 5: $10,000 $1,000 $1,0
00
Project A
0 1 2 3
-$10,000
$1,000 $1,000 $12,000
Project B
0 1 2 3
-$10,000

The preferred project in this case depends on the discount

rate, not the IRR.
© Professor Ho-Mou Wu Corporate Finance 3-20
The Timing Problem
Example 5:
$5,000.00
$4,000.00
Project A
$3,000.00
Project B
$2,000.00
10.55% = crossover rate
$1,000.00
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
12.94% = IRRB 16.04% = IRRA
($4,000.00)

Discount rate

© Professor Ho-Mou Wu Corporate Finance 3-21

Calculating the Crossover Rate
Example 5:
Compute the IRR for either project “A-B” or “B-A”
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000

$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
A-B
NPV

$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate

© Professor Ho-Mou Wu Corporate Finance 3-22

Mutually Exclusive vs. Independent Project
• Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.

– RANK all alternatives and select the best one.

• Independent Projects: accepting or rejecting one project

does not affect the decision of the other projects.

– Must exceed a MINIMUM acceptance criteria.

© Professor Ho-Mou Wu Corporate Finance 3-23

(4) The Profitability Index (PI) Rule

• Minimum Acceptance Criteria:

– Accept if PI > 1
• Ranking Criteria:
– Select alternative with highest PI
• Disadvantages:
– Problems with mutually exclusive investments
• Advantages:
– May be useful when available investment funds are limited
– Easy to understand and communicate
– Correct decision when evaluating independent projects
© Professor Ho-Mou Wu Corporate Finance 3-24
3.4 Why Use Net Present Value?
• Accepting positive NPV projects benefits
shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the project
 NPV discounts the cash flows properly

© Professor Ho-Mou Wu Corporate Finance 3-25

The Net Present Value (NPV) Rule
• Net Present Value (NPV) = Total PV of future CF’s +
Initial Investment

• Estimating NPV:
– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate
– 3. Estimate initial costs

• Minimum Acceptance Criteria: Accept if NPV > 0

• Ranking Criteria: Choose the highest NPV

© Professor Ho-Mou Wu Corporate Finance 3-26

Good Attributes of the NPV Rule
• 1. Uses cash flows
• 2. Uses ALL cash flows of the project
• 3. Discounts ALL cash flows properly

• Reinvestment assumption: the NPV rule assumes

that all cash flows can be reinvested at the discount
rate.

© Professor Ho-Mou Wu Corporate Finance 3-27

The Practice of Capital Budgeting

• Varies by industry:
– Some firms use payback, others use accounting
rate of return.
• The most frequently used technique for large
corporations is IRR or NPV.

© Professor Ho-Mou Wu Corporate Finance 3-28