Principles of

Chapter 3 Corporate Finance

Tenth Edition

Valuing Bonds

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

3-2

Topics Covered
Using The Present Value Formula to
Value Bonds
How Bond Prices Vary With Interest
Rates
The Term Structure of Interest Rates
Explaining the Term Structure
Real and Nominal Rates of Interest
Corporate Bonds and the Risk of
Default
 3-3

Valuing a Bond

C1 C2 1,000  C N
PV    ... 
(1  r )1 (1  r ) 2 (1  r ) N

3-4

Valuing a Bond

Example
 If today is October 1, 2010, what is the value of the
following bond? An IBM Bond pays $115 every
September 30 for 5 years. In September 2015 it pays
an additional $1000 and retires the bond. The bond is
rated AAA (WSJ AAA YTM is 7.5%)

Cash Flows
Sept 11 12 13 14 15
115 115 115 115 1115
 3-5

Valuing a Bond

Example continued
 If today is October 1, 2010, what is the value of the following
bond? An IBM Bond pays $115 every September 30 for 5 years.
In September 2015 it pays an additional $1000 and retires the
bond. The bond is rated AAA (WSJ AAA YTM is 7.5%)

115 115 115 115 1,115

PV     
1.075 1.075 1.075 1.075 1.0755
2 3 4

 $1,161.84

3-6

Valuing a Bond

Example - France
 In December 2008 you purchase 100 Euros of bonds in France
which pay a 8.5% coupon every year. If the bond matures in 2012
and the YTM is 3.0%, what is the value of the bond?
8.5 8.5 8.5 108.5
PV    
1.03 1.03 1.03 1.034
2 3

 120.44 Euros
 3-7

Valuing a Bond

Another Example - Japan

 In July 2010 you purchase 200 Yen of bonds in Japan which pay
a 8% coupon every year. If the bond matures in 2015 and the
YTM is 4.5%, what is the value of the bond?

16 16 16 16 216
PV     
1.045 1.045 1.045 1.045 1.0455
2 3 4

 243.57 Yen

3-8

Valuing a Bond

Example - USA
 In February 2009 you purchase a 3 year US Government bond.
The bond has an annual coupon rate of 4.875%, paid semi-
annually. If investors demand a 0.006003% semiannual return,
what is the price of the bond?

24.375 24.375 24.375 24.375 24.375 1024.375

PV      
1.006003 1.0060032 1.0060033 1.0060034 1.0060035 1.0060036

 $1,107.95
 3-9

Valuing a Bond

Example continued - USA

 Take the same 3 year US Government bond. If investors demand
a 4.0% semiannual return, what is the new price of the bond?

24.375 24.375 24.375 24.375 24.375 1024.375

PV      
1.04 1.042 1.043 1.044 1.045 1.046

 $918.09

Interest Rate on 10yr 3-10

Treasuries
16

14

12

10
Yield , %

0
1900

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008

Year
 3-11

Bond Prices and Yields

115.00

110.00

105.00
Bond Price, %

100.00

95.00

90.00

85.00

80.00
0

10
Interest Rates, %

3-12

Maturity and Prices

3,000

2,500
Bond Price, ($)

30 yr bond
2,000 When the interest rate
equals the 5% coupon,
both bonds sell for
1,500 face value

1,000
3 yr bond

500

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Interest Rates, %
 3-13

Duration Formula

1 PV (C1 ) 2  PV (C2 ) 3  PV (C3 ) T  PV (CT )

Duration     ... 
PV PV PV PV

duration
Modified Duration  volatility (%) 
1  yield

3-14

Duration Calculation

Proportion of Total Value Proportion of Total

Year Ct PV(Ct) at 5.0% [PV(Ct)/V] Value Time
1 100 95.24 0.084 0.084
2 100 90.7 0.08 0.16
3 1100 950.22 0.836 2.509
V = 1136.16 1 Duration= 2.753 years
 3-15

Duration
Example (Bond 1)
Calculate the duration of our 6 7/8 % bond @ 4.9 %
YTM
Year CF PV@YTM % of Total PV % x Year
1 68.75 65.54 .060 0.060
2 68.75 62.48 .058 0.115
3 68.75 59.56 .055 0.165
4 68.75 56.78 .052 0.209
5 68.75 841.39 .775
3.875
1085.74 1.00 Duration 4.424

3-16

Duration
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM,
what is this bond’s duration?

Year CF PV@YTM % of Total PV % x Year

1 90 82.95 .081 0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 1.00 Duration= 4.249
 3-17

Duration & Bond Prices

Bond Price, percent

Interest rate, percent

3-18

Interest Rates
 Short- and long-term interest rates do not always move in
parallel. Between September 1992 and April 2000 U.S. short-
term rates rose sharply while long term rates declined.
 Term Structure of Interest 3-19

Rates
YTM (r)

1981
1987 & Normal

1976
Year
1 5 10 20 30
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan
made in the future at a fixed time.
Future Rate - The spot rate that is expected in the future
Yield To Maturity (YTM) - The IRR on an interest bearing
instrument

3-20

Yield Curve
U.S. Treasury Strip Spot Rates as of February
2009
4.5

4.0

3.5
Spot rates (%)

3.0

2.5

2.0

1.5

1.0

0.5

0.0
2009 Aug 15

2011 Aug 15

2013 Aug 15

2015 Aug 15

2017 Aug 15

2019 Aug 15

2021 Aug 15

2023 Aug 15

2025 Aug 15

2027 Aug 15

2029 Aug 15

2031 Aug 15

2033 Aug 15

2035 Aug 15

2037 Aug 15

Maturity
 3-21

Law of One Price

All interest bearing instruments are
priced to fit the term structure
This is accomplished by modifying the
asset price
The modified price creates a New Yield,
which fits the Term Structure
The new yield is called the Yield To
Maturity (YTM)

3-22

Yield to Maturity
Example
A $1000 treasury bond expires in 5
years. It pays a coupon rate of 10.5%.
If the market price of this bond is
107.88, what is the YTM?
 3-23

Yield to Maturity
Example
A $1000 treasury bond expires in 5 years. It
pays a coupon rate of 10.5%. If the market
price of this bond is 107.88, what is the YTM?

C0 C1 C2 C3 C4 C5
-1078.80 105 105 105 105 1105

Calculate IRR = 8.5%

3-24

Term Structure
What Determines the Shape of the Term Structure?

Expectations Theory

Term Structure & Capital Budgeting

 CF should be discounted using Term Structure info
 Since the spot rate incorporates all forward rates,
then you should use the spot rate that equals the term
of your project.
 If you believe in other theories take advantage of the
arbitrage.
 3-25

Debt & Interest Rates

Classical Theory of Interest Rates (Economics)
 developed by Irving Fisher

Nominal Interest Rate = The rate you actually pay when

you borrow money

Real Interest Rate = The theoretical rate you pay when

you borrow money, as determined by supply and
demand r
Supply

Real r

Demand

$ Qty

3-26

Inflation Rates
Annual rates of inflation in the United States from 1900–
2008.
25

20
Annual Inflation (%)

15

10

0
1900

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008

-5

-10

-15
 3-27

Global Inflation Rates

Averages from 1900-2006
12.00

10.00
Average Inflation, %
8.00

6.00

4.00

2.00

0.00

d
us y

B e 2 3)
Sw da

19 age

n
s
er d

N en

(e ve a

Fr in
ce
k

m
Ca A

ly
nm a

UK
A wa
nd

ut lan

pa
ar
th lan

De ra li

A ic

a
S

Ita
iu

an
na
ed

Sp
r

/
U

Ja
la

22

lg
r
or

Af
So re
Ne zer

I
h
it
Sw

x
y
an
m
er
G

3-28

Debt & Interest Rates

Nominal r = Real r + expected inflation (approximation)

Real r is theoretically somewhat stable

Inflation is a large variable

Q: Why do we care?
A: This theory allows us to understand the Term
Structure of Interest Rates.

Q: So What?
A: The Term Structure tells us the cost of debt.
 Interest rate (%)

0
2
4
6
8
10
12
14
16
18
20
1-Jan-84
1-Apr-85
1-Jul-86
Actual formula

1-Oct-87
1-Jan-89
1-Apr-90
1-Jul-91
1-Oct-92

10 year real interest rate

1-Jan-94
1-Apr-95
1-Jul-96
1-Oct-97
1-Jan-99

10 year nominal interest rate

1-Apr-00

UK Bond Yields
1-Jul-01
1-Oct-02
1-Jan-04
Debt & Interest Rates

1-Apr-05
1  rnominal  (1  rreal )  (1  i )

1-Jul-06
1-Oct-07
1-Jan-09
3-30
3-29
Govt. Bills vs. Inflation (’53- 3-31

’08)
United Kingdom
30.00

25.00 Inflation

20.00

15.00
%

T-Bill Returns
10.00

5.00

0.00

Govt. Bills vs. Inflation (’53- 3-32

’08)
United States
16.00

14.00

12.00
Inflation

10.00

8.00

T-Bill Returns
6.00
%

4.00

2.00

0.00

-2.00
 Govt. Bills vs. Inflation (’53- 3-33

’08)
Germany
12.00

10.00

T-Bill Returns
8.00

6.00

4.00
%

2.00 Inflation

0.00

-2.00

-4.00

3-34

Bond Ratings
 Key to bond ratings. The highest-quality bonds are rated triple
A. Bonds rated triple B or above are investment grade. Lower-
rated bonds are called high-yield, or junk, bonds.
 3-35

Yield Spread
Yield spreads between corporate and 10-
year Treasury bonds.
7
corporate and government
Yield spread between
6

5
bonds, %

4 Spread on Baa bonds

1
Spread on Aaa bonds
0
0.24
0.22

0.22
0.42
0.44
0.58
0.79
0.25
-0.05
-0.01
0.83
0.75
1.21
1.08
1.18

1.38
0.67
0.4

0.5

1.9
-1

Years

3-36

Prices and Yields

 Prices and yields of a sample of corporate
bonds, December 2008.

Source: Bond transactions reported on FINRA’s TRACE service:

http://cxa.marketwatch.com/finra/BondCenter
 3-37

Web Resources
Click to access web sites
Internet connection required

http://cxa.marketwatch.com/finra/BondCenter
www.ft.com
www.smartmoney.com
www.wsj.com
www.finpipe.com
www.investinginbonds.com
www.investorguide.com
http://money.cnn.com/markets/bondcenter
www.federalreserve.gov
www.stls.frb.org
www.ustreas.gov