MKL-SESI 1-2 Interest Rate and Bond Valuation (CH 6)

INTEREST RATE AND BOND VALUATION
Semester: Gasal 2020/2021
Acknowledgement
The source of this power point slides comes from the
following textbook:
Lawrence J. Gitman (2015). Principles of

Managerial Finance, 14e,John Wiley & Sons, Inc.
San Francisco. ISBN: 978-1-292-01820-1
Chapter 6
Chapter 6
Interest Rates
and Bond
Valuation
Learning Goals
LG1 Describe interest rate fundamentals, the term

structure of interest rates, and risk premiums.
LG2 Review the legal aspects of bond financing and

bond cost.
LG3 Discuss the general features, yields, prices,

popular types, and international issues of
corporate bonds.
© Pearson Education Limited, 2015. 6-3

Learning Goals (cont.)
LG4 Understand the key inputs and basic model

used in the valuation process.
LG5 Apply the basic valuation model to bonds and

describe the impact of required return and time
to maturity on bond values.
LG6 Explain yield to maturity (YTM), its calculation,

and the procedure used to value bonds that pay
interest semiannually.

Interest Rates and Required Returns:
Interest Rate Fundamentals
• The term interest rate is usually applied to debt
instruments such as bank loans or bonds; the
compensation paid by the borrower of funds to the
lender; from the borrower’s point of view, the cost
of borrowing funds.
• The term required return is usually applied to
equity instruments such as common stock; the cost
of funds obtained by selling an ownership interest.

Interest Rate Fundamentals
Several factors can influence the equilibrium interest
rate:
1. Inflation, which is a rising trend in the prices of most
goods and services.
2. Risk, which leads investors to expect a higher return on
their investment
3. Liquidity preference, which refers to the general tendency
of investors to prefer short-term securities

Matter of Fact
Fear Turns T-bill Rates Negative

– Near the height of the financial crisis in December 2008,
interest rates on Treasury bills briefly turned negative,
meaning that investors paid more to the Treasury than the
Treasury promised to pay back.
– Why would anyone put their money into an investment
that they know will lose money?
– Remember that 2008 saw the demise of Lehman Brothers,
and fears that other commercial banks and investments
banks might fail were rampant.
– Evidently, some investors were willing to pay the U.S.
Treasury to keep their money safe for a short time.

Interest Rates and Required Returns: The
Real Rate of Interest
• The real rate of interest is the rate that creates
equilibrium between the supply of savings and the
demand for investment funds in a perfect world,
without inflation, where suppliers and demanders of
funds have no liquidity preferences and there is no
risk.
• The real rate of interest changes with changing
economic conditions, tastes, and preferences.
• The supply-demand relationship that determines
the real rate is shown in Figure 6.1 on the following
slide.

Figure 6.1
Supply–Demand Relationship

Nominal or Actual Rate of Interest (Return)
• The nominal rate of interest is the actual rate of

interest charged by the supplier of funds and paid
by the demander.
• The nominal rate differs from the real rate of
interest, r* as a result of two factors:
– Inflationary expectations reflected in an inflation premium
(IP), and
– Issuer and issue characteristics such as default risks and
contractual provisions as reflected in a risk premium (RP).

Nominal or Actual Rate of Interest (cont.)
• The nominal rate of interest for security 1, r1, is
given by the following equation:
• The nominal rate can be viewed as having two basic

components: a risk-free rate of return, RF, and a
risk premium, RP1:

Nominal or Actual Rate of Interest (cont.)
• For the moment, ignore the risk premium, RP1, and
focus exclusively on the risk-free rate. The risk free
rate can be represented as:
RF = r* + IP
• The risk-free rate (as shown in the preceding
equation) embodies the real rate of interest plus
the expected inflation premium.
• The inflation premium is driven by investors’
expectations about inflation—the more inflation
they expect, the higher will be the inflation
premium and the higher will be the nominal interest
rate.

