Essentials of Corporate Finance 8th Edition Ross Solutions Manual 1

Chapter 06 – Interest Rates and Bond Valuation
Essentials of Corporate Finance 8th

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Chapter 6
INTEREST RATES AND BOND VALUATION
6-1
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Interest Rates and Bond Valuation

Slide
6 Chapter Organization Number
Slide Title
Introduction 6.2 Key Concepts and Skills

6.3 Chapter Outline
6.1 Bonds and Bond Valuation
Bond Features and Prices 6.4 Bond Definitions
6.5 Key Features of a Bond
6.6 Key Features of a Bond
Bond Values and Yields 6.7 Bond Value
6.8 The Bond-Pricing Equation
6.9 Texas Instruments BA-II Pus
6.10 Spreadsheet Formulas
6.11 Pricing Specific Bonds on the TI BAII +
6.12 Pricing Specific Bonds in Excel
6.13 Valuing a Discount Bond with Annual Coupons
6.14 Valuing a Premium Bond with Annual Coupons
6.15 Graphical Relationship Between Price and Yield-to-Maturity
6.16 Bond Prices: Relationship between Coupon and Yield
6.17 Bond Value ($) vs. Years remaining to Maturity
6.18 The Bond Pricing Equation Adjusted for Semiannual Coupons
6.19 Semiannual Bonds Example 6.1
6.20 Example 6.1
Interest Rate Risk 6.21 Interest Rate Risk
6.22 Interest Rate Risk
6.23 Figure 6.2
6.24 Computing Yield-to-Maturity YTM
6.25 YTM with Annual Coupons
6.26 YTM with Semiannual Coupons
6.27 YTM with Semiannual Coupons
6.28 Table 6.1
6.2 More on Bond Features
Is it Debt or Equity? 6.29 Debt or Equity
The Indenture 6.30 The Bond Indenture
6.31 Bond Classifications
6.32 Bond Characteristics and Required Returns
6.3 Bond Ratings
6.33 Bond Ratings - Investment Quality
6.34 Bond Ratings - Speculative
6.4 Some Different Types of Bonds
Government Bonds 6.35 Government Bonds
6.36 Government Bonds
6.37 Example 6.4
Zero Coupon Bonds 6.38 Zero Coupon Bonds
Floating Rate Bonds 6.39 Floating Rate Bonds
Other Types of Bonds 6.40 Other Bond Types
6-2
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Interest Rates and Bond Valuation

Slide
6 Chapter Organization Number
Slide Title
6.5 Bond Markets

How are Bonds Bought and Sold 6.41 Bond Markets
6.42 Work the web
Bond Price Reporting 6.43 Corporate Bond Quotations
6.44 Treasury Quotations
6.47 Quoted Price vs. Invoice Price
6.6 Inflation and Interest Rates
6.48 Inflation and Interest Rates
Real versus Nominal Rates 6.49 The Fisher Effect
The Fisher Effect 6.50 Example 6.6
6.7 Determinants of Bond Yields
The Term Structure of Interest Rates 6.51 Term Structure of Interest Rates
Bond Yields and the Yield Curve 6.52 Figure 6.5 A Upward-Sloping Yield Curve
6.53 Figure 6.5 B Downward-Sloping Yield Curve
6.54 Figure 6.6 Treasury Yield Curve
6.55 Factors Affecting Required Returns
6.56 Quick Quiz
CHAPTER WEBSITES
Websites may be referenced more than once in a chapter. This table just includes the section for
the first reference.
Chapter Section Web Address

