Chapter 7: Valuation and Characteristics of Bonds

What's Ahead
Types of Bonds
Debentures

Subordinated Debentures

Mortgage Bonds

Eurobonds

Zero and Very Low Coupon Bonds

Junk Bonds (High-Yield Bonds)

Terminology and Characteristics of Bonds

Claims on Assets and Income

Par Value

Coupon Interest Rate

Maturity

Indenture

Current Yield

Bond Ratings

Definitions of Value
Determinants of Value
Valuation: The Basic Process
Bond Valuation
Semiannual Interest Payments

The Bondholder's Expected Rate of Return (Yield to

Maturity)
Bond Valuation: Three Important Relationships
First Relationship

Second Relationship

Third Relationship

Chapter Wrap-Up

What's Ahead

Practically all companies use debt to finance their firms, and many of those companies issue bonds,
just one form of debt. Bonds provide investors a fixed income each year in the form of interest. Just as
you can open a savings account at a bank and earn interest on your savings, so you can buy a bond
that pays interest and then repays your principal on a designated date when the bond matures. Many of
these bonds are traded in the public capital markets. Three examples of companies that have issued
bonds to investors include the computer firm, IBM; the telephone company, Pacific Bell; and the
athletic wear business, Converse. Each of these bonds pay $70 in interest each year on a bond that will
repay the investor $1,000 when it matures. However, while these bonds are similar in terms of their
interest payment, investors do not value them the same. In mid-1999, they were selling for the
following amounts:

Pacific Bell $1,040

IBM $1,000
Converse $ 481

Why would there be differences in the values of these bonds? Why would Pacific Bell's bonds be
worth more than IBM's bonds? And why would the Converse bonds be so "cheap"? They all pay the
same amount of interest. Why would an investor pay $1,000 for a bond that promises $70 in interest,
when they could buy Converse bonds for only $481? Or a more general question, "What determines a
bond's value?" Read on and you will find the answer to this puzzle.

We now begin our study by considering the different kinds of bonds.

Before you begin, take a moment to familiarize yourself with the key objectives of
this chapter.

Chapter Preview

Knowing the fair value or price of an asset is no easy matter. The Maxims of the French
writer La Rouchefoucauld, written over three centuries ago, still speak to use: "The greatest
of all gifts is the power to estimate things at their true worth."

Understanding how to value financial securities is essential if managers are to meet the
objective of maximizing the value of the firm. If they are to maximize the investors' value,
they must know what drives the value of an asset. Specifically, they need to understand
how bonds and stocks are valued in the marketplace; otherwise, they cannot act in the best
interest of the firm's investors.

A bond is one form of a company's long-term debt. In this chapter, we begin by identifying
the different kinds of bonds. We next look at the features or characteristics of most bonds.
We then examine the concepts of and procedures for valuing an asset and apply these
ideas to valuing bonds, one form of a company's long-term debt.

Types of Bonds

A bond is a type of debt or long-term promissory note, issued by the borrower, promising to pay its
holder a predetermined and fixed amount of interest per year. However, there are a wide variety of
such creatures. Just to mention a few, we have

 Debentures
 Subordinated debentures
 Mortgage bonds
  Eurobonds
 Zero and very low coupon bonds
 Junk bonds

The following sections briefly explain each of these types of bonds.

DEBENTURES

The term debenture applies to any unsecured long-term debt. Because these bonds are unsecured, the
earning ability of the issuing corporation is of great concern to the bondholder. They are also viewed
as being more risky 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 prohibiting the firm from issuing 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 secured by them. This allows the firm to issue debt and still
preserve some future borrowing power.

SUBORDINATED DEBENTURES

Many firms have more than one issue of debentures outstanding. In this case a hierarchy may be
specified, in which some debentures are given subordinated standing in case of insolvency. The claims
of the subordinated debentures are honored only after the claims of secured debt and unsubordinated
debentures have been satisfied.

MORTGAGE BONDS

A mortgage bond is a bond secured by a lien on real property. Typically, the value of the real property
is greater than that of the mortgage 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 trustees have the power to sell the secured property and use the proceeds to pay the
bondholders. In the event that 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.

Are bonds secured with real property only? How about using cigarettes instead?

EUROBONDS

Eurobonds are not so much a different type of security. They are simply securities, in this case bonds,
issued in a country different from the one in whose currency the bond is denominated. For example, a
bond that is issued in Europe or in Asia by an American company and that pays interest and principal
to the lender in U.S. dollars would be considered a Eurobond. Thus, even if the bond is not issued in
Europe, it merely needs to be sold in a country different from the one in whose currency it is
denominated to be considered a Eurobond. The Eurobond market actually had its roots in the 1950s
and 1960s as the U.S. dollar became increasingly popular because of its role as the primary
international reserve. In recent years as the U.S. dollar has gained a reputation for being one of the
most stable currencies, demand for Eurobonds has increased. The primary attractions of Eurobonds to
borrowers, aside from favorable rates, are the relative lack of regulation (Eurobonds are not registered
with the Securities and Exchange Commission [SEC]), less rigorous disclosure requirements than
those of the SEC, and the speed with which they can be issued. Interestingly, not only are Eurobonds
not registered with the SEC, but U.S. citizens and residents may not be offered them during their
initial distribution.

What do you think about Eurobonds?

