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Valuing Debt
INTRODUCTION

This chapter provides fundamental insights into the valuation of debt. The five sections of the
chapter describe: i) the relationship of nominal rates and real interest rates, ii) the term structure
(variation of interest for different maturities) of interest rates, iii) the concept of duration and
how it affects the bond values when interest rates change, iv) the theories of term structure, and
v) the risk structure and debt value. The chapter is important and gives you answers to some
vexing questions you would have on interest rates, debt values and their changes from time to
time. Financial managers have to deal with the valuation of debt at some point or other and it is
necessary that they understand the basic theoretical principles, which explain the relationship
among the term structure, risk structure, and debt values.

The chapter begins with Irving Fisher's classical theory of interest. Fisher postulated that real
rates of return are determined by the equilibration of the supply of and demand for real capital
and are reasonably constant over time, and therefore, changes in nominal rates essentially reflect
changes in inflation expectations. This insight has been fundamental to our understanding of
changes in interest rates over time. While economists debate Fisher’s theory, it appears that the
broad relationship of inflation, nominal interest rates, and real interest rates support Fisher’s
ideas.

KEY CONCEPTS IN THE CHAPTER

Real and Nominal Interest Rates: Most debt securities promise a fixed nominal interest rate.
Fisher postulated that real rates are not affected by changes in inflation. According to Fisher, the
relationship between real interest rates and nominal or money rates of interest rate is given by:

1 + rmoney = (1 + rreal)(1 + i)

Therefore, real rate = money rate - inflation rate (approximately)

A change in the expected inflation rate will cause the same change in the money rate or nominal
interest rate. Critics of Fisher's theory argue that real rates are affected by inflation rates.
Historically, real rates have changed over time. Unfortunately, real rates are not observable.
What is observed is the difference between nominal rates and inflation. Again, part of the
problem is Fisher’s theory is in terms of expected inflation, which cannot be observed.
Empirical studies indicate that inflation expectations have been the principal causes of nominal
interest rate changes. Fisher’s theory appears to hold in broad approximation. Remember that
the real rate is an expected rate. Actual rates may be different from what you expected to get
when you bought a T-bill or some other investment. Also, the real rate may vary over time.
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Spot Rates, Term Structure, and Yield to Maturity: The spot rate is the rate of interest
obtainable on a bond at the present, or spot, time period. The series of spot rates of different
maturities results in a term structure of interest rates; typically, the term structure is upward
sloping, with long-term rates higher than short-term rates. The term structure is a series of spot
rates r1, r2, r3,….. . Safe cash flows are valued as:

PV = ,

where rI is the spot rate for the "ith" year.

This is how each bond is valued in the market. However, we use the yield to maturity as a
summary measure. The yield to maturity is an internal rate of return and unambiguous and easy
to calculate. The problems with yield to maturity include:

- Assumes that yield to maturity does not change,

- Assumes a constant reinvestment rate of return, and
- Yield to maturity does not determine price; it is vice versa.

The term structure of government bonds can be estimated using a series of zero coupon “strips”.
This is the yield curve you see in the Wall Street Journal every day. This provides the spot rates
for different maturities.

Duration and Volatility: The prices of long-term bonds vary more than short-term bonds.
Duration and volatility are two useful measures, which enable us to formalize this relationship.
Duration is the average time for the total cash flow to be realized from an asset, such as a bond.
It is actually a weighted average, where the date to each cash flow is weighted by its present
value. The other statistic, called volatility, is easily obtained from duration. In fact, it is just
duration discounted by the one time period. Volatility measures the sensitivity of the asset price
(in percent) to a (unit) change in its yield. Both of these measures are extremely important for
understanding the riskiness of bonds and portfolios containing bonds.

Duration =

where V is the total value of the bond.

Volatility (percent) =

Explaining the Term Structure: The three primary explanations of the upward-sloping term
structure of interest rates are the expectations hypothesis, the liquidity preference theory, and the
inflation premium theory. The expectations hypothesis says that the investor's expectations that
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future spot rates will be higher than the current spot rates explain an upward-sloping term
structure. The liquidity preference theory says that a liquidity premium, which is the difference
between forward rates and expected future spot rates, is required because of the uncertainty
regarding the reinvestment rate when bonds mature. The inflation premium argument says that
the typically upward-sloping term structure is attributable to the risk associated with the
uncertainty about the inflation rate. None of these explanations is totally satisfactory, although
the expectations hypothesis is the least satisfactory of all.