6.1 bonds.yahoo.com
personal.fidelity.com
money.cnn.com/markets/bondcenter
www.bankrate.com
www.investorguide.com
6.2 www.investinginbonds.com
www.bondsonline.com
www.bondmarkets.com
www.sec.gov
6.3 www.standardandpoors.com
www.moodys.com
www.fitchinv.com
6.4 money.cnn.com
http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm
http://www.publicdebt.treas.gov/
http://www.brillig.com/debt_clock/
www.ny.frb.org
6.5 www.nasd.com
research.stlouisfed.org/fred/files
www.nasd.com
www.direct-notes.com
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www.internotes.com
http://cxa.marketwatch.com/finra/BondCenter
www.treasurydirect.gov
www.wsj.com
http://www.publicdebt.treas.gov/
6.7 www.bloomberg.com/markets
www.smartmoney.com
What’s On the Web? www.nasdbondinfo.com
www.stls.frb.org
Lecture/Teaching Suggestions: Chapter 6 builds on the TVM concepts covered in Chapters 4 and
5, beginning the process of applying those concepts to valuation. Beyond bond valuation, this
chapter also covers the basic characteristics of fixed income securities including corporate and
government bonds.
The value of a bond—like all financial assets—is fundamentally the present value of its expected
future cash flows. With bonds, those cash flows—their dollar value, timing, and number—are
known when the bond is issued. This makes bonds significantly easier to value and provides a
better introduction to discounted cash flow valuation.
ANNOTATED CHAPTER OUTLINE
Slide 6.2 Key Concepts and Skills
Slide 6.3 Chapter Outline
Slide 6.4 Bond Definitions

Bond = public debt of a corporation or government entity
Bonds are frequently referred to as “fixed income securities” because, in their most basic form,
they provide a fixed stream of coupon payments until maturity.
Other terms covered on following slides.
Slide 6.5 Key Features of a Bond

Par value is assumed to be $1,000 though bonds have been issued in larger and smaller
denominations.
A bond’s coupon rate is set at the time the bond is issued and usually remains constant for the
life of the issue. Whenever coupon rate = YTM (market rate), then bond price = par.
Example (not on slide):

Suppose Wilhite, Co. issues $1,000 par bonds with 20 years to maturity. The annual
coupon is $110. Similar bonds have a yield to maturity of 11%.
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Bond value = PV of coupons + PV of face value

Bond value = 110[1 – 1/(1.11)20] / .11 + 1000 / (1.11)20
Bond value = 875.97 + 124.03 = $1000
or 20 N; 11 I/Y; 110 PMT; 1000 FV; CPT PV = -1000
Because the coupon rate and the yield are the same, the price should equal face value.
A bond’s coupon payment is the interest payment. Coupon payments are typically made in
cash.
Real World Tip: Not all bond interest is paid in cash. Isle of Arran Distillers Ltd., a UK firm,
offered investors the chance to purchase bonds for approximately $675; the bonds gave
investors the right to receive 10 cases of the firm’s products: malt whiskeys. The reason?
According to Harold Currie, the company’s chairman, “The idea of the bond is to create a
customer base from the beginning. The whiskey will not be available in shops and will be
exclusive to the bondholders.”
Slide 6.6 Key Features of a Bond

Yield to maturity (YTM)—the required market rate or rate that makes the discounted cash
flows from a bond equal to the bond’s market price.
To avoid confusion, emphasize that the terms yield to maturity, required return, and market
rate are used synonymously.
Slide 6.7 Bond Value

The cash flows from a bond are the coupons and the face value. The value of a bond (market
price) is the present value of the expected cash flows discounted at the market rate of interest.
Consistent with present values, bond prices and discount rates are inversely related—they
move in opposite directions.
Slide 6.8 The Bond-Pricing Equation

Bond value = present value of coupons + present value of par
Bond value = C[1 – 1/(1 + r)t] / r + FV / (1 + r)t

Where “r” = YTM
Slide 6.9 Texas Instruments BA II+

Solving bond valuation problems with the TI BAII+ uses the TVM keys covered in Chapters 4
and 5.
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Slide 6.10 Spreadsheet Formulas

Similarly, in Excel use the same TVM functions covered in Chapter 4 and 5.
Slide 6.11 Pricing Specific Bonds in the TI BA II+

Using basic TVM functions to solve bond valuation problems does not yield exact results if
applied to a “real” bond. Valuation of a specific bond requires that the settlement (purchase)
date and maturity (redemption) dates be actual calendar dates. In addition, there are “day
count” conventions describing how many days in a month or year should be used in the
calculations in both calculators and Excel.
For classroom academic purposes, this is more complicated than necessary, so basic TVM
equations using years or periods to maturity will be employed.
Still, students should be aware of the Bond Worksheet in the TI BA II+ accessed by pressing
. This slide shows the various field entries required in this worksheet. Fields are entered in
the same manner as in the Cash Flow worksheet.
Slide 6.12 Pricing Specific Bonds in Excel (Excel link)

Much like the TI BAII+, Excel also has functions designed to value specific bonds.
Note that you have to have the Analysis Tool Pak add-in to access the PRICE and YIELD
functions shown on this slide.
In Excel, both settlement and redemption dates must be entered as sequential numbers
generated by Excel’s “DATE” function. Other field entries are similar to those required in the
TI BAII+.
Slide 6.13 Valuing a Discount Bond with Annual Coupons

Discount bond—a bond that sells for less than its par value. We knew the price would be less
than the par value because the YTM is greater than the coupon rate.
The slide shows the formula, calculator and Excel solutions.
Remember the sign convention. The easy way to remember it with bonds is we pay the PV (–)
so that we can receive the PMT (+) and the FV (+).
Lecture Tip: Stress that the coupon rate and the face value are fixed by the bond indenture
when the bond is issued (except for floating-rate bonds). Therefore, the expected cash flows
don’t change during the life of the bond. However, the bond price will change as interest rates
change and as the bond approaches maturity.
Slide 6.14 Valuing a Premium Bond with Annual Coupons

Premium bond—a bond that sells for more than its par value. Again, we should know this in
advance because the YTM is less than the coupon rate. This is discussed further on Slide 6.16.
6-6
Slide 6.15 Graphical Relationship Between Price and YTM

Consistent with Present Value valuation, as the discount rate (YTM) increases, the present
value (bond price) declines.
Slide 6.16 Bond Prices: Relationship between Coupon and Yield

We know that present values decrease as rates increase. Therefore, if we decrease our yield
below the coupon, the present value (price) must increase above par. On the other hand, if we
increase our yield above the coupon, the present value (price) must decrease below par.
There are more intuitive ways to explain this relationship. Explain that the yield to maturity is
the interest rate on newly issued debt of the same risk and that debt would be issued so that the
coupon = yield. Then, suppose that the coupon rate is 8% and the yield is 9%. Ask the students
which bond they would be willing to pay more for. Most will say that they would pay more for
the new bond. Because it is priced to sell at $1,000, the 8% bond must sell for less than $1,000.
The same logic works if the new bond has a yield and coupon less than 8%.
Slide 6.17 Bond Value ($) versus Years Remaining to Maturity

The graph depicts the convergence of a bond’s price toward its par value as time to maturity
decreases. This makes sense intuitively. The day before a bond matures, no one would pay
much more (or less) than its face value.
While this graph is symmetrically pleasing, in truth a bond’s value may fluctuate over its life,
dipping below par and rising above par depending on market rates.
Lecture Tip: This offers an opportunity to discuss the components of a bond’s total return.
Total return = Current yield + Capital gains yield. The current yield, in the case of a par value
bond, is just the coupon rate. The capital gains yield has to make up the difference to reach the
yield to maturity. Therefore, if the coupon rate is 8% and the YTM is 9%, the capital gains
yield must equal 1%. The only way to have a capital gains yield of 1% is if the bond is selling
for less than par value. (If price = par, there is no capital gain.) You may wish to discuss the
components of required returns for bonds in a fashion analogous to the stock return discussion
in the next chapter. As with common stocks, the required return on a bond can be decomposed
into current income and capital gains components. The yield-to-maturity (YTM) equals the
current yield plus the capital gains yield.
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Consider the premium bond described in Example 6.2. The bond has $1,000 face value, $30
semiannual coupons, 5 years to maturity, and sells for $1,080.42. The current yield is thus
60/1,080.42 = 5.55%. If one purchases this bond at the market price, then the yield to maturity
is 2.1% per semiannual period  2 = 4.2%, thus the other component of return, the capital
gains yield, must be 4.2 – 5.55% = –1.35%. Assuming no change in interest rates, the capital
gains yield equals the change in bond price divided by the initial outlay. Given no change in
market rates, the “one-year-later” price must be $1,065.83, which is consistent with the
capital gains yield of –1.35%: (1,065.83 – 1,080.42) / 1,080.42 = –1.357%.
While buying a premium bond and holding it to maturity ensures capital losses over the life of
the bond, the higher-than-market coupon will offset the losses, ensuring that the YTM is earned
over the bond’s life (if coupons can also be reinvested at that same YTM). The opposite is true
for discount bonds.
Slide 6.18 The Bond Pricing Equation Adjusted for Semiannual Coupons
Semiannual coupons – coupons are paid twice a year. Everything is quoted on an annual
basis so you divide the annual coupon and the yield by two and multiply the number of years
by 2. Note that since YTM is traditionally quoted as an APR, the appropriate 6-month
periodic rate can be derived by simply dividing the quoted YTM by two.
Example: (not on the slide) A $1,000 bond with an 8% coupon rate, with coupons paid every 6
months, is maturing in 10 years. If the quoted YTM is 10%, what is the bond price?
C = .08(1,000)/2 = 40; r = .1/2 = .05; t = 10*2 = 20

Bond value = 40[1 – 1/(1.05)20] / .05 + 1,000 / (1.05)20
Bond value = 498.49 + 376.89 = $875.38
or 20 N; 5 I/Y; 40 PMT; 1000 FV; CPT PV = –875.38
Slide 6.19 Example 6.1

The students can read the example in the book. This slide is included to reinforce the changes
needed to value a semi-annual coupon bond.
Example 6.1 is solved using the formula, the calculator and Excel on Slide 6.20.
Slide 6.21 Interest Rate Risk

Interest rate risk = risk arising from fluctuating interest rates. Interest rate risk has two
dimensions: Price Risk and Reinvestment Rate Risk.
Price Risk = changes in bond prices due to fluctuating interest rates.
6-8
All else equal, the longer the time to maturity, the greater the interest rate price risk. It takes
longer to receive the large cash flow at the end and we know from previous chapters that the
present value decreases as time increases.
All else equal, the lower the coupon rate, the greater the interest rate price risk. The par value
makes up a larger portion of the bond’s cash flows and it comes at the end.
Slide 6.22 Interest Rate Risk

Another type of interest rate risk is called reinvestment rate risk, which is the uncertainty
concerning the rate at which cash flows received can be reinvested.
All else equal, the shorter the time to maturity, the greater the interest rate reinvestment risk.
The large cash flow at maturity will be received sooner and will need to be reinvested at
current market rates, which may be less than the bond’s coupon rate.
All else equal, the higher the coupon rate, the greater the interest rate reinvestment risk.
The coupons make up a larger portion of the bond’s cash flows and must be reinvested at
market rates.
Slide 6.23 Figure 6.2

This figure shows graphically the interest rate risk concepts. Note that the slope of the 30-year
curve is substantially steeper than that of the 1-year bond.
Slide 6.24 Computing YTM

Usually, the price, coupon rate, par value and maturity of a bond are known. The yield-to-
maturity is the unknown variable. Solving for YTM manually involves a tedious trial-and-error
process to “zero in” on the answer.
Using either the TI BAII+’s TVM keys or Excel’s TVM functions, YTM is easily found. We
simply enter the four known variables and solve for the rate.
Slide 6.25 YTM with Annual Coupons

A straightforward example of using the TI BAII+ to solve for the YTM.
Note that the bond’s current market price is entered as the present value and is a negative
number because this is the amount that would be paid to purchase the bond.
Slide 6.26 YTM with Semiannual Coupons

This problem is posed to make students think about the adjustments needed to solve for YTM
on a semiannual coupon bond.
• If the bond is selling for more than its par value, then the YTM must be LESS than the
coupon rate of 10%.
• The semiannual coupon payment = (10%  1000)/2 = $50.
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• The bond matures in 20 years or 40 six-month periods.
Slide 6.27 YTM with Semiannual Coupons

The problem from the previous slide is solved using both the calculator and Excel.
Stress that solving for the YTM of a semiannual bond requires that the resulting rate—from the
calculator or Excel—must be doubled to arrive at an annual YTM.
This is a good opportunity to illustrate a “reasonableness test.” If one forgets to double the
semiannual rate, then they would report a YTM well below the bond coupon rate.
Slide 6.28 Table 6.1

Recap of topics covered so far in this chapter.
Slide 6.29 Debt or Equity

It is sometimes difficult to tell whether a hybrid security is debt or equity. The distinction is
important for many reasons, not the least of which is that
(a) The IRS takes a keen interest in the firm’s financing expenses in order to be sure that
nondeductible expenses are not deducted.
(b) Investors are concerned with the strength of their claims on firm cash flows.
In general, debt securities are characterized by the following attributes:

• Creditors (or lenders or bondholders) generally have no voting rights.
• Payment of interest on debt is a tax-deductible business expense.
• Unpaid debt is a liability, so default subjects the firm to legal action by its creditors.
Slide 6.30 The Bond Indenture

Indenture—written agreement between issuer and creditors detailing terms of borrowing. (Also
deed of trust.) Indenture provisions include:
Security provisions (covered on the next slide).
Sinking fund—an account managed by the bond trustee for early redemption. Reduces risk of
default, but bondholders may not receive all of expected coupons.
Callable—bondholders bear the risk of the bond being called early, usually when rates are
lower. They don’t receive all of the expected coupons and they have to reinvest at lower rates.
• Call provision—allows company to “call” or repurchase part or all of issue.
• Call premium—amount by which the call price exceeds the par value.
• Deferred call—firm cannot call bonds for a designated period.
• Call protected—the description of a bond during the period it can’t be called.
Protective covenants—indenture conditions that limit the actions of firms to protect the
debtholders.
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Negative covenant—“thou shalt not” sell major assets, etc.
Positive covenant—“thou shalt” keep working capital at or above $X, etc.
Real-World Tip: The bond indenture is a real-world example of the effects of agency conflicts
between security holders—stockholders and bondholders.
Slide 6.31 Bond Classifications

Registered form—ownership is recorded, payment made directly to owner.
Bearer form—payment is made to holder (bearer) of bond.
Lecture Tip: Domestically issued bearer bonds have become virtually obsolete. Because
bearer bonds are not registered with the corporation, it is easy for bondholders to receive
interest payments without reporting them on their income tax returns. In an attempt to
eliminate this potential for tax evasion, all bonds issued in the U.S. after July 1983 must be in
registered form. It is still legal to offer bearer bonds in some other nations, however. Some
foreign bonds are popular among international investors particularly due to their bearer
status.
Security—debt classified by the type of collateral.

Collateral—strictly speaking, pledged securities.
Mortgage securities—secured by mortgage on real property.
Debenture—an unsecured debt with 10 or more years to maturity.
This is standard terminology in the U.S., but it may not transfer to other countries. For
example, debentures are secured debt in the United Kingdom.
Notes—debentures with 10 years or less maturity.
Seniority—order of precedence of claims in the event of bankruptcy.

Senior debt is paid first. Junior or subordinated debt is lower in priority.
Slide 6.32 Bond Characteristics and Required Returns

A bond’s coupon rate is set at issue and, except in special cases, does not change over the life
of the bond. The coupon rate selected is a function of the risk characteristics of the bond on
the day it is issued. A firm preparing a bond issue would research bonds of similar maturity
and risk level and base its coupon rate on those comparables so that the bond will sell for its
par value.
Higher coupons:
• Debenture—secured debt is less risky because the income from the security is used to
pay it off first.
• Subordinated debenture—will be paid after the senior debt.
• Bond without sinking fund—company has to come up with substantial cash at maturity
to retire debt, and this is riskier than systematic retirement of debt through time.
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• Callable bond—call potential is unattractive to investors. Debt is usually purchased

with the expectation of receiving periodic coupon payments for many years. If a bond
is called before maturity, the coupon stream stops.
Slide 6.33 Bond Ratings—Investment Quality

Firms typically pay rating agencies to have a bond issue rated. The major rating agencies are
Moody’s, Standard & Poor’s, and Fitch. The rating categories of the three agencies are similar,
dividing bonds into two main groups: investment grade and speculative grade.
Bond ratings are important to a firm because a higher rating indicates lower default risk and
translates into a lower coupon rate required by the market. Additionally, many large
institutional investors are prohibited from investing in any bonds below the investment grade
categories, which are shown on this slide.
Slide 6.34 Bond Ratings—Speculative

Originally, bonds in the speculative categories started life as investment-grade bonds that fell
on hard times and were termed “fallen angels.” The advent of the “junk bond” era of the 1980s
brought about a type of speculative bond termed “original issue junk”—popularized by
Michael Milken and Drexel Burnham Lambert. These bonds were issued with high coupon
rates to compensate investors for their high risk. Junk bonds were, and still are, frequently used
to finance acquisitions. They also served to open up the public bond market to firms unable to
secure funds in this manner before.
Slide 6.35 Government Bonds

Long-term debt instruments issued by a governmental entity. Treasury bonds are bonds issued
by the federal government. In the U.S., Treasuries are exempt from state taxation but not
federal tax. Three basic categories: bills, notes, and bonds.
Slide 6.36 Government Bonds

Municipal bonds are issued by state or local governments. “Munis” are frequently referred to
as the “tax-exempt market” because they are exempt from federal taxation and, usually, from
state tax in the state of issue.

You should be willing to accept a lower stated yield on municipals because you do not have to
pay taxes on the interest received. The discount you are willing to accept depends on your tax
bracket.
Consider a taxable bond with a yield of 8% and a tax-exempt municipal bond with a yield of
6%.
Suppose you own one $1,000 bond of each, and both bonds are selling at par. You receive $80
per year from the corporate and $60 per year from the municipal. How much do you have after
taxes if you are in the 40% tax bracket?
6-12
Corporate: 80 – 80(.4) = 48; Municipal = 60.
Slide 6.38 Zero Coupon Bonds

Zero coupon bonds are bonds that are offered at deep discounts because there are no periodic
coupon payments. Although, no cash interest is paid, firms deduct the implicit interest while
holders report it as income. Interest expense equals the periodic change in the amortized value
of the bond.
Real-World Tip: Most students are familiar with Series EE savings bonds. Point out that these
are actually zero coupon bonds. The investor pays one-half of the face value and must hold the
bond for a given number of years before the face value is realized. As with any other zero-
coupon bond, reinvestment risk is eliminated, but an additional benefit of EE bonds is that,
unlike corporate zeroes, the investor need not pay taxes on the accrued interest until the bond
is redeemed. Further, it should be noted that interest on these bonds is exempt from state
income taxes. And, savings bonds yields are indexed to Treasury rates.
Real-World Tip: A popular financial innovation of the last decade are Treasury “strips.”
Treasury strips are created when a coupon-bearing Treasury issue is purchased, placed in
escrow, and the coupon payments are “stripped away” from the principal portion. Each
component is then sold separately to investors with different objectives: The coupon portion is
purchased by those desirous of safe current income, while the principal portion is purchased
by those with cash needs in the future. (The latter portion is, in essence, a synthetically created
zero coupon bond.) Merrill Lynch was the first to offer these instruments, calling them
“TIGRs” (Treasury Investment Growth Receipts), soon to be followed Salomon Brothers’
CATs (Certificates of Accrual of Treasury securities). “Strips” have gained such popularity
that the Treasury now packages strips for investors.
Slide 6.39 Floating Rate Bonds

A floating rate bond is quite simply one whose rate changes over its life, typically indexed to
some widely used benchmark such as the CPI or LIBOR.
Real-World Tip: The “Marketable Treasury Inflation-Indexed Securities” have floating

coupon payments, but the interest rate is set at auction and fixed over the life of the bond. The
principal amount is periodically adjusted for inflation, and the coupon payment is based on the
current inflation-adjusted principal amount. The CPI-U is used to adjust the principal for
inflation. The bonds will pay either the original par value or the inflation-adjusted principal;
whichever is greater, at maturity.
The Treasury Department has issued another type of floating rate bond based on inflation. It is
an I-Bond and is similar to an EE savings bond. The major difference is that the bonds pay a
fixed coupon rate plus current annualized inflation, based on the CPI-U. Essentially, these
bonds guarantee a real rate of return, regardless of the inflation rate.
6-13
For more information on either of these Treasury securities, see the Bureau of the Public Debt
online (www.treasurydirect.gov).
Slide 6.40 Other Bond Types

Ask the students if these bonds will tend to have higher or lower required returns compared to
bonds without these specific provisions.
Stress that any feature that is good for the issuing firm (i.e., a call feature), results in the
demand for a higher coupon rate from the market.
Conversely, bondholders will accept a lower coupon rate if the bond issue includes features in
their best interest (i.e., a “put” feature or collateral).
Structured notes—bonds that are based on stocks, bonds, commodities, or currencies.

One particular type of structured note has a return based on a stock market index.
At expiration, if the stock index has declined, the bond returns the principal. However, if
the stock index has increased, the bond will return a portion of the stock index return, say
80 percent. Another type of structured note will return twice the stock index return, but
with the potential for loss of principal.
Required return depends on the structure.
Convertible bonds—bonds can be converted into shares of common stock at the bondholder’s
discretion
Lower required return
Put bond—bondholder can force the company to buy the bond back prior to maturity Lower
required return
Video Note: “Bonds” follows the bond underwriting process through secondary market sales
for an $83 million bond issue to finance a hotel in Miami’s South Beach.
Slide 6.41 Bond Markets

Most transactions are OTC (over-the-counter), a market that is not very transparent.
Daily bond trading volume exceeds stock trading volume, but trading in individual issues tends
to be very thin except for Treasury issues, which are very heavily traded.
Slide 6.42 Example: Work the Web (Web link)

The bond market has traditionally been quite opaque, but more and more information is
becoming available online. Follow the Web Surfer link to explore an online source of bond
prices and yields.
6-14
Slide 6.43 Corporate Bond Quotations

Corporate Bond Quote:
Company: “ABC”
Coupon rate: 8.375%; coupon payment per year = $83.75
Bond matures on July 15, 2033
Current yield = 8.32%; computed as annual coupon divided by current price
Trading volume = 765,528 bonds
Quoted price: 100.641% of face value, so if face value is $1,000, the price is $1,006.41.
It is important to emphasize that bond prices are quoted as a percent of par, just as the
coupon is quoted as a percent of par.
The bond’s yield is 362 basis points (3.62%) above the 30-year Treasury bond yield.
Slide 6.44 Treasury Quotations

The quote is taken from Figure 6.3—the highlighted quote.
The answers to the questions on slide 45 are on slide 46.
Note that Treasury quotes have been recently decimalized. The old method of pricing in 32nds
is no more.
Also, students may not be familiar with the concept of bid and ask prices.
The bid is the price a dealer will pay an investor to purchase the bond.
The ask is the price a dealer is willing to sell the bond to an investor.
The bid-ask spread is the dealer’s profit.
Slide 6.47 Quoted Price versus Invoice Price

Bond prices are traditionally quoted “clean” or without accrued interest. If a bond is purchased
(or sold) between coupon payment dates, then any interest earned since the last coupon
payment is due to the holder (seller) of the bond.
At the time of the exchange, accrued interest is computed and added to the quoted price to
arrive at the “invoice price,” also called the “full” or “dirty” price.
6-15
Slide 6.48 Inflation and Interest Rates

Be sure to ask students to define inflation to make sure they understand what it is.
A quoted rate of interest is a “nominal” rate because it includes inflation expectations.
Nominal rates are sometimes called “observed” rates, because they are what we observe in the
financial markets and are reported in the financial press.
Slide 6.49 The Fisher Effect

The Fisher Effect is a theoretical relationship between nominal returns, real returns, and the
expected inflation rate. Let R be the nominal rate, r the real rate, and h the expected inflation
rate; then,
(1 + R) = (1 + r)(1 + h)
The real rate can be found by deflating the nominal rate by the inflation rate:
r = [(1 + R) / (1 + h)] – 1
A reasonable approximation, when expected inflation is relatively low, is R = r + h.
The approximation works pretty well with “normal” real rates of interest and expected
inflation. If the expected inflation rate is high, then there can be a substantial difference.

An example using the Fisher Effect formula.
Slide 6.51 Term Structure of Interest Rates

Term structure of interest rates = the relationship between nominal interest rates on default-
free, pure discount securities and time to maturity.
Inflation premium—compensation for expected inflation.
Interest rate risk premium—compensation for bearing interest rate risk (maturity premium).
Slide 6.52 Figure 6.5—Upward Sloping Yield Curve

An upward sloping yield curve, as shown in this graph, is considered “normal” because it
depicts a situation in which long-term rates are higher than short-term rates.
Slide 6.53 Figure 6.5—Downward Sloping Yield Curve

A downward sloping or inverted yield curve implies that expectations for future short-term
rates are lower than current short-term rates.
6-16
Slide 6.54 Figure 6.6—Treasury Yield Curve (Web link)

www.bloomberg.com/markets provides current Treasury yield curve.
Treasury yield curve—plot of yields on Treasury notes and bonds relative to maturity.
Slide 6.55 Factors Affecting Required Returns

The required return on any bond is a combination of components compensating investors for
various risk factors:
Default risk premium—compensation for the possibility of default.
Taxability premium—compensation for unfavorable tax status.
Liquidity premium—compensation for lack of liquidity.
Maturity premium—compensates investors for tying up funds for longer periods of time.
Not all bonds will have all components. For example, Treasury bonds have no default or
liquidity risk. Municipal bonds have no taxability premium. Short-term securities would have
no maturity premium.
Slide 6.56 Quick Quiz

Clicking on the slide link will take you to that slide in the presentation. Each referenced slide
has a “Return to Quiz” arrow to bring up back to this slide.
Q1: Bond valuation Slide 6.8

Q2: Indenture Slide 6.30
Q3: Bond ratings Slice 6.33
Q4: Inflation effect Slide 6.49
Q5: Term structure Slide 6.51
Q6: Return affects Slide 6.55
Slide 6.57 Chapter 6 END
6-17

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Chapter 06 – Interest Rates and Bond Valuation

Essentials of Corporate Finance 8th

Test Bank: https://testbankpack.com/p/test-bank-for-essentials-of-

Solution Manual: https://testbankpack.com/p/solution-manual-for-

Interest Rates and Bond Valuation

Introduction 6.2 Key Concepts and Skills

Interest Rates and Bond Valuation

6.5 Bond Markets

Chapter Section Web Address

ANNOTATED CHAPTER OUTLINE

Slide 6.2 Key Concepts and Skills

Slide 6.3 Chapter Outline

Slide 6.4 Bond Definitions

Other terms covered on following slides.

Slide 6.5 Key Features of a Bond

Example (not on slide):

Bond value = PV of coupons + PV of face value

or 20 N; 11 I/Y; 110 PMT; 1000 FV; CPT PV = -1000

Slide 6.6 Key Features of a Bond

Slide 6.7 Bond Value

Slide 6.8 The Bond-Pricing Equation

Bond value = C[1 – 1/(1 + r)t] / r + FV / (1 + r)t

Slide 6.9 Texas Instruments BA II+

Slide 6.10 Spreadsheet Formulas

Slide 6.11 Pricing Specific Bonds in the TI BA II+

Slide 6.12 Pricing Specific Bonds in Excel (Excel link)

Slide 6.13 Valuing a Discount Bond with Annual Coupons

The slide shows the formula, calculator and Excel solutions.

Slide 6.14 Valuing a Premium Bond with Annual Coupons

Slide 6.15 Graphical Relationship Between Price and YTM

Slide 6.16 Bond Prices: Relationship between Coupon and Yield

Slide 6.17 Bond Value ($) versus Years Remaining to Maturity

C = .08(1,000)/2 = 40; r = .1/2 = .05; t = 10*2 = 20

Slide 6.19 Example 6.1

Slide 6.21 Interest Rate Risk

Price Risk = changes in bond prices due to fluctuating interest rates.

Slide 6.22 Interest Rate Risk

Slide 6.23 Figure 6.2

Slide 6.24 Computing YTM

Slide 6.25 YTM with Annual Coupons

Slide 6.26 YTM with Semiannual Coupons

• The bond matures in 20 years or 40 six-month periods.

Slide 6.27 YTM with Semiannual Coupons

Slide 6.28 Table 6.1

Slide 6.29 Debt or Equity

In general, debt securities are characterized by the following attributes:

Slide 6.30 The Bond Indenture

Security provisions (covered on the next slide).

Negative covenant—“thou shalt not” sell major assets, etc.

Positive covenant—“thou shalt” keep working capital at or above $X, etc.

Slide 6.31 Bond Classifications

Bearer form—payment is made to holder (bearer) of bond.

Security—debt classified by the type of collateral.

Seniority—order of precedence of claims in the event of bankruptcy.

Slide 6.32 Bond Characteristics and Required Returns

• Callable bond—call potential is unattractive to investors. Debt is usually purchased

Slide 6.33 Bond Ratings—Investment Quality

Slide 6.34 Bond Ratings—Speculative

Slide 6.35 Government Bonds

Slide 6.36 Government Bonds

Slide 6.37 Example 6.4

Corporate: 80 – 80(.4) = 48; Municipal = 60.

Slide 6.38 Zero Coupon Bonds

Slide 6.39 Floating Rate Bonds