ZERO AND VERY LOW COUPON BONDS

Zero and very low coupon bonds allow the issuing firm to issue bonds at a substantial discount from
their $1,000 face value with a zero or very low coupon rate. The investor receives a large part (or all
with zero coupon bonds) of the return from the appreciation of the bond. For example, in 1998, 21st
Century Telecom Group, Inc., a telecommunications firm, issued $43 million of debt maturing in 2008
with a zero coupon rate. These bonds were sold at a 57 percent discount from their par value; that is,
investors only paid $433 for a bond with a $1,000 par value. Investors who purchased these bonds for
$433 and hold them until they mature in 2008 will receive an 8.8-percent yield to maturity, with all of
this yield coming from appreciation of the bond. On the other hand, 21st Century Telecom Group,
Inc., will have no cash outflows until these bonds mature; however, at that time it will have to pay
back $100 million even though they only received $43 million when the bonds were first issued.

As with any form of financing, there are both advantages and disadvantages of issuing zero or very
low coupon bonds. As already mentioned, the disadvantage is, when the bonds mature, 21st Century
Group will face an extremely large cash outflow, much greater than the cash inflow it experienced
when the bonds were first issued. The advantages of zero and low coupon bonds are, first, that annual
cash outflows associated with interest payments do not occur with zero coupon bonds and are at a
relatively low level with low coupon bonds. Second, because there is relatively strong investor
demand for this type of debt, prices tend to be bid up and yields tend to be bid down. That is to say,
21st Century Telecom Group was able to issue zero coupon bonds at about half a percent less than it
would have been if they had been traditional coupon bonds. Finally, 21st Century Telecom Group is
able to deduct the annual amortization of the discount from taxable income, which will provide a
positive annual cash flow to 21st Century Telecom Group.

Check out the following example to see just how far down those yields can go as in
the case of these Japanese government bonds.

JUNK BONDS (HIGH-YIELD BONDS)

Junk bonds are high-risk debt with ratings of BB or below by Moody's and Standard & Poor's. The
lower the rating, the higher the chance of default; the lowest class is CC for Standard & Poor's and Ca
for Moody's. Originally, the term was used to describe bonds issued by "fallen angels"; that is, firms
with sound financial histories that were facing severe financial problems and suffering from poor
credit ratings.

Junk bonds are also called high-yield bonds for the high interest rates they pay the investor, typically
having an interest rate of between 3 and 5 percent more than AAA grade long-term debt.

Before the mid-1970s, smaller firms simply did not have access to the capital markets because of the
reluctance of investors to accept speculative grade bonds. However, by the late 1980s, junk bonds
became the way to finance hostile takeovers—buying a firm without the management's approval. For
example, the purchase of RJR Nabisco for some $20 billion by the investment group KKR was largely
accomplished by junk bond financing. However, the eventual bankruptcy of Drexel Burnham
Lambert, the investment banker most responsible for developing a large junk bond market, the jailing
of the "king of junk bonds" Michael Milken, and increasing interest rates brought an end to the
extensive use of junk bonds for financing corporate takeovers. (Michael Milken, a partner at Drexel
Burnham Lambert, used to have an annual conference in Beverly Hills, California, nicknamed "The
Predator's Ball" for attracting takeover investors and corporate raiders who needed junk bond
financing to accomplish their takeovers.)

When corporate takeovers subsided from their highs, most people thought the junk bond was forever
dead. By 1990, the junk bond market was virtually nonexistent. Then, in 1992, with investors looking
for higher interest rates and a rebounding economy, the junk bond market was revitalized. The
following year, new junk bond issues reached a record $62 billion. Also, by 1995, less than 20 percent
of the proceeds from junk bonds were being used to finance mergers and acquisitions, compared to 60
percent in the 1980s. In addition, in 1995, more than 800 companies had issued junk bonds, up from
several hundred in the 1980s. Then in early 1998, the junk bond market suffered a sudden, jarring
setback that led to the market for these bonds essentially dying. By year-end 1998, the capital market
had returned to relatively moderate levels, in part because the Federal Reserve lowered interest rates.
The borrowers in the 1990s came from a variety of industries, including manufacturing, media,
retailing, consumer products, financial services, and housing. Also, credit quality improved. Only 17
percent of new issues in 1995 fell into the lower ratings of creditworthiness, compared with 66 percent
in 1988.

Back to the Foundations

Some have thought junk bonds were fundamentally different from other securities, but they
are not. They are bonds with a great amount of risk, and therefore promise high expected
returns. Thus, Axiom 1: The Risk-Return Trade-off—We Won't Take on Additional Risk
Unless We Expect to Be Compensated with Additional Return.

As we begin the new millennium, junk bonds will continue to play an important role in the financing
of many middle-sized firms. Mutual funds and pension funds, who owned 40 percent of all junk bonds
in 1995, should continue to provide an active market for such securities. So, contrary to the
conventional wisdom of the early 1990s, the junk bond market is alive and well.

Terminology and Characteristics of

Bonds

Before valuing bonds, we first need to understand the terminology related to bonds. We should also
know the different types of bonds that exist. Then we will be better prepared to determine the value of
a bond.
When a firm or nonprofit institution needs financing, one source is bonds. As already noted, this type
of financing instrument is simply a long-term promissory note, issued by the borrower, promising to
pay its holder a predetermined and fixed amount of interest each year. Some of the more important
terms and characteristics that you might hear about bonds are as follows:

 Claims on assets and income

 Par value
 Coupon interest rate
 Maturity
 Indenture
 Current yield
 Bond ratings

Let's consider each in turn.

CLAIMS ON ASSETS AND INCOME

In the case of insolvency, claims of debt in general, including bonds, are honored before those of both
common stock and preferred stock. However, different types of debt may also have a hierarchy among
themselves as to the order of their claim on assets.