Term structure analysis is static; it catches a slice of time and fixes interest rates of like kind and
quality bonds. Recent analyses incorporate interest rate changes. One system shows financial
managers how to replicate one bond by using two others, given that interest rates may change.

Default Risk: Bonds have market-related risks and firm-specific default risks. When the value
of bonds and the term structure of interest rates are determined, default risk must also be
considered. The threat of default on bonds, similar in all respects except their expected ability to
pay interest and principal, is another reason why different rates of return exist. Bonds are
evaluated by financial services whose ratings are reasonably good predictors. The decade of the
1980s witnessed an explosion of so-called junk bonds, primarily by poor credit-worthy firms.
The default rate has been high, and the market for them is thin, yet high-yielding debt
instruments have always had their place in corporate finance.

Debt as Options: When option pricing is extended to debt analysis, corporate bonds become the
equivalent to lending money with no chance of default while giving stockholders a put option on
the firm's assets. Thus, the value of a bond consists of the value of a risk-free debt less the value
of the put option. The value of the put equals the value of the limited liability of stockholder's
right to walk away from the firm's debt in exchange for handing over the firm's assets to
creditors. We have discussed this in chapter 20. The relationship can be written as:

Bond value = bond value with no chance of default - value of put

Guaranteed Debt: Government loan guarantees are valuable because they lift the onus of
default from the borrower. A loan guarantee is valued as a put option on the firm's assets. The
value of the loan without the guarantee is equal to the value assuming no chances whatsoever of
a default less the value of the put.

WORKED EXAMPLES

1. Find the real rate of interest, given that the nominal rate is 7 percent and the inflation rate is
3 percent.

SOLUTION

The solution is obtained by using the formula:

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 1 + rmoney = (1 + rrea1)(l +i)

where
rmoney = nominal or money rate of interest
rrea1 = real rate of interest
i = inflation rate

Substituting in the equation, we obtain:

1 + 0.07 = (1+rreal)(1 + 0.03)

We then solve for rreal:

1 + rreal = (1 + rmoney)/(l + i)
= 1.07/1.03
= 1.0388
rreal = 0.0388 = 3.88 percent

Any of the rates can be calculated given the other two rates.

2. Calculate the yield to maturity on a 10-year bond carrying a coupon rate of 7 percent.
Assume that the interest is payable annually and the bond is selling at 97.

SOLUTION

The setup for the solution of this problem is similar to every other internal rate-of-return
problem, for that is what solving for the yield of maturity is, an internal rate-of-return problem.
Using the present value of an annuity formula allows you to find the present value of the 10
equal interest payments. You also have to calculate the present value of the maturity value of
$1,000. Doing this by hand requires a hunt-and-peck method, because the object is to find the
present value that sums to the present market price of $970. Here is the BA-II Plus calculator
solution:

PV = price of the bond = -$970

FV = principal paid at maturity = $1,000
PMT = coupon payments = $70
N = Number of coupons = 10
I = yield to maturity = solve = 7.44 percent.

3. It is 1996 and you notice that the yields to maturity of your company's two bonds, 5s of 2000
and 9s of 2000, are selling at 87.44 and 100.71 respectively, which results in yields to
maturity of 8.87 and 8.78 percent. Your financial manager is puzzled as to why two bonds
of the same quality and same maturity do not have the same yield to maturity. What
reasonable answer will you give?

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SOLUTION

The answer lies in estimating the spot rates for each of the remaining years and taking the
present value of the payments to be received. This is done in the table below using a set of
assumed spot rates. Each year’s coupon payments and the principal payments are discounted
using the respective spot rates, not the yield to maturity. It clearly shows that the two bonds are
valued correctly by the market. The yield to maturity is different because the two bonds have
different cash flow patterns. The lower coupon bond has more of its cash flows coming later.
Remember that the market uses spot rates for different periods (not the yield to maturity) to
discount the cash flows for different years.

Yield to maturity is a measure of convenience used by us – not the one that actually gets into the
discounted cash flow for the bonds.

