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 1112 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 0.6003% 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 1.04 1.04 1.04 1.046
2 3 4 5

 $918.09
 3- 10

Interest Rate on 10yr Treasuries

Yield , %

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

Interest Rates, %
 3- 12

Maturity and Prices

30 yr bond
Bond Price, ($)

When the interest rate

equals the 5% coupon,
both bonds sell for
face value

3 yr bond

Interest Rates, %
 3- 13

Duration Formula

1 PV (C1 ) 2  PV (C 2 ) 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.
 3- 19

Term Structure of Interest 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
Spot rates (%)

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.
Annual Inflation (%)
 Average Inflation, %

Sw
it
Ne zer

0.00
2.00
4.00
6.00
8.00
10.00
12.00

th lan
er d
la
nd
s
US
Ca A
na
Sw da
ed
No en
r
Au wa
st y
De ra lia
nm
ar
k
UK
So Ire
G ut lan
er
m h d
an Af
ric
y A
(e ve a
x r
19 age
22
/
Be 2 3)
lg
iu
m
Averages from 1900-2006

Sp
a
Fr i n
an
Global Inflation Rates

ce
Ja
pa
n
Ita
ly
3- 27
 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.
 3- 29

Debt & Interest Rates

Actual formula

1  rnominal  (1  rreal )  (1  i )
 Interest rate (%)

0
2
4
6
8
10
12
14
16
18
20

1-Jan-84
1-Apr-85
1-Jul-86
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
1-Apr-05
1-Jul-06
1-Oct-07
1-Jan-09
3- 30
 3- 31

Govt. Bills vs. Inflation (’53-’08)

United Kingdom

Inflation
%

T-Bill Returns
 3- 32

Govt. Bills vs. Inflation (’53-’08)

United States

Inflation

T-Bill Returns
%
 3- 33

Govt. Bills vs. Inflation (’53-’08)

Germany

T-Bill Returns
%

Inflation
 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.
Yield spread between corporate
and government bonds, %

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