Bonds also have a claim on income that comes ahead of common and preferred stock. In general if
interest on bonds is not paid, the bond trustees can classify the firm as insolvent and force it into
bankruptcy. Thus, the bondholder's claim on income is more likely to be honored than that of common
and preferred stockholders, whose dividends are paid at the discretion of the firm's management.

PAR VALUE

The par value of a bond is its face value that is returned to the bondholder at maturity. In general,
corporate bonds are issued in denominations of $1,000, although there are some exceptions to this
rule. Also, when bond prices are quoted, either by financial managers or in the financial press, prices
are generally expressed as a percentage of the bond's par value. For example, a Revlon bond was
recently quoted in the Wall Street Journal as selling for 96¼. That does not mean you can buy the
bond for $96.25. It means that this bond is selling for 96¼ percent of its par value of $1,000. Hence,
the market price of this bond is actually $962.50. At maturity in 2008 the bondholder will receive the
$1,000.

COUPON INTEREST RATE

The coupon interest rate on a bond indicates the percentage of the par value of the bond that will be
paid out annually in the form of interest. Thus, regardless of what happens to the price of a bond with
an 8 percent coupon interest rate and a $1,000 par value, it will pay out $80 annually in interest until
maturity (.08 × $1,000 = $80).

MATURITY

The maturity of a bond indicates the length of time until the bond issuer returns the par value to the
bondholder and terminates or redeems the bond.

INDENTURE
An indenture is the legal agreement between the firm issuing the bonds and the bond trustee who
represents the bondholders. The indenture provides 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. This legal document may run 100 pages or more in length, with the
majority of it devoted to defining protective provisions for the bondholder. The bond trustee, usually a
banking institution or trust company, is then assigned the task of overseeing the relationship between
the bondholder and the issuing firm, protecting the bondholder, and seeing that the terms of the
indenture are carried out.

Typically, the restrictive provisions included in the indenture attempt to protect the bondholders'
financial position relative to that of other outstanding securities. Common provisions involve (1)
prohibiting the sale of accounts receivable, (2) limiting common stock dividends, (3) restricting the
purchase or sale of fixed assets, and (4) setting limits on additional borrowing. Not allowing the sale
of accounts receivable is specified because such sales would benefit the firm's short-run liquidity
position at the expense of its future liquidity position. Common stock dividends may not be allowed if
the firm's liquidity falls below a specified level, or the maximum dividend payout may be limited to
some fraction, say 50 percent or 60 percent of earnings under any circumstance. Fixed-asset
restrictions generally require lender permission before the liquidation of any fixed asset or prohibit the
use of any existing fixed asset as collateral on new loans. Constraints on additional borrowing usually
involve limiting the amount and type of additional long-term debt that can be issued. All these
restrictions have one thing in common: They attempt to prohibit actions that would improve the status
of other securities at the expense of bonds and to protect the status of bonds from being weakened by
any managerial action.

Should we let the private sector supervise itself, or should we invite government
regulation?

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-percent coupon interest rate, a par value of
$1,000, and a market price of $700, it would have a current yield of

(7-1)
BOND RATINGS

John Moody first began to rate bonds in 1909; since that time three rating agencies— Moody's,
Standard and Poor's, and Fitch Investor Services—have provided ratings on corporate bonds. These
ratings involve a judgment about the future risk potential of the bond. Although they deal with
expectations, several historical factors seem to play a significant role in their determination. Bond
ratings are favorably affected by (1) a greater reliance on equity as opposed to debt in financing the
firm, (2) profitable operations, (3) a low variability in past earnings, (4) large firm size, and (5) little
use of subordinated debt. In turn, the rating a bond receives affects the rate of return demanded on the
bond by the investors. The poorer the bond rating, the higher the rate of return demanded in the capital
markets. Table 7-1 provides an example and description of these ratings. Thus, bond ratings are
extremely important for the financial manager. They provide an indicator of default risk that in turn
affects the rate of return that must be paid on borrowed funds.

Back to the Foundations

When we say that a lower bond rating means a higher interest rate charged by the
investors (bondholders), we are observing an application of Axiom 1: The Risk-Return
Trade-off—We Won't Take on Additional Risk Unless We Expect to Be Compensated
with Additional Return.

Table 7-1 Standard & Poor's Corporate Bond Ratings

AAA This is the highest rating assigned by Standard and Poor's for debt obligation and
indicates an extremely strong capacity to pay principal and interest.

AA Bonds rated AA also qualify as high-quality debt obligations. Their capacity to pay
principal and interest is very strong, and in the majority of instances, they differ from
AAA issues only in small degree.

A Bonds rated A have a strong capacity to pay principal and interest, although they are
somewhat more susceptible to the adverse effects of changes in circumstances and
economic conditions.

BBB Bonds rated BBB are regarded as having an adequate capacity to pay principal and
interest. Whereas they normally exhibit adequate protection parameters, adverse
economic conditions or changing circumstances are more likely to lead to a weakened
capacity to pay principal and interest for bonds in this category than for bonds in the A
category.

BB Bonds rated BB, B, CCC, and CC are regarded, on balance, as predominantly

B speculative with respect to the issuer's capacity to pay interest and repay principal

CCC in accordance with the terms of the obligation.

CC BB indicates the lowest degree of speculation and CC the highest. While such bonds
will likely have some quality and protective characteristics, these are outweighed by
large uncertainties or major risk exposures to adverse conditions.

C The rating C is reserved for income bonds on which no interest is being paid.

D Bonds rated D are in default, and payment of principal and/or interest is in arrears.

Plus (+) or Minus (-): To provide more detailed indications of credit quality, the ratings from
AA to BB may be modified by the addition of a plus or minus sign to show relative standing
within the major rating categories.