Personal Finance Example
Marilyn Carbo has $10 that she can spend on candy costing
$0.25 per piece. She could buy 40 pieces of candy
($10.00/$0.25) today. The nominal rate of interest on a 1-year
deposit is currently 7%, and the expected rate of inflation over
the coming year is 4%.
If Marilyn invested the $10, how many pieces of candy could
she buy in one year?
– In one year, Marilyn would have (1 + 0.07)  $10.00 = $10.70
– Due to inflation, one piece of candy would cost (1 + 0.04) 
$0.25 = $0.26
– As a result, Marilyn would be able to buy $10.70/$0.26 = 41.2
pieces
– This 3% increase in buying power (41.2/40) is Marilyn’s real rate
of return

Focus on Practice
I-Bonds Adjust for Inflation
– One of the disadvantages of bonds is that they usually
offer a fixed interest rate.
– This presents a serious risk to bond investors, because if
inflation rises while the nominal rate on the bond remains
fixed, the real rate of return falls.
– The U.S. Treasury Department now offers the I-bond,
which is an inflation-adjusted savings bond.
– A Series-I bond earns interest through the application of a
composite rate. The composite rate consists of a fixed rate
that remains the same for the life of the bond and an
adjustable rate equal to the actual rate of inflation.
– The adjustable rate changes twice per year and is based on
movements in the Consumer Price Index for All Urban
Consumers (CPI-U).
What effect do you think the inflation-adjusted interest rate
has on the cost of an I-bond in comparison with similar bonds
with no allowance for inflation?
Figure 6.2
Impact of Inflation

Term Structure of Interest Rates
• The term structure of interest rates is the

relationship between the maturity and rate of
return for bonds with similar levels of risk.
• A graphic depiction of the term structure of interest
rates is called the yield curve.
• The yield to maturity is the compound annual
rate of return earned on a debt security purchased
on a given day and held to maturity.

Figure 6.3
Treasury Yield Curves

Term Structure of Interest Rates: Yield
Curves (cont.)
• A normal yield curve is an upward-sloping yield
curve indicates that long-term interest rates are
generally higher than short-term interest rates.
• An inverted yield curve is a downward-sloping
yield curve indicates that short-term interest rates
are generally higher than long-term interest rates.
• A flat yield curve is a yield curve that indicates
that interest rates do not vary much at different
maturities.

Matter of Fact
Bond Yield Hits Record Lows

– On July 25, 2012, the 10-year Treasury note and 30-year
Treasury bond yields reached all-time lows of 1.43% and
2.46%.
– That was good news for the housing market. Many
mortgage rates are linked to rates on Treasury securities.
For example, the traditional 30-year mortgage rate is
typically linked to the yield on 10-year Treasury notes.
– With mortgage rates reaching new lows, potential buyers
found that they could afford more expensive homes, and
existing homeowners were able to refinance their existing
loans, lowering their monthly mortgage payments and
leaving them with money to spend on other things.
– This kind of activity is precisely what the Federal Reserve
hoped to stimulate by keeping interest rates low during the
economic recovery.
Theories of Term Structure
Three theories are frequently cited to explain the

general shape of the yield curve:
• Expectations theory
• Liquidity preference theory
• Market segmentation theory

Theories of Term Structure
Expectations Theory
Expectations theory is the theory that the yield curve
reflects investor expectations about future interest rates;
an expectation of rising interest rates results in an upward-
sloping yield curve, and an expectation of declining rates
results in a downward-sloping yield curve.

Theories of Term Structure (cont.)
Expectations Theory (example)

Suppose that a 5-year Treasury note currently offers a 3%
annual return. Investors believe that interest rates are
going to decline, and 5 years from now, they expect the
rate on a 5-year Treasury note to be 2.5%. According to
the expectations theory, what is the return that a 10-year
Treasury note has to offer today? What does this imply
about the slope of the yield curve?

Expectations Theory (example)

Consider an investor who purchases a 5-year note today
and plans to reinvest in another 5-year note in the future.
Over the 10-year investment horizon, this investor expects
to earn about 27.5%, ignoring compounding (that’s 3% per
year for the first 5 years and 2.5% per year for the next 5
years). To compete with that return, a 10-year bond today
could offer 2.75% per year. That is, a bond that pays
2.75% for each of the next 10 years produces the same
27.5% total return that the series of two, 5-year notes is
expected to produce. Therefore, the 5-year rate today is
3% and the 10-year rate today is 2.75%, and the yield
curve is downward sloping.

