Chapter 3

Principles of
Corporate Finance
Tenth Edition

Valuing Bonds

Slides by
Matthew Will

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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

3-2

Valuing a Bond

1,000 C N
C1
C2
PV

...

1
2
N
(1 r )
(1 r )
(1 r )

3-3

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 11 12 13 14 15
115
115 115 115 1115

3-4

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

2
3
4
1.075 1.075
1.075 1.075 1.075 5
$1,161.84

3-5

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

2
3
1.03 1.03
1.03 1.03 4
120.44 Euros

3-6

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

2
3
4
1.045 1.045
1.045 1.045 1.045 5
243.57 Yen

3-7

Valuing a Bond

3-8

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 0.006003% semiannual return, what is the price of
the bond?

PV

24.375
24.375
24.375
24.375
24.375
1024.375

1.006003 1.006003 2 1.006003 3 1.006003 4 1.006003 5 1.006003 6

$1,107.95

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?

PV

24.375 24.375 24.375 24.375 24.375 1024.375

2
3
4
5
1.04
1.04 1.04 1.04 1.04
1.04 6

$918.09

3-9

Yield , %

Interest Rate on 10yr Treasuries

Year

3-10

Bond Price, %

Bond Prices and Yields

Interest Rates, %

3-11

Bond Price, ($)

Maturity and Prices

30 yr bond

When the interest rate

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

3 yr bond

Interest Rates, %

3-12

Duration Formula
Duration

1 PV (C1 ) 2 PV (C2 ) 3 PV (C3 )

T PV (CT )

...
PV
PV
PV
PV

duration
Modified Duration volatility (%)
1 yield

3-13

Duration Calculation

3-14

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

68.75 65.54

.060

0.060

68.75 62.48

.058

0.115

68.75 59.56

.055

0.165

68.75 56.78

.052

0.209

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 bonds
duration?

Year

CF

PV@YTM

% of Total PV

% x Year

90

82.95

.081

0.081

90

76.45

.075

0.150

90

70.46

.069

0.207

90

64.94

.064

0.256

1090

724.90

.711

3.555

1019.70

1.00

Duration= 4.249

Bond Price, percent

Duration & Bond Prices

Interest rate, percent

3-17

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.

3-18

Term Structure of Interest Rates

YTM
(r)

1981
1987 & Normal
1976
1

10

20

30

Year

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

3-19

Yield Curve

Spot rates (%)

U.S. Treasury Strip Spot Rates as of February 2009

Maturity

3-20

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)

3-21

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?

3-22

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
-1078.80 105

C1

C2

C3

C4

105

105

105

1105

Calculate IRR = 8.5%

C5

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.

3-24

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

3-25

Inflation Rates

Annual Inflation (%)

Annual rates of inflation in the United States from 19002008.

3-26

Global Inflation Rates

Averages from 1900-2006

3-27

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.

3-28

Debt & Interest Rates

Actual formula

1 rnominal (1 rreal ) (1 i )

3-29

UK Bond Yields

Interest rate (%)

10 year nominal interest rate

10 year real interest rate

3-30

Govt. Bills vs. Inflation (53-08)

United Kingdom

Inflation

T-Bill Returns

3-31

Govt. Bills vs. Inflation (53-08)

United States

Inflation

T-Bill Returns

3-32

Govt. Bills vs. Inflation (53-08)

Germany

T-Bill Returns

Inflation

3-33

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.

3-34

Yield Spread

Yield spread between corporate

and government bonds, %

Yield spreads between corporate and 10-year

Treasury bonds.

Years

3-35

Prices and Yields

Prices and yields of a sample of corporate bonds,
December 2008.

Source: Bond transactions reported on FINRAs TRACE service:

http://cxa.marketwatch.com/finra/BondCenter

3-36

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

3-37