Source: Standard & Poor's Fixed Income Investor, Vol. 8 (1980). Reprinted by permission.

We are now ready to think about bond valuation. But, to begin, we must first clarify precisely what we
mean by value. Next, we need to understand the basic concepts of valuation and the process for
valuing an asset. Then we may apply these concepts to valuing a bond—and in Chapter 8 to valuing
stocks.

Definitions of Value

The term value is often used in different contexts, depending on its application. Examples of different
uses of this term include the following:

Book value is the value of an asset as shown on a firm's balance sheet. It represents the historical cost
of the asset rather than its current worth. For instance, the book value of a company's preferred stock
is the amount the investors originally paid for the stock and therefore the amount the firm received
when the stock was issued.

Liquidation value is the dollar sum that could be realized if an asset were sold individually and not as
part of a going concern. For example, if a firm's operations were discontinued and its assets were
divided up and sold, the sales price would represent the asset's liquidation value.

The market value of an asset is the observed value for the asset in the marketplace. This value is
determined by supply and demand forces working together in the marketplace, where buyers and
sellers negotiate a mutually acceptable price for the asset. For instance, the market price for Ford
common stock on June 20, 1999, was $34. This price was reached by a large number of buyers and
sellers working through the New York Stock Exchange. In theory, a market price exists for all assets.
However, many assets have no readily observable market price because trading seldom occurs. For
instance, the market price for the common stock of Blanks Engraving, a Dallas-based, family-owned
firm, would be more difficult to establish than the market value of J. C. Penney's common stock.

The intrinsic or economic value of an asset—also called the fair value—is the present value of the
asset's expected future cash flows. This value is the amount an investor should be willing to pay, given
the amount, timing, and riskiness of future cash flows. Once the investor has estimated the intrinsic
value of a security, this value could be compared with its market value when available. If the intrinsic
value is greater than the market value, then the security is undervalued in the eyes of the investor.
Should the market value exceed the investor's intrinsic value, then the security is overvalued.

We hasten to add that if the securities market is working efficiently, the market value and the intrinsic
value of a security will be equal. Whenever a security's intrinsic value differs from its current market
price, the competition among investors seeking opportunities to make a profit will quickly drive the
market price back to its intrinsic value. Thus, we may define an efficient market as one in which the
values of all securities at any instant fully reflect all available public information, which results in the
market value and the intrinsic value being the same. If the markets are efficient, it is extremely
difficult for an investor to make extra profits from an ability to predict prices.

Back to the Foundations

 The fact that investors have difficulty identifying stocks that are undervalued relates to
Axiom 6: Efficient Capital Markets—The Markets Are Quick and the Prices Are Right.
In an efficient market, the price reflects all available public information about the security,
and therefore, it is priced fairly.

The idea of market efficiency has been the backdrop for an intense battle between professional
investors and university professors. The academic community has contended that someone throwing
darts at the list of securities in the Wall Street Journal could do as well as a professional money
manager. Market professionals retort that academicians are grossly mistaken in this view. The war has
been intense but also one that the student of finance should find intriguing, and it can be followed each
month in the Wall Street Journal, where the investment performance of dart throwers and different
professional investors are compared. Through June 1998, there had been 109 contests between these
rivals. The score: 68 for the professional managers and 41 for the dart throwers. Also, as aptly
expressed by one teacher, the real point about efficient markets is that an investor should throw a large
wet towel at the Wall Street Journal, not a dart. That is, we want to be broadly diversified with a large
group of stocks, not just one. For example, when the professional investors are compared with the
performance of the 30 companies represented on the Dow Jones Industrial Index they have won only
57 of the contests. The importance of diversification is explained in Chapter 9.

Determinants of Value

For our purposes, the value of an asset is its intrinsic value or the present value of its expected future
cash flows, where these cash flows are discounted back to the present using the investor's required rate
of return. This statement is true for valuing all assets and serves as the basis of almost all that we do in
finance. Thus, value is affected by three elements:

1. The amount and timing of the asset's expected cash flows

2. The riskiness of these cash flows
3. The investor's required rate of return for undertaking the investment

The first two factors are characteristics of the asset; the third one, the required rate of return, is the
minimum rate of return necessary to attract an investor to purchase or hold a security, which is
determined by the rates of return available on similar investments, or what is called the opportunity
cost of funds. This rate must be high enough to compensate the investor for the risk perceived in the
asset's future cash flows. (The required rate of return is explained more fully in Chapter 9.)

Back to the Foundations

Our discussions should remind us of three of our axioms that help us understand finance:

Axiom 1: The Risk-Return Trade-off—We Won't Take on Additional Risk Unless We

Expect to Be Compensated with Additional Return.

Axiom 2: The Time Value of Money—A Dollar Received Today Is Worth More Than a
Dollar Received in the Future.

Axiom 3: Cash—Not Profits—Is King.

Determining the economic worth or value of an asset always relies on these three axioms.
 Without them, we would have no basis for explaining value. With them, we can know that
the amount and timing of cash, not earnings, drive value. Also, we must be rewarded for
taking risk; otherwise, we will not invest.

Figure 7-1 depicts the basic factors involved in valuation. As the figure shows, finding the value of an
asset involves the following steps:

1. Assessing the asset's characteristics, which include the amount and timing of the expected
cash flows and the riskiness of these cash flows

2. Determining the investor's required rate of return, which embodies the investor's attitude
about assuming risk and perception of the riskiness of the asset
3. Discounting the expected cash flows back to the present, using the investor's
required rate of return as the discount rate

Figure 7-1 Basic Factors Determining an Asset's Value

Thus, intrinsic value is a function of the cash flows yet to be received, the riskiness of these cash
flows, and the investor's required rate of return.

