6- 1

Fundamentals
of Corporate
Finance

Chapter 5
Valuing Bonds

Sixth Edition

Richard A. Brealey
Stewart C. Myers

Alan J. Marcus

Slides by
Matthew Will

McGraw
McGraw Hill/Irwin
Hill/Irwin

Copyright Copyright
2009 by The
McGraw-Hill
Companies, Inc.
All rights
reserved
2009
by The McGraw-Hill
Companies,
Inc.
All rights reserved

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Topics Covered
The Bond Market
Interest Rates and Bond Prices
Current Yield and Yield to Maturity
Bond Rates and Returns
The Yield Curve
Corporate Bonds and the Risk of Default

6- 3

Bonds
Terminology
Bond - Security that obligates the issuer to
make specified payments to the bondholder.
Coupon - The interest payments made to the
bondholder.
Face Value (Par Value or Principal Value) - Payment
at the maturity of the bond.
Coupon Rate - Annual interest payment, as a
percentage of face value.

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Bonds
WARNING
The coupon rate IS NOT the discount rate
used in the Present Value calculations.
The coupon rate merely tells us what cash flow the
bond will produce.
Since the coupon rate is listed as a %, this
misconception is quite common.

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Bond Pricing
The price of a bond is the Present Value of all
cash flows generated by the bond (i.e.
coupons and face value) discounted at the
required rate of return.

cpn
cpn
(cpn par )
PV

....
1
2
t
(1 r ) (1 r )
(1 r )

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Bond Cash Flows

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Bond Pricing
Example
What is the price of a 5.0 % annual coupon bond,
with a $1,000 face value, which matures in 3 years?
Assume a required return of 2.15%.

50
50
1,050
PV

1
2
(1.0215 ) (1.0215 )
(1.0215 ) 3
PV $1,081 .95

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Bond Pricing
Example (continued)
Q: How did the calculation change, given semi-annual
coupons versus annual coupon payments?

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Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 2.15% AND the coupons are paid semiannually?
25
25
25
1,025
PV

...

1
2
5
(1.01075 ) (1.01075 )
(1.01075 ) (1.01075 ) 6
PV $1,082 .37

Year
2005

2000

1995

1990

1985

1980

1975

1970

1965

1960

1955

1950

1945

1940

1935

1930

1925

1920

1915

1910

1905

1900

Yield %

6- 10

Treasury Yields

The interest rate on 10-year U.S. Treasury bonds

16

14

12

10

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Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 5.0 %?

50
50
1,050
PV

1
2
3
(1.050 ) (1.050 )
(1.050 )
PV $1,000

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Bond Pricing
Example (continued)
What is the price of the bond if the required rate of
return is 8 %?

50
50
1,050
PV

1
2
3
(1.08 ) (1.08 )
(1.08 )
PV $922 .69

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Bond Pricing
Example (continued)
Q: How did the calculation change, given semiannual coupons versus annual coupon payments?

Time Periods

Discount Rate

Paying coupons twice a

year, instead of once
doubles the total number of
cash flows to be discounted
in the PV formula.

Since the time periods are

now half years, the
discount rate is also
changed from the annual
rate to the half year rate.

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Interest Rate Risk

The value of the 5% bond falls as interest rates rise
1,200

Bond price ($)

1,100

1,000

900

800

700

10

Interest rate (%)

12

14

16

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Interest Rate Risk

3,000

When the interest rate equals

the 5.0% coupon rate, both
bonds sell at face value

2,500

30 yr bond
$ Bond Price

2,000

1,500

3 yr bond

1,000

500

YTM

10

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Bond Yields
Current Yield - Annual coupon payments
divided by bond price.
Yield To Maturity - Interest rate for which
the present value of the bonds payments
equal the price.

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Bond Yields
Calculating Yield to Maturity (YTM=r)
If you are given the price of a bond (PV) and
the coupon rate, the yield to maturity can be
found by solving for r.

cpn
cpn
(cpn par )
PV

....
1
2
t
(1 r ) (1 r )
(1 r )

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Bond Yields
Example
What is the YTM of a 5.0 % annual coupon bond,
with a $1,000 face value, which matures in 3 years?
The market price of the bond is $1,081.95.

50
50
1,050
PV

1
2
3
(1 r ) (1 r ) (1 r )
PV $1,081.95
YTM = 2.15%

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Bond Yields
WARNING
Calculating YTM by hand can be very
tedious.
It is highly recommended that you learn to
use the IRR or YTM or i functions on a
financial calculator.

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Bond Yields
Rate of Return - Earnings per period per dollar
invested.
total income
Rate of return =
investment
Coupon income + price change
Rate of return =
investment

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Bond Valuation Spreadsheet

Valuing bonds using a spreadsheet
5.0 % coupon
maturing Feb 2011
Settlement date
Maturity date
Annual coupon rate
Yield to maturity
Redemption value (% of face value)
Coupon payments per year
Bond price (% of par)

2/15/08
2/15/11
0.05
0.0215
100
1
108.195

6.0% coupon
10-year maturity
1/1/00
1/1/10
0.06
0.07
100
1
92.976

=PRICE(B7,B8,B9,B10,B11,B12)

Esc and Double click on spreadsheet to access

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Interest Rate Risk

1,400

Price path for

Premium Bond

1,300

Bond Price

1,200

1,100

1,000

Price path for

Discount Bond

900

800

Today

Maturity

700

600
0

10

15

Time to Maturity

20

25

30

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Bond Yield Spreadsheet

Finding yield to maturity using a spreadsheet
Feb 2011 maturity bond, coupon rate = 5.0%, maturity = 3 years

Annual coupons

Semiannual coupons

Settlement date
Maturity date
Annual coupon rate
Bond price
Redemption value (% of face value)
Coupon payments per year

2/15/08
2/15/11
0.05
108.195
100
1

2/15/08
2/15/11
0.05
108.195
100
2

Yield to maturity (decimal)

0.0215

0.0216
=YIELD(B7,B8,B9,B10,B11,B12)

Esc and Double click on spreadsheet to access

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The Yield Curve

Term Structure of Interest Rates - A listing of
bond maturity dates and the interest rates that
correspond with each date.

Yield Curve - Graph of the term structure.

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The Yield Curve

Treasury strips are bonds that make a single payment. The yields on Treasury
strips in February 2008 show that investors received a higher yield on longer
term bonds.
6

4
3
2
1

Maturity (years)

29

27

25

23

21

19

17

15

13

11

0
1

Yield %

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Corporate Bonds
Zero coupons
Floating rate bonds
Convertible bonds

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Nominal and Real rates

14

12

Yield on UK
nominal bonds

Percent

10

Yield on UK
indexed bonds

Year

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Default Risk
Credit risk
Default premium
Investment grade
Junk bonds

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Default Risk
Moody' s

Standard
& Poor's

Aaa

AAA

Aa

AA

Baa

BBB

Ba
B

BB
B

Caa
Ca
C

CCC
CC
C

Safety

The strongest rating; ability to repay interest and principal

is very strong.
Very strong likelihood that interest and principal will be
repaid
Strong ability to repay, but some vulnerability to changes in
circumstances
Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Considerable uncertainty about ability to repay.
Likelihood of interest and principal payments over
sustained periods is questionable.
Bonds in the Caa/CCC and Ca/CC classes may already be
in default or in danger of imminent default
C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.

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Default Risk
Yield spreads between corporate and 10-year Treasury bonds

10
8

Junk bonds

6
4
2
0

Baa-rated
bonds

Aaa-rated bonds

19
80
19
83
19
86
19
89
19
92
19
95
19
98
20
01
20
04
20
07

Yield spread %

12

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