Present Value of Two Comparable-Risk Bonds with Different Coupon Rates

Present-Value Calculations
5s of 2000 9s of 2000
Interest
Period t rate rt Ct PV at rt Ct PV at rt
1 0.06 $ 50 $ 47.17 $ 90 $ 84.91
2 0.07 50 43.67 90 78.61
3 0.08 50 39.69 90 71.44
4 0.09 1050 743.85 1090 772.18
$874.38 $1,007.14

4. Calculate the duration of 8 and 14 percent, 5-year Treasury bonds whose yields are 7.85
percent.

Duration = [1 X PV(C1)/V] + [2 X PV(C2)/V] + [3 X PV(C3)/V] + ……

SOLUTION

Yield 7.85%
Coupon 8.00%
PV(C1) at Proportion of Total Proportion of
Year Ct 7.85% Value [PV(Ct/V] Value x Time
1 80 74.18 0.0737 0.0737
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 2 80 68.78 0.0684 0.1368
3 80 63.77 0.0634 0.1902
4 80 59.13 0.0588 0.2352
5 1,080 740.16 0.7357 3.6785
Totals 1,400 1,006.02 1.00 4.3144

Yield 7.85%
Coupon 14.00%
PV(Ct) at Proportion of Total Proportion of
Year Ct 7.85% Value [PV(Ct)/V] Value X Time
1 140 129.81 0.1041 0.1041
2 140 120.36 0.0966 0.1932
3 140 111.60 0.0895 0.2685
4 140 103.48 0.0830 0.3320
5 1,140 781.27 0.6268 3.1340
Totals 1,700 1,246.52 1.00 4.0318

5. What is the impact of a 0.5 percentage point increase and decrease in interest rates on the
present value of each of the two bonds in problem 4? Compute their volatilities and compare
with what you would have estimated from their duration.

SOLUTION

The yields are now 7.35 percent and 8.35 percent. The results of the computations are as
follows:

8% Bonds 14% Bonds

New Price % Change New Price % Change
Yield falls to 7.35 1,026.40 2.026 1,270.13 1.894
Yield rises to 8.35 986.15 -1.975 1,223.51 -1.846
Difference 40.25 4.001 46.62 3.740

The percentage change is, for example, the present value of the 8 percent bond yielding 7.35
percent divided by the present value of the 8 percent bond yielding 7.85 percent; that is,
percentage change [($1026.40/$1006.02) - 1] X 100 = 2.03 percent.

The volatility results for the two bonds are as follows:

Bond Duration Volatility Volatility

(from duration) (direct)
8 percent 4.3144 4.001 3.999
l4 percent 4.0317 3.740 3.739

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6. Determine the better financial strategy when confronted with a 2-year spot rate of 9 percent,
a 1-year spot rate of 8 percent, and an expected spot rate on 1-year bonds 1 year from now of
10 percent. Assume you do not need your money for 2 years and are not bothered by risk.

SOLUTION

To find the answer, you want to know the expected return of each strategy. The setup is:

$1,000(1 + r1)[1 + E(1r2)] compared with $1,000(1 + r2)2

where

r1 = 1-year spot rate

E(1r2) = expected spot rate on 1-year bonds 1 year from now
r2 = 2-year spot rate

Substituting the values above, we obtain:

$1,000(1 + 0.08)(1 + 0.10) compared with $1,000(1 + 0.09)2

$1,000(1.08)(1. 10) compared with $1,000(1.09)2
$1,000(1.188) compared with $1,000(1.1881)
$1,188 compared with $1,188.10

For all practical purposes, there is no difference between the two outcomes; therefore, you
would be indifferent about this investment.

If you wish to lock in the final outcome of $1,188, say, because of your queasiness about the
expected 1-year spot rate, choose the 9 percent, 2-year spot rate. You should also note that the
implied forward rate is:
(1 + r2)2 = (1+ri)(l + f2)

where f2 is the implied forward rate. Substituting the above values, we obtain:

(1 +0.09)2 = (1 + 0.08)(1 + f2)

(1.09)2 = (1.08)(1 + f2)
1.1881 = 1.08(1 + f2)
1 + f2 = 1.1881/1.08
= 1.1000
f2 = 0.1000 = 10.00 percent

As expected, the implicit forward rate is almost exactly equal to the expected future spot rate,
again indicating a condition of relative indifference.

SUMMARY

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This chapter explores the full complexities of valuing debt. The chapter attempts to answer
fundamental questions on interest rates, term structure, and risk structure. It starts with the basic
relationship between inflation and nominal interest rates. Irving Fisher’s theory still forms the
basis for the widely accepted rule of thumb:

Real interest rate = Nominal interest rate – inflation.

Keep in mind that only the nominal rate is observed and the other two are expectations. Fisher’s
theory should be seen as a broad approximation.

The three term structure theories are explored. The expectations theory ignores the possibility of
risk and is thus not acceptable as it is. There appears to be a risk premium in the term structure;
i. e. the forward interest rates are on average higher than future spot rates. This risk premium
can be on account of inflation or general risk based on future uncertainty. New theories are
taking a different approach and would probably gain currency as more work is done.