Valuation: The Basic Process

The valuation process can be described as follows: It is assigning value to an asset by calculating the
present value of its expected future cash flows using the investor's required rate of return as the
discount rate. The investor's required rate of return, k, is determined by the level of the risk-free rate of
interest and the risk premium that the investor feels is necessary to compensate for the risks assumed
in owning the asset. Therefore, a basic security valuation model can be defined mathematically as
follows:
 (7-2)

where:
C = cash flow to be received at time t
t

V = the intrinsic value or present value of an asset producing

expected future cash flows, Ct, in years 1 through n
k = the investor's required rate of return

Using equation (7-2), there are three basic steps in the valuation process:

Step 1: Estimate the Ct in equation (7-2), which is the amount and timing of the future cash
flows the security is expected to provide.
Step 2: Determine k, the investor's required rate of return.
Step 3: Calculate the intrinsic value, V, as the present value of expected future cash flows
discounted at the investor's required rate of return.

Equation (7-2), which measures the present value of future cash flows, is the basis of the valuation
process. It is the most important equation in this chapter, because all the remaining equations in this
chapter and in Chapters 8 and 9 are merely reformulations of this one equation. If we understand
equation (7-2), all the valuation work we do, and a host of other topics as well, will be much clearer in
our minds.

With the foregoing principles of valuation as our foundation, let's now look at how bonds are valued.

Bond Valuation

The value of a bond is the present value both of future interest to be received and the par or maturity
value of the bond. It's that simple.

The process for valuing a bond, as depicted in Figure 7-2, requires knowing three essential elements:
(1) the amount and timing of the cash flows to be received by the investor, (2) the time to maturity of
the loan, and (3) the investor's required rate of return. The amount of cash flows is dictated by the
periodic interest to be received and by the par value to be paid at maturity. Given these elements, we
can compute the value of the bond, or the present value.
 Figure 7-2 Data Requirements for Bond Valuation

Consider a bond issued by American Airlines with a maturity date of 2020 and a stated coupon rate of
10.2 percent.1 In 1999, with 21 years left to maturity, investors owning the bonds are requiring an 8-
percent rate of return. We can calculate the value of the bonds to these investors using the following
three-step valuation procedure:

Step 1: Estimate the amount and timing of the expected future cash flows. Two types of cash
flows are received by the bondholder:

a. Annual interest payments equal to the coupon rate of interest times the face
value of the bond. In this example, the bond's coupon interest rate is 10.2
percent; thus the annual interest payment is $102 = .102 × $1,000. Assuming
that 1999 interest payments have already been made, these cash flows will be
received by the bondholder in each of the 21 years before the bond matures
(2000 through 2020 = 21 years).

b. The face value of the bond of $1,000 to be received in 2020. To summarize,

the cash flows received by the bondholder are as follows:

Years 1 2 3 4 ... 20 21
$102 $102 $102 $102 ... $102 $ 102
+$1,000
$1,102
c.
Step 2: Determine the investor's required rate of return by evaluating the riskiness of the
bond's future cash flows. An 8-percent required rate of return for the bondholders is
given. In Chapter 9, we learn how this rate is determined. For now, simply realize that
the investor's required rate of return is equal to a rate earned on a risk-free security
plus a risk premium for assuming risk.
Step 3: Calculate the intrinsic value of the bond as the present value of the expected future
interest and principal payments discounted at the investor's required rate of return.

The present value of American Airlines bonds is found as follows:

 (7-3a)
or, summing over the interest payments,

The foregoing equation is a restatement in a slightly different form of equation (7-2). Recall that
equation (7-2) states that the value of an asset is the present value of future cash flows to be received
by the investor.

Using It to represent the interest payment in year t, M to represent the bond's maturity (or par) value,
and kb to equal the bondholder's required rate of return, we may express the value of a bond maturing
in year n as follows:

(7-3b)
Finding the value of the American Airlines bonds may be represented graphically as follows:
Using the TI BAII Plus, we find the value of the bond to be $1,220, as calculated in the margin. 2 Thus,
if investors consider 8 percent to be an appropriate required rate of return in view of the risk level
associated with American Airlines bonds, paying a price of $1,220 would satisfy their return
requirement.

We can also solve for the value of American Airlines' bonds using a spreadsheet. The solution using
Excel appears as follows:

SEMIANNUAL INTEREST PAYMENTS

In the preceding American Airlines illustration, the interest payments were assumed to be paid
annually. However, companies typically pay interest to bondholders semiannually. For example,
consider Alaskan Airlines' bonds maturing in 14 years that pay $68.75 per year, but disburses the
interest semiannually ($34.375 each January 15 and July 15).

Several steps are involved in adapting equation (7-3b) for semiannual interest payments. 3 First,
thinking in terms of periods instead of years, a bond with a life of n years paying interest semiannually
has a life of 2n periods. In other words, a 5-year bond (n.5.5) that remits its interest on a semiannual
basis actually makes 10 payments. Yet although the number of periods has doubled, the dollar amount
of interest being sent to the investors for each period and the bondholders' required rate of return are
half of the equivalent annual figures. It becomes It/2 and kb is changed to kb/2; thus, for semiannual
compounding, equation (7-3b) becomes
 (7-4)
Alternatively, using the notations introduced in Chapter 6 for discounting cash flows, the above
equation may be restated as follows:

Assuming the Alaskan Airlines bondholders' annual required rate of return is 7.2 percent, we can use
the TI BAII Plus calculator in the margin to find the bond value, but now assuming semiannual
interest payments. Thus, the value of a bond paying $34.375 in semiannual interest for 14 years, where
the investor has a 7.2 percent required rate of return, would be $972.