Liquidity Preference Theory

Liquidity preference theory suggests that long-term
rates are generally higher than short-term rates (hence,
the yield curve is upward sloping) because investors
perceive short-term investments to be more liquid and less
risky than long-term investments. Borrowers must offer
higher rates on long-term bonds to entice investors away
from their preferred short-term securities.

Market Segmentation Theory

Market segmentation theory suggests that the market
for loans is segmented on the basis of maturity and that
the supply of and demand for loans within each segment
determine its prevailing interest rate; the slope of the yield
curve is determined by the general relationship between
the prevailing rates in each market segment.

Risk Premiums: Issue and Issuer
Characteristics
• So far, we have considered only risk-free U.S.
Treasury securities.
• The nominal rate of interest for a security is equal
to the risk-free rate (consisting of the real rate of
interest plus the inflation expectation premium)
plus the risk premium.
• The risk premium varies with specific issuer and
issue characteristics.

Risk Premiums: Issue and Issuer
Characteristics
The nominal rates on

a number of classes
of long-term
securities in May
2013 were:
Because the
Treasury bond
would represent
the risk-free, long-
term security, we
can calculate the
risk premium of
the other securities
by subtracting the
risk-free rate.

Table 6.1 Debt-Specific Risk Premium
Components

Corporate Bonds
• A corporate bond is a long-term debt instrument
indicating that a corporation has borrowed a certain
amount of money and promises to repay it in the
future under clearly defined terms.
• The coupon interest rate is the percentage of a
bond’s par value that will be paid annually,
typically in two equal semiannual payments, as
interest.
• The bond’s par value, or face value, is the amount
borrowed by the company and the amount owed to
the bond holder on the maturity date.
• The bond’s maturity date is the time at which a
bond becomes due and the principal must be repaid.

Corporate Bonds: Legal Aspects of
Corporate Bonds
• The bond indenture is a legal document that
specifies both the rights of the bondholders and the
duties of the issuing corporation.
• Standard debt provisions are provisions in a
bond indenture specifying certain record-keeping
and general business practices that the bond issuer
must follow; normally, they do not place a burden
on a financially sound business.
• Restrictive covenants are provisions in a bond
indenture that place operating and financial
constraints on the borrower.

Corporate Bonds (cont.)
The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan
default.
2. Prohibit the sale of accounts receivable to generate cash. Selling
receivables could cause a long-run cash shortage if proceeds
were used to meet current obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a
specified level of fixed assets to guarantee its ability to repay
the bonds.
4. Constrain subsequent borrowing. Additional long-term debt may
be prohibited, or additional borrowing may be subordinated to
the original loan. Subordination means that subsequent
creditors agree to wait until all claims of the senior debt are
satisfied.
5. Limit the firm’s annual cash dividend payments to a specified
percentage or amount.

Corporate Bonds (cont.)
• Sinking fund requirements are a restrictive provision often
included in a bond indenture, providing for the systematic
retirement of bonds prior to their maturity.
• A security interest is a provision in the bond indenture that
identifies any collateral pledged against the bond and how it is
to be maintained. The protection of bond collateral is crucial to
guarantee the safety of a bond issue.
• A trustee is a paid individual, corporation, or commercial
bank trust department that acts as the third party to a bond
indenture and can take specified actions on behalf of the
bondholders if the terms of the indenture are violated.

Corporate Bonds:
Cost of Bonds to the Issuer
• In general, the longer the bond’s maturity, the
higher the interest rate (or cost) to the firm.
• In addition, the larger the size of the offering, the
lower will be the cost (in % terms) of the bond.
• Also, the greater the default risk of the issuing firm,
the higher the cost of the issue.
• Finally, the cost of money in the capital market is
the basis form determining a bond’s coupon
interest rate.