Bond values reflect present values of cash flows produced discounted by the series of spot rates
over the bond’s maturity. For convenience, the yield to maturity is used as a summary measure.
It is important to understand that the yield to maturity is derived from the price of the bond and
the other way around. Duration and volatility are useful measures of the sensitivity of a bond’s
value to changes in interest rates.

Lastly, the risk structure of bonds is explored. Bond ratings capture the default risk of corporate
bonds fairly well. A risky bond can be seen as the combination of a risk-free bond less the value
of a put given to the shareholders. Thus, the value of a government guarantee to a private
corporation is the value of this put.

LIST OF TERMS

Clean price Money rate of interest

Duration Nominal interest rate
Expectations hypothesis Promised yield
Forward rate Real interest rate
Inflation premium Spot rate
Junk bonds Strips
Liquidity preference theory Term structure of interest rates
Liquidity premium Yield to maturity

EXERCISES

Fill-in Questions

1. ________________ include a premium for anticipated inflation.

2. The nominal rate of interest must equal the _____________ plus the __________________.
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3. If the money (nominal) rate of interest is 10 percent and the anticipated inflation rate is 10
percent, the real rate of interest is ___________________.

4. Under Fisher's scheme of interest rates, if the forecasted inflation rate is 5 percent and the
real interest rate is 0.3 percent, the nominal interest rate is _______________________.

5. The real rate of interest is equal to the _____________________ minus the

______________.

6. Any interest rate, which is fixed today, is called the _____________________.

7. The term structure of interest rates consists of a series of _______________________ on

bonds of comparable risk.

8. A bond's internal rate of return is called ________________.

9. When government bonds are repackaged into mini-bonds, each of which makes only one
payment; they are known as ____________________.

10. _____________ measures the average time that the total cash flow from an asset is realized
over the life of that asset.

11. ______________________ measures the percentage change in the price of a bond or other
asset corresponding to a unit change in its yield.

12. The ___________________ rate between two dates is the interest rate we can lock into
between buying them today and by selling discount bonds for those two dates.

13. Ordinarily, the term structure of interest rates presents a condition in which the
____________ rates are higher than the __________________ rates, and therefore, the term
structure slopes upward.

14. The ______________ of the term structure of interest rates says the only reason for an
upward-sloping term structure is that investors expect future spot rates to be higher than
current spot rates.

15. The difference between forward rates and expected future spot rates is called ____________.

16. The ________________ theory of term structure of interest rates takes into account risk,
whereas the explanation does not.

17. The ________________ theory of the term structure of interest rates assumes that the risk
from holding bonds comes only from uncertainty about expected inflation rates.

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18. The history of bond ratings indicates that they are (good, poor) _____________________
indicators of overall quality.

19. When one assumes that bonds create options, the bond value is equal to the value of the
bond, assuming no chance of default, minus ___________________.

20. A loan guarantee may be valued as a(n) ____________________ on the firm's assets.

21. High-yield bonds are also called __________________ bonds and are usually rated at
___________ or lower.

22. The ___________________ on junk bonds is typically much higher than the _________.

Problems

1. Find the real interest rate, given that the nominal rate is 9 percent and the inflation rate is 5
percent.

2. If the money rate of interest is 9.3 percent and the real rate is expected to be 5 percent, what
is the implied inflation rate? How realistic is it to assume that the real rate will be 5 percent?

3. How different is your inflation estimate in Problem 2 if you use the approximate formula,
subtracting one rate from the other?

4. Calculate the yield to maturity on a 15-year bond carrying a coupon rate of 9 percent.
Assume that the interest is payable annually and the bond is selling at 92.

5. As the financial manager of Ink, Inc., you estimate the following spot interest rates on
Treasury securities:
SPOT INTEREST
YEAR RATE,%
1 r1 = 4.00
2 r2 = 5.00
3 r3 = 5.60
4 r4 = 7.20
5 r5 = 6.50

Your company's bonds have an 11 percent coupon rate, interest is payable annually, and they
mature in exactly 5 years.

a. What is the present value of the bond?

b. Calculate the present values of the following Treasury issues: (1) 5 percent, 3-year bond;
(2) 8 percent, 3-year bond; and (3) 6 percent, 5-year bond.
c. Determine the yield to maturity of each of the bonds.

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 d. What differences between the yields to maturity do you observe, and how might you
explain them to the board of directors, who also happen to have noticed the differences?

6. Calculate the duration and volatilities of 9 and 13 percent, 5-year Treasury bonds whose
yields are 8.00 percent.

7. Trace the impact of a 0.5 percentage point increase and decrease in interest rates on the
present value of each of the two bonds in problem 6. Use this to compute their volatilities
and compare with your answer from problem 6.

Essay Questions

1. Explain the term structure of interest rates and the theories that attempt to explain the term
structure.

2. How are nominal rates of interest adjusted for the effects of inflation? Explain fully, using
whatever equations you feel are necessary.

3. Explain the relationship between the price of a bond and the yield to maturity. Does the
yield determine the price or is it the other way around? What really determines the price of a
bond in the market?

4. Why are there bond ratings, and what influence do you think they have on the value of
bonds?

5. Government guarantees do not cost the taxpayer anything as they are rarely invoked.
Discuss.

6. How do you think bond-rating agencies determine the ratings they place on bonds?

ANSWERS TO EXERCISES

Fill-in Questions

1. Nominal interest rates 12. Forward

2. Real rate; inflation premium 13. Long; short
3. Zero 14. Expectations hypothesis
4. 5.3 percent 15. Liquidity premium
5. Nominal rate on Treasury bills; 16. Liquidity preference
expected inflation rate 17. Inflation premium
6. Spot rate 18. Good
7. Spot rates 19. Value of a put
8. Yield to maturity 20. Put option
9. Strip 21. Junk; B
10. Duration 22. Promised yield; expected yield
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11. Volatility

Problems

1. l + rreal = (1 + rn)/(1 + i)
= 1.09/1.05
= 3.81 percent

2. 1 + I = (1 + rn/(1 + rreal)
= 1.093/1.05
= 4.10 percent

Not very, because it is well above the historical (1926-1994) arithmetic average of 0.6
percent.

3. i = rn - rreal
= 9.3 percent - 5.0 percent
= 4.30 percent, 20 basis points different.

4. 10.00 percent

5. a. INTEREST CASH PRESENT

PERIOD RATE FLOW VALUE
1 4.00 110 105.77
2 5.00 110 99.77
3 5.60 110 93.41
4 7.20 110 83.29
5 6.50 1,110 810.17
1,192.41

b. INTEREST CASH PRESENT

PERIOD RATE FLOW VALUE
(1) 1 4.00 50 48.08
2 5.00 50 45.35
3 5.60 1,050 891.66
985.09

(2) 1 4.00 80 76.92

2 5.00 80 72.56
3 5.60 1,080 917.13
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 1,066.61

(3) 1 4.00 60 57.69

2 5.00 60 54.42
3 5.60 60 50.95
4 7.20 60 45.43
5 6.50 1,060 773.67
982.16

c. Using the prices above:

1 5.75%
2 5.50
3 6.43

6. Yield 8.00%
Coupon 9.00%
PV(Ct) at Proportion of Total Proportion of
Year Ct 8.00% Value [PV(Ct)/V] Value X Time
1 90 83.33 0.0801 0.0801
2 90 77.16 0.0742 0.1484
3 90 71.44 0.0687 0.2061
4 90 66.15 0.0636 0.2544
5 1,090 741.84 0.7134 3.5670
Totals 1,450 1,039.92 1.00 4.2560

Yield 8.00% Coupon 13.00%

PV(Ct) at Proportion of Total Proportion of
Year Ct 8.00% Value [PV(Ct)/V] Value X Time
1 130 120.37 0.1003 0.1003
2 130 111.45 0.0929 0.1858
3 130 103.20 0.0860 0.2581
4 130 95.55 0.0797 0.3186
5 1,130 760.06 0.6411 3.2054
Totals 1,650 1,190.63 1.00 4.0682

Discounting by their yields, we find that the volatilities of the two bonds are:

9.00% bond: 3.941, 13% bond: 3.767.

7. The yields are now 7.50 and 8.50 percent. We obtain:

9% Bonds 13% Bonds

New Price % Change New Price % Change
Yield falls to 7.50 1,060.69 1.997 1,222.51 2.678
Yield rises to 8.50 1,019.70 -1.944 1,177.33 -1.117
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Difference 40.99 3.941 45.18 3.767

The percentage change is, for example, the present value of the 9 percent bond yielding 7.50
percent divided by the present value of the 9 percent bond yielding 8.00 percent; that is,
percentage change = (($1060.69/$1039.92) - 1] X 100 = 2.00 percent.

The volatility results for the two bonds are as follows:

Bond Volatility Volatility

(direct) (from problem 5)
9 percent 3.941 3.941
13 percent 3.767 3.767

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