This solution can be found using a spreadsheet that would look as follows:

The Bondholder's Expected Rate of Return (Yield to Maturity)

Theoretically, each investor could have a different required rate of return for a particular security.
However, the financial manager is only interested in the required rate of return that is implied by the
market prices of the firm's securities. In other words, the consensus of a firm's investors about the
expected rate of return is reflected in the current market price of the stock.

To measure the bondholder's expected rate of return, kb, we would find the discount rate that equates
the present value of the future cash flows (interest and maturity value) with the current market price of
the bond.4 The expected rate of return for a bond is also the rate of return the investor will earn if the
bond is held to maturity, or the yield to maturity. Thus, when referring to bonds, the terms expected
rate of return and yield to maturity are often used interchangeably.

To illustrate this concept, consider the Brister Corporation's bonds, which are selling for $1,100. The
bonds carry a coupon interest rate of 9 percent and mature in 10 years. (Remember, the coupon rate
determines the interest payment—coupon rate × par value.)
In determining the expected rate of return (kb), implicit in the current market price, we need to find the
rate that discounts the anticipated cash flows back to a present value of $1,100, the current market
price (P0) for the bond.

Finding the expected rate of return for a bond using the present value tables is done by trial and error.
We have to keep trying new rates until we find the discount rate that results in the present value of the
future interest and maturity value of the bond just equaling the current market value of the bond. If the
expected rate is somewhere between rates in the present value tables, we then must interpolate
between the rates.

For our example, if we try 7 percent, the bond's present value is $1,140.16. Because the present value
of $1,140.16 is greater than the market price of $1,100, we should next try a higher rate. Increasing the
discount rate, say, to 8 percent gives a present value of $1,066.90. (These computations are shown
below.) Now the present value is less than the market price; thus, we know that the investor's expected
rate of return is between 7 percent and 8 percent.

7% 8%
Present Value Present Present Value Present
Years Cash Flow Factors Value Factors Value
1-10 $90 per year 7.024 $ 632.16 6.710 $ 603.90
10 $1,000 in year 10 0.508 508.00 0.463 $ 463.00
Present value at 7% $1,140.16 Present value at 8% $1,066.90

The actual expected return for the Brister Corporation bondholders is 7.54 percent, which may be
found by using the TI BAII Plus calculator as presented in the margin, or by using a computer
spreadsheet shown as follows:

Bond Valuation: Three Important

Relationships

We have now learned to find the value of a bond (Vb), given (1) the amount of interest payments (It),
(2) the maturity value (M), (3) the length of time to maturity (n periods), and (4) the investor's
required rate of return, kb. We also know how to compute the expected rate of return (kwb), which also
happens to be the current interest rate on the bond, given (1) the current market value (P0), (2) the
amount of interest payments (It), (3) the maturity value (M), and (4) the length of time to maturity (n
periods). We now have the basics. But let's go further in our understanding of bond valuation by
studying several important relationships.

FIRST RELATIONSHIP

The value of a bond is inversely related to changes in the investor's present required rate of return
(the current interest rate). In other words, as interest rates increase (decrease), the value of the bond
decreases (increases).

To illustrate, assume that an investor's required rate of return for a given bond is 12 percent. The bond
has a par value of $1,000 and annual interest payments of $120, indicating a 12-percent coupon
interest rate ($120 ÷ $1,000 5]12%). Assuming a 5-year maturity date, the bond would be worth
$1,000, computed as follows:

(7-3b)
Using present value tables we have:

If, however, the investor's required rate of return increases from 12 percent to 15 percent, the value of
the bond would decrease to $899.24, computed as follows:
On the other hand, if the investor's required rate of return decreases to 9 percent, the bond would
increase in value to $1,116.80:

This inverse relationship between the investor's required rate of return and the value of a bond is
presented in Figure 7-3. Clearly, as an investor demands a higher rate of return, the value of the bond
decreases. The higher rate of return the investor desires can be achieved only by paying less for the
bond. Conversely, a lower required rate of return yields a higher market value for the bond.

Figure 7-3 Value and Required Rates for a 5-Year Bond at 12 Percent Coupon Rate

Changes in bond prices represent an element of uncertainty for the bond investor. If the current
interest rate (required rate of return) changes, the price of the bond also fluctuates. An increase in
interest rates causes the bondholder to incur a loss in market value. Because future interest rates and
the resulting bond value cannot be predicted with certainty, a bond investor is exposed to the risk of
changing values as interest rates vary. This risk has come to be known as interest rate risk.

SECOND RELATIONSHIP

The market value of a bond will be less than the par value if the investor's required rate of return is
above the coupon interest rate; but it will be valued above par value if the investor's required rate of
return is below the coupon interest rate.

Using the previous example, we observed that:

1. The bond has a market value of $1,000, equal to the par or maturity value, when the investor's
required rate of return equals the 12-percent coupon interest rate. In other words, if
 2. When the required rate is 15 percent, which exceeds the 12-percent coupon rate, the market
value falls below par value to $899.24; that is, if

In this case the bond sells at a discount below par value; thus, it is called a discount bond.

3. When the required rate is 9 percent, or less than the 12 percent coupon rate, the market value,
$1,116.80, exceeds the bond's par value. In this instance, if

The bond is now selling at a premium above par value; thus, it is a premium bond.

THIRD RELATIONSHIP

Long-term bonds have greater interest rate risk than do short-term bonds.

As already noted, a change in current interest rates (required rate of return) causes an inverse change
in the market value of a bond. However, the impact on value is greater for long-term bonds than it is
for short-term bonds.

In Figure 7-3 we observed the effect of interest rate changes on a 5-year bond paying a 12-percent
coupon interest rate. What if the bond did not mature until 10 years from today instead of 5 years?
Would the changes in market value be the same? Absolutely not. The changes in value would be more
significant for the 10-year bond. For example, if we vary the current interest rates (the bondholder's
required rate of return) from 9 percent to 12 percent and then to 15 percent, as we did earlier with the
5-year bond, the values for both the 5-year and the 10-year bonds are as shown below.

Market Value for a 12% Coupon-Rate

Bond Maturing In

Required Rate 5 Years 10 Years

9% $1,116.80 $1,192.16

12 1,000.00 1,000.00

15 899.24 849.28

Using these values and the required rates, we can graph the changes in values for the two bonds
relative to different interest rates. These comparisons are provided in Figure 7-4. The figure clearly
illustrates that the price of a long-term bond (say, 10 years) is more responsive or sensitive to interest
rate changes than the price of a short-term bond (say, 5 years).
 Market Values of a 5-Year and a 10-Year Bond at Different Required Rates of
Figure 7-4
Return

The reason long-term bond prices fluctuate more than short-term bond prices in response to interest
rate changes is simple. Assume an investor bought a 10-year bond yielding a 12-percent interest rate.
If the current interest rate for bonds of similar risk increased to 15 percent, the investor would be
locked into the lower rate for 10 years. If, on the other hand, a shorter-term bond had been purchased
—say, one maturing in 2 years—the investor would have to accept the lower return for only 2 years
and not the full 10 years. At the end of year 2, the investor would receive the maturity value of $1,000
and could buy a bond offering the higher 15-percent rate for the remaining 8 years. Thus, interest rate
risk is determined, at least in part, by the length of time an investor is required to commit to an
investment. However, the holder of a long-term bond may take some comfort from the fact that long-
term interest rates are usually not as volatile as short-term rates. If the short-term rate changed 1
percentage point, for example, it would not be unusual for the long-term rate to change only .3
percentage points.

Summary

Valuation is an important issue if we are to manage the company effectively. An understanding of the
concepts and how to compute the value of a security underlie much of what we do in finance and in
making correct decisions for the firm as a whole. Only if we know what matters to our investors can
we maximize the firm's value.

Distinguish between different kinds of bonds

There are a variety of types of bonds, including:

 Debentures
 Subordinated debentures
 Mortgage bonds
 Eurobonds
 Zero and very low coupon bonds
 Junk bonds

Explain the more popular features of bonds

Some of the more popular terms and characteristics that you might hear about bonds include the
following:
  Claims on assets and income
 Par value
 Coupon interest rate
 Maturity
 Indenture
 Current yield
 Bond ratings

Define the term value as used for several different purposes

Value is defined differently depending on the context. But for us, value is the present value of future
cash flows expected to be received from an investment discounted at the investor's required rate of
return.

Explain the determinants of value

Three basic factors determine an asset's value: (1) the amount and timing of future cash flows, (2) the
riskiness of the cash flows, and (3) the investor's attitude about the risk.

Describe the basic process for valuing assets

The valuation process can be described as follows: It is assigning value to an asset by calculating the
present value of its expected future cash flows using the investor's required rate of return as the
discount rate. The investor's required rate of return, k, equals the risk-free rate of interest plus a risk
premium to compensate the investor for assuming risk.

Estimate the value of a bond

The value of a bond is the present value both of future interest to be received and the par or maturity
value of the bond.

Compute a bondholder's expected rate of return

To measure the bondholder's expected rate of return, we find the discount rate that equates the present
value of the future cash flows (interest and maturity value) with the current market price of the bond.
The expected rate of return for a bond is also the rate of return the investor will earn if the bond is held
to maturity, or the yield to maturity.

Explain three important relationships that exist in bond valuation

Certain key relationships exist in bond valuation, these being:

1. A decrease in interest rates (required rates of return) will cause the value of a bond to
increase; an interest rate increase will cause a decrease in value. The change in value caused
by changing interest rates is called interest rate risk.

2. If the bondholder's required rate of return (current interest rate):

a. Equals the coupon interest rate, the bond will sell at par, or maturity value.
b. Exceeds the bond's coupon rate, the bond will sell below par value, or at a discount.
c. Is less than the bond's coupon rate, the bond will sell above par value, or at a
premium.
 d. A bondholder owning a long-term bond is exposed to greater interest rate risk than
one owning a short-term bond.

Key Terms
bond
A long-term (10-year or more) promissory note issued by the borrower, promising to pay the
owner of the security a predetermined and fixed amount of interest each year.

debenture
Any unsecured long-term debt.

subordinated debentures
A debenture that is subor-dinated to other debentures in being paid in case of insolvency.

mortgage bond
A bond secured by a lien on real property.

Eurobonds
A bond issued in a country different from the one in whose currency the bond is denominated;
for example, a bond issued in Europe or Asia by an American company that pays interest and
principal to the lender in U.S. dollars.

zero and very low coupon bonds

A bond issued at a substantial discount from its $1,000 face value and that pays little or no
interest.

Junk bonds (high-yield bonds)

Any bond rated BB or below.

par value of a bond

The face value of a bond that is returned to the bondholder at maturity.

coupon interest rate

The interest to be paid annually on a bond as a percent of par value, which is specified in the
contractual agreement.

maturity
The length of time until the bond issuer returns the par value to the bondholder and terminates
the bond.

indenture
The legal agreement between a firm issuing bonds and the bond trustee who represents the
bondholders, providing the specific terms of the loan agreement.

current yield
The ratio of the annual interest payment to the bond’s market price.

book value
(1) The value of an asset as shown on the firm’s balance sheet. It represents the historical cost
of the asset rather than its current market value or replacement cost. (2) The depreciated value
of a company’s assets (original cost less accumulated depreciation) less the outstanding
liabilities.
liquidation value
The dollar sum that could be realized if an asset were sold independently of the going
concern.

market value
The value observed in the marketplace, where buyers and sellers negotiate a mutually
acceptable price for the asset.

intrinsic or economic value

The present value of an asset’s expected future cash flows. This value is the amount the
investor considers to be fair value, given the amount, timing, and riskiness of future cash
flows.

fair value
The present value of an asset’s expected future cash flows.

efficient market
These are the markets in which values of all assets and securities at any instant in time fully
reflect all available information.

opportunity cost of funds

The next-best rate of return available to the investor for a given level of risk.

expected rate of return

(1) The discount rate that equates the present value of the future cash flows (interest and
maturity value) with the current market price of a bond. It is the rate of return an investor will
earn if the bond is held to maturity. (2) The rate of return the investor expects to receive on an
investment by paying the existing market price of the security. (3) The arithmetic mean or
average of all possible outcomes where those outcomes are weighted by the probability that
each will occur.

yield to maturity
(1) See Term Structure of Interest Rates. (2) The rate of return a bondholder will receive if the
bond is held to maturity. (Equivalent to the expected rate of return.)

interest rate risk

(1) The variability in a bond’s value (risk) caused by changing interest. (2) The uncertainty
that envelops the expected returns from a security caused by changes in interest rates. Price
changes induced by interest rate changes are greater for long-term than for short-term
financial instruments.

discount bond
A bond that sells at a discount below par value.

premium bond
A bond that is selling above its par value.

Study Problems

1. (Bond Valuation) Calculate the value of a bond that expects to mature in 12 years and has a
$1,000 face value. The coupon interest rate is 8 percent, and the investor's required rate of
return is 12 percent.
2. (Bond Valuation) Enterprise, Inc., bonds have a 9-percent coupon rate. The interest is paid
semiannually, and the bonds mature in 8 years. Their par value is $1,000. If your required rate
of return is 8 percent, what is the value of the bond? What is the value if the interest is paid
annually?
3. (Bondholder's Expected Rate of Return) The market price is $900 for a 10-year bond ($1,000
par value) that pays 8 percent interest (4 percent semiannually). What is the bond's expected
rate of return?
4. (Bond Valuation) Exxon 20-year bonds pay 9 percent interest annually on a $1,000 par value.
If bonds sell at $945, what is the bond's expected rate of return?
5. (Bondholder's Expected Rate of Return) Zenith Co.'s bonds mature in 12 years and pay 7
percent interest annually. If you purchase the bonds for $1,150, what is your expected rate of
return?
6. (Bond Valuation)National Steel 15-year, $1,000 par value bonds pay 8 percent interest
annually. The market price of the bonds is $1,085, and your required rate of return is 10
percent.
a. Compute the bond's expected rate of return.
b. Determine the value of the bond to you, given your required rate of return.
c. Should you purchase the bond?
7. (Bond Valuation)You own a bond that pays $100 in annual interest, with a $1,000 par value. It
matures in 15 years. Your required rate of return is 12 percent.
a. Calculate the value of the bond.
b. How does the value change if your required rate of return (1) increases to 15 percent
or (2) decreases to 8 percent?
c. Explain the implications of your answers in part b as they relate to interest rate risk,
premium bonds, and discount bonds.
d. Assume that the bond matures in 5 years instead of 15 years. Recompute your
answers in part b.
e. Explain the implications of your answers in part d as they relate to interest rate risk,
premium bonds, and discount bonds.
8. (Bond Valuation)Arizona Public Utilities issued a bond that pays $80 in annual interest, with
a $1,000 par value. It matures in 20 years. Your required rate of return is 7 percent.
a. Calculate the value of the bond.
b. How does the value change if your required rate of return (1) increases to 10 percent
or (2) decreases to 6 percent?
c. Explain the implications of your answers in part b as they relate to interest rate risk,
premium bonds, and discount bonds.
d. Assume that the bond matures in 10 years instead of 20 years. Recompute your
answers in part b.
e. Explain the implications of your answers in part d as they relate to interest rate risk,
premium bonds, and discount bonds.
9. (Bond Valuation—Zero Coupon)The Kumar Corporation is planning on issuing bonds that
pay no interest but can be converted into $1,000 at maturity, seven years from their purchase.
To price these bonds competitively with other bonds of equal risk, it is determined that they
should yield 10 percent, compounded annually. At what price should the Kumar Corporation
sell these bonds?
10. (Bond Values)You are examining three bonds with par value of $1,000 (you receive $1,000 at
maturity) and are concerned with what would happen to their market value if interest rates (or
the market discount rate) changed. The three bonds are:

Bond A—A bond with 3 years left to maturity that pays 10 percent per year compounded
semiannually.
Bond B—A bond with 7 years left to maturity that pays 10 percent per year compounded
semiannually.

Bond C—A bond with 20 years left to maturity that pays 10 percent per year compounded
semiannually.

What would be the value of these bonds if the market discount rate were

a. 10 percent per year compounded semiannually?

b. 4 percent per year compounded semiannually?

c. 16 percent per year compounded semiannually?
d. What observations can you make about these results?