Corporate Bonds:
General Features of a Bond Issue
• A conversion feature for convertible bonds allows
bondholders to change each bond into a stated
number of shares of common stock.
– Bondholders will exercise this option only when the market
price of the stock is greater than the conversion price.
• A call feature, which is included in nearly all
corporate bond issues, gives the issuer the
opportunity to repurchase bonds at a stated call
price prior to maturity.
– The call price is the stated price at which a bond may be
repurchased, by use of a call feature, prior to maturity.
– The call premium is the amount by which a bond’s call
price exceeds its par value.

Corporate Bonds: General Features of a
Bond Issue (cont.)
• In general, the call premium is equal to one year
of coupon interest and compensates the holder for
having it called prior to maturity.
• Furthermore, issuers will exercise the call feature
when interest rates fall and the issuer can refund
the issue at a lower cost.
• Issuers typically must pay a higher rate to investors
for the call feature compared to issues without the
feature.

Corporate Bonds: General Features of a
Bond Issue (cont.)
• Bonds also are occasionally issued with stock
purchase warrants, which are instruments that
give their holders the right to purchase a certain
number of shares of the issuer’s common stock at
a specified price over a certain period of time.
Occasionally attached to bonds as “sweeteners.”
• Including warrants typically allows the firm to raise
debt capital at a lower cost than would be possible
in their absence.

Corporate Bonds: Bond Yields
The three most widely cited yields are:

– Current yield
– Yield to maturity (YTM)
– Yield to call (YTC)

Corporate Bonds: Bond Prices
• Because most corporate bonds are purchased and

held by institutional investors, such as banks,
insurance companies, and mutual funds, rather
than individual investors, bond trading and price
data are not readily available to individuals.
• Although most corporate bonds are issued with a
par, or face, value of $1,000, all bonds are quoted
as a percentage of par.
– A $1,000-par-value bond quoted at 94.007 is priced at
$940.07 (94.007%  $1,000). Corporate bonds are quoted
in dollars and cents. Thus, Company C’s price of 103.143
for the day was $1,031.43—that is, 103.143%  $1,000.

Table 6.2
Data on Selected Bonds

Table 6.3 Moody’s and Standard & Poor’s
Bond Ratings

Focus on Ethics
Can We Trust the Bond Raters?

– Credit-rating agencies evaluate and attach ratings to credit
instruments (e.g, bonds). Historically, bonds that received
higher ratings were almost always repaid, while lower
rated more speculative “junk” bonds experienced much
higher default rates.
– Recently, the credit-rating agencies have been criticized for
their role in the subprime crisis. The agencies attached
ratings to complex securities that did not reflect the true
risk of the underlying investments.
What ethical issues may arise because the companies
that issue bonds pay the rating agencies to rate
their bonds?

Table 6.4 Characteristics and Priority of Lender’s
Claim of Traditional Types of Bonds

Table 6.4 Characteristics and Priority of Lender’s
Claim of Traditional Types of Bonds (Cont.)

Corporate Bonds:
International Bond Issues
• Companies and governments borrow internationally
by issuing bonds in two principal financial markets:
– A Eurobond is a bond issued by an international borrower
and sold to investors in countries with currencies other
than the currency in which the bond is denominated.
– In contrast, a foreign bond is a bond issued in a host
country’s financial market, in the host country’s currency,
by a foreign borrower.
• Both markets give borrowers the opportunity to
obtain large amounts of long-term debt financing
quickly, in the currency of their choice and with
flexible repayment terms.

Table 6.5 Characteristics of Contemporary
Types of Bonds

Valuation Fundamentals
• Valuation is the process that links risk and return

to determine the worth of an asset.
• There are three key inputs to the valuation process:
1. Cash flows (returns)
2. Timing
3. A measure of risk, which determines the required return

• Celia Sargent wishes to estimate the value of three

assets she is considering investing in:
– Stock in Michaels Enterprises Expect to receive cash
dividends of $300 per year indefinitely.
– Oil well Expect to receive cash flow of $2,000 at the end
of year 1, $4,000 at the end of year 2, and $10,000 at the
end of year 4, when the well is to be sold.
– Original painting Expect to be able to sell the painting in 5
years for $85,000.
• With these cash flow estimates, