CH 06-1

Chapter 6
Bonds and Bond

Valuation
Learning Objectives
1. Understand basic bond terminology and apply the
time value of money equation in pricing bonds.
2. Understand the difference between annual and
semiannual bonds and note the key features of
zero-coupon bonds.
3. Explain the relationship between the coupon rate
and the yield to maturity.
4. Delineate bond ratings and why ratings affect
bond prices.
5. Appreciate bond history and understand the
rights and obligations of buyers and sellers of
bonds.
6. Price government bonds, notes, and bills.
Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-2

6.1 Application of the Time Value
of Money Tool: Bond Pricing
• Bonds – Long-term debt instruments
• Provide periodic interest income – annuity series
• Return of the principal amount at maturity –
future lump sum
• Prices can be calculated by using present value
techniques i.e. discounting of future cash flows.
• Combination of present value of an annuity and of
a lump sum

Table 6.1 Bond Information
August 1, 2008

6.1 (A) Key Components of a
Bond
Figure 6.1 Merrill Lynch • Par value : Typically $1000
corporate bond. • Coupon rate: Annual rate of
interest paid.
• Coupon: Regular interest
payment received by holder
per year.
• Maturity date: Expiration
date of bond when par value
is paid back.
• Yield to maturity: Expected
rate of return based on price
of bond

6.1 (A) Key Components of a
Bond
Example 1: Key components of a

corporate bond
Let’s say you see the following price quote
for a corporate bond:
Issue Price Coupon(%) Maturity YTM% Current Yld. Rating
Hertz Corp. 91.50 6.35 15-Jun-2010 15.438 6.94 B
Price = 91.5% of $1000➔$915; Annual coupon = 6.35% *1000 ➔ $63.50

Maturity date = June 15, 2010; If bought and held to maturity➔Yield = 15.438%
Current Yield = $ Coupon/Price = $63.5/$915 ➔ 6.94%

6.1 (B) Pricing a Bond in Steps
Since bonds involve a combination of an annuity

(coupons) and a lump sum (par value) its price is
best calculated by using the following steps:
Figure 6.2 How to price a bond.

(continued)
Example 2: Calculating the price of a corporate bond.

Calculate the price of an AA-rated, 20-year, 8% coupon
(paid annually) corporate bond (Par value = $1,000) which
is expected to earn a yield to maturity of 10%.
Year 0 1 2 3 18 19 20
$80 $80 $80 … $80 $80 $80

$1,000
Annual coupon = Coupon rate * Par value = .08 * $1,000 = $80 = PMT
YTM = r = 10%
Maturity = n = 20
Price of bond = Present Value of coupons + Present Value of par value

(continued)
Example 2: Calculating the price of a corporate bond

 1 
 1− 
Present value of coupons = PMT   (1+ r )
n

 r 
 
 
 1 
 1− 
= $80   (1 + 0.10 )
20

 0.10 
 
 
= $80 x 8.51359 = $681.09
Present Value of Par Value = 1
FV 
(1 + r )n
Present Value of Par Value = 1
$1,000 
(1 + 0.10 )20
Present Value of Par Value = $1,000 x 0.14864 = $148.64
Price of bond = $681.09 + $148.64
= $829.73

(continued)
Method 2. Using a financial calculator
Mode: P/Y=1; C/Y = 1
Input: N I/Y PV PMT FV

Key: 20 10 ? 80 1000
Output -829.73

6.2 Semiannual Bonds and
Zero-Coupon Bonds
• Most corporate and government bonds pay coupons on a
semiannual basis.
• Some companies issue zero-coupon bonds by selling them at
a deep discount.
• For computing price of these bonds, the values of the inputs
have to be adjusted according to the frequency of the coupons
(or absence thereof).
– For example, for semi-annual bonds, the annual coupon is
divided by 2, the number of years is multiplied by 2, and
the YTM is divided by 2.
– The price of the bond can then be calculated by using the
TVM equation, a financial calculator, or a spreadsheet.

6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)
Figure 6.4 Coca-Cola semiannual corporate bond.

Figure 6.5
Future cash
flow of the
Coca-Cola
bond.
Using TVM
Equation
Using
Financial
Calculator


6.2 (A) Pricing Bonds after
Original Issue
The price of a bond is a function of the remaining

cash flows (i.e. coupons and par value) that would
be paid on it until expiration.
As of August, 2008 the 8.5%, 2022 Coca-Cola bond

has only 27 coupons left to be paid on it until it
matures on Feb. 1, 2022
Figure 6.6 Remaining cash flow of the Coca-Cola bond.

Original Issue (continued)
Example 3: Pricing a semi-annual coupon bond after
original issue:
Four years ago, the XYZ Corporation issued an 8% coupon
(paid semi-annually), 20-year, AA-rated bond at its par value
of $1000. Currently, the yield to maturity on these bonds is
10%. Calculate the price of the bond today.
Remaining number of semi-annual coupons
= (20-4)*2 = 32 coupons = n
Semi-annual coupon = (.08*1000)/2 = $40
Par value = $1000
Annual YTM = 10% ➔YTM/2➔5% = r

Method 1: Using TVM equations

 1 
 1 − n 
Bond Price = Par Value 
1
+ Coupon   (1 + r ) 
(1+ r )n  r 
 
 
 1 
 1 − 
Bond Price = $1,000
1
+ $40  (1+ 0.05)
32

(1+ 0.05) 32  0.05 
 
 
Bond Price = $1000 x 0.209866 + $40 x 15.80268
Bond Price = $209.866 + $632.107
Bond Price = $841.97

Method 2: Using a financial calculator

Key: 32 10 ? 40 1000
Output -841.97

6.2 (B) Zero-Coupon Bonds
• Known as “pure” discount bonds and sold at

a discount from face value
• Do not pay any interest over the life of the
bond.
• At maturity, the investor receives the par
value, usually $1000.
• Price of a zero-coupon bond is calculated by
merely discounting its par value at the
prevailing discount rate or yield to maturity.

6.2 (C) Amortization of a Zero-
Coupon Bond
Table 6.2
Amortized
Interest on a
Zero-Coupon
Bond
• The discount on a zero-coupon bond is amortized over its life.

• Interest earned is calculated for each 6-month period.
• for example .04*790.31=$31.62
• Interest is added to price to compute ending price.
• Zero-coupon bond investors have to pay tax on annual price
appreciation even though no cash is received.

Coupon Bond (continued)
Example 4: Price of and taxes due on a
zero-coupon bond:
John wants to buy a 20-year, AAA-rated, $1000 par
value, zero-coupon bond being sold by Diversified
Industries Inc. The yield to maturity on similar
bonds is estimated to be 9%.
a) How much would he have to pay for it?
b) How much will he be taxed on the investment
after 1 year, if his marginal tax rate is 30%?

Example 4 Answer
Method 1: Using TVM equation
Bond Price = Par Value * [1/(1+r)n]
Bond Price = $1000*(1/(1.045)40
Bond Price = $1000 * .1719287 = $171.93
Method 2: Using a financial calculator


Key: 40 9 ? 0 1000
Output -171.93

Example 4 (Answer) (continued)
Calculate the price of the bond at the end of 1
year.
Key: 38 9 ? 0 1000
Output -187.75
Taxable income = $187.75 - $171.93 = $15.82

Taxes due = Tax rate * Taxable income =
0.30*$15.82 = $4.75

Example 4 (Answer) (continued)
Alternately, we can calculate the semi-annual
interest earned, for each of the two semi-annual
periods during the year.
➔$171.93 * .045 = $7.736 ➔ Price after 6 months
➔$171.93+7.736 = $179.667
➔$179.667 * .045=$8.084➔ Price at end of year
➔$179.667+8.084 = $187.75
➔Total interest income for 1 year = $7.736+$8.084
➔$15.82
➔ Tax due = 0.30 * $15.82 = $4.75

6.3 Yields and Coupon Rates
• A bond’s coupon rate differs from its yield to

maturity (YTM).
• Coupon rate -- set by the company at the
time of issue and is fixed (except for newer
innovations which have variable coupon
rates)
• YTM is dependent on market, economic, and
company-specific factors and is therefore
variable.

6.3 (A) The First Interest Rate:
Yield to Maturity
• Expected rate of return on a bond if held to
maturity.
• The price that willing buyers and sellers settle
at determines a bond’s YTM at any given point.
• Changes in economic conditions and risk factors
will cause bond prices and their corresponding
YTMs to change.
• YTM can be calculated by entering the coupon
amount (PMT), price (PV), remaining number of
coupons (n), and par value (FV) into the TVM
equation, financial calculator, or spreadsheet.

6.3 (B) The “Other” Interest
Rate: Coupon Rate
• The coupon rate on a bond is set by the

issuing company at the time of issue
• It represents the annual rate of interest that
the firm is committed to pay over the life of
the bond.
• If the rate is set at 7%, the firm is
committing to pay .07*$1000 = $70 per
year on each bond,
• It is paid either in a single check or two
checks of $35 paid six months apart.

6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
• An issuing firm gets the bond rated by a rating
agency such as Standard & Poor’s or Moody’s.
• Then, based on the rating and planned maturity of
the bond, it sets the coupon rate to equal the
expected yield as indicated in the Yield Book
(available in the capital markets at that time) and
sells the bond at par value ($1000).
• Once issued, if investors expect a higher yield on
the bond, its price will go down and the bond will
sell below par or as a discount bond and vice-versa.
• Thus, a bond’s YTM can be equal to (par bond),
higher than (discount bond) or lower than
(premium bond) its coupon rate.

(continued)
Table 6.3 Premium Bonds, Discount Bonds, and
Par Value Bonds

(continued)
Figure 6.8 Bond prices and interest rates
move in opposite directions.

(continued)
Example 5: Computing YTM
Last year, The ABC Corporation had issued 8% coupon

(semi-annual), 20-year, AA-rated bonds (Par value =
$1000) to finance its business growth. If investors are
currently offering $1200 on each of these bonds, what is
their expected yield to maturity on the investment? If
you are willing to pay no more than $980 for this bond,
what is your expected YTM?
Remaining number of coupons = 19*2 = 38

Semi-annual coupon amount =( .08*$1000)/2 = $40

(continued)
Example 5 Answer
PV = $1200
Key: 38 ? -120 40 1000
Output 6.19
Note: This is a premium bond, so it’s YTM

< Coupon rate of 8%

(continued)
Example 5 Answer (continued)
PV = $980
Key: 38 ? -980 40 1000
Output 8.21%
Note: This would be a discount bond,

so it’s YTM>Coupon rate of 8%

6.4 Bond Ratings
• Ratings are produced by Moody’s, Standard and Poor’s, and

Fitch
• Range from AAA (top-rated) to C (lowest-rated) or D

(default).
• Help investors gauge likelihood of default by issuer.
• Assist issuing companies establish a yield on newly-issued

bonds.
– Junk bonds: is the label given to bonds that are rated below BBB.
These bonds are considered to be speculative in nature and carry
higher yields than those rated BBB or above (investment grade).
– Fallen angels: is the label given to bonds that have had their ratings
lowered from investment to speculative grade.

Table 6.4
Bond Ratings

6.5 Some Bond History and More
Bond Features
• Corporate bond features have gone through

some major changes over the years.
– Bearer bonds
– Indenture or deed of trust
– Collateral
– Mortgaged security
– Debentures
– Senior debt
– Sinking fund
– Protective covenants

Bond Features (continued)
– Callable bond
– Yield to call
– Putable bond
– Convertible bond
– Floating-rate bond
– Prime rate
– Income bonds
– Exotic bonds

Example 6: Calculating Yield to Call.

Two years ago, the Mid-Atlantic Corporation
issued a 10% coupon (paid semi-annually),
20-year maturity, bond with a 5-year
deferred call feature and a call penalty of
one coupon payment in addition to the par
value ($1000) if exercised.
If the current price on these bonds is $1080,
what is its yield to call?

Example 6 Answer
Remaining number of coupons until first call date = 6
=n
Semi-annual coupon = $50 = PMT
Call price = $1050 = FV
Bond price = $1080 = PV

Key: 6 ? -1080 50 1050
Output 8.43
YTC

6.6 U.S. Government Bonds
• Include bills, notes, and bonds sold by the

Department of the Treasury
• State bonds, issued by state governments
• Municipal bonds issued by county, city, or local
government agencies.
• Treasury bills, are zero-coupon, pure discount
securities with maturities ranging from 1-, 3-, and
6-months up to 1 year.
• Treasury notes have between two to 10 year
maturities.
• Treasury bonds have greater than 10-year
maturities, when first issued.
6.6 U.S. Government Bonds
(continued)
Table 6.6 Government Notes and Bonds,

Prices as of April 8, 2008

6.6 (A) Pricing a U.S.
Government Note or Bond
• Similar to the method used for pricing corporate bonds and can be
done by using TVM equations, a financial calculator or a spreadsheet
program.
• For example, let’s assume you are pricing a 7-year, 6% coupon
(semi-annual) $100,000 face value Treasury note, using an expected
yield of 8%:
Figure 6.11 U.S.

Government
Treasury note cash
flows.

6.6 (B) Pricing a Treasury bill
Calculated by discounting the bill’s face value for the

number of days until maturity and at the prevailing
bank discount yield.
Bank discount yield: is a special discount rate used in

conjunction with treasury bills under a 360 day-per-
year convention (commonly assumed by bankers).
Bond equivalent yield (BEY), is the APR equivalent of

the bank discount yield calculated by adjusting it as
follows:
BEY = 365 * Bank discount yield________

360 - (days to maturity * discount yield)

(continued)
Table 6.7 Selected Historical Treasury Bill Bank
Discount Rates

(continued)
Example 7: Calculating the price and BEY of a Treasury bill.
Calculate the price and BEY of a treasury bill which matures in
105 days, has a face value of $10,000 and is currently being quoted
at a bank discount yield of 2.62%.
Price of T-bill = Face value * [1-(discount yield * days until maturity/360)]
Price of T-bill = $10,000 * [ 1 - (.0262 * 105/360)] = $10,000*0.9923583
Price of T-bill = $9,923.58
BEY = 365 * Bank discount yield____ = 365 * .0262

360 - (days to maturity * discount yield) 360 - (105*.0262)
BEY = .026768 = 2.68% (rounded to 2 decimals)

Additional Problems with Answers
Problem 1
Pricing a semi-annual bond: Last year,

The Harvest Time Corporation sold
$40,000,000 worth of 7.5% coupon, 15-year
maturity, $1000 par value, AA-rated; non-
callable bonds to finance its business
expansion. Currently, investors are
demanding a yield of 8.5% on similar bonds.
If you own one of these bonds and want to
sell it, how much money can you expect to
receive on it?

Problem 1 (Answer)
Using a financial calculator

Key: 28 8.5 ? 37.5 1000
Output -919.03

Problem 2
Yield-to-Maturity: Joe Carter is looking to

invest in a four-year bond that pays semi-
annual coupons at a coupon rate of 5.6
percent and has a par value of $1,000. If
these bonds have a market price of $1,035,
what yield to maturity is being implied in the
pricing?

Problem 2 (Answer)
Using a financial calculator

Key: 8 ? -1035 28 1000
Output 4.63
The expected YTM is 4.63%

Problem 3
Krypton Inc. wants to raise $3 million by

issuing 10-year zero coupon bonds with a face
value of $1,000. Their investment banker
informs them that investors would use a
9.25% percent discount rate on such bonds.
At what price would these bonds sell in the
market place assuming semi-annual
compounding? How many bonds would the
firm have to issue to raise $3 million?

Problem 3 (Answer)
Using a financial calculator : Price of zero-coupon bond

Key: 20 9.25 ? 0 1000
Output -404.85
The zero-coupon bond would sell for $404.85
To raise $3,000,000, the company would have to sell:

$3,000,000/$404.85 = 7411 bonds

Problem 4
Tax on zero-coupon bond income: Let’s

say that you buy 100 of the 7411 bonds that
were issued by Krypton Inc. as described in
Problem 3 above for $404.85. At the end of
the year, how much money will the bond be
worth, and how much tax will you be
assessed assuming that you have a marginal
tax rate of 35%?

Problem 1 (Answer)
Calculate the price of the bond at the end of

each semi-annual period during the next year.
The change in price for each semi-annual period
represents the implied interest income on a zero
which is taxed at 35%
Price of Zero after 6 months assuming YTM of 9.25%:

Key: 19 9.25 ? 0 1000
Output -423.57

Problem 4 (Answer) (continued)
Price of Zero at the end of 2 semi-annual periods

assuming YTM of 9.25%

Key: 18 9.25 ? 0 1000
Output -443.16
Implied interest earned on zero = $443.16 - $404.85 = $38.31
Taxes due =Tax rate*Taxable income = 0.35 * $38.31 = $13.41

Problem 5
Price, and BEY, on a Treasury bill:

Calculate the price, and BEY of a treasury bill
which matures in 181 days, has a face value
of $10,000, and is currently being quoted at a
bank discount yield of 2.32%.

Problem 5 (Answer)
Price of T-bill = FV* [1-(discount yield * days until maturity/360)]
Price of T-bill = $10,000 * [ 1 - (.0232 * 181/360)]

= $10,000*0.98833555
Price of T-bill = $9,883.36
BEY = 365 * Bank discount yield = 365 * .0232

360 - (days to maturity * discount yield) 360 - (181*.0232)
BEY = .023799 = 2.38% (rounded to 2 decimals)

Figure 6.3 Future cash flow of a
Merrill Lynch bond

FIGURE 6.7 Goodyear
semiannual corporate bond.

TABLE 6.5 Annual
Interest Rates on
Corporate Bonds Rated
Aaa to Baa, 1980 to 2013

FIGURE 6.9 Pacific Bell semiannual
callable corporate bond

FIGURE 6.10 Pacific Bell callable
bond cash flows.

CH 06-1

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Chapter 6

Bonds and Bond

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-2

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-3

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-4

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-5

Example 1: Key components of a

Price = 91.5% of $1000➔$915; Annual coupon = 6.35% *1000 ➔ $63.50

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-6

Since bonds involve a combination of an annuity

Figure 6.2 How to price a bond.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-7

Example 2: Calculating the price of a corporate bond.

$80 $80 $80 … $80 $80 $80

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-8

Example 2: Calculating the price of a corporate bond

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-9

Method 2. Using a financial calculator

Mode: P/Y=1; C/Y = 1

Input: N I/Y PV PMT FV

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-10

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-11

Figure 6.4 Coca-Cola semiannual corporate bond.

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Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-13

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-14

The price of a bond is a function of the remaining

As of August, 2008 the 8.5%, 2022 Coca-Cola bond

Figure 6.6 Remaining cash flow of the Coca-Cola bond.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-16

Method 1: Using TVM equations

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-17

Method 2: Using a financial calculator

Mode: P/Y=2; C/Y = 2

Input: N I/Y PV PMT FV

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-18

• Known as “pure” discount bonds and sold at

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-19

• The discount on a zero-coupon bond is amortized over its life.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-20

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-21

Method 2: Using a financial calculator

Input: N I/Y PV PMT FV

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-22

Taxable income = $187.75 - $171.93 = $15.82

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-23

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-24

• A bond’s coupon rate differs from its yield to

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-25

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-26

• The coupon rate on a bond is set by the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-27

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-28

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-29

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-30

Last year, The ABC Corporation had issued 8% coupon

Remaining number of coupons = 19*2 = 38

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-31

Note: This is a premium bond, so it’s YTM

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-32

Note: This would be a discount bond,

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 6-33

Taxes due =Tax rateTaxable income = 0.35 $38.31 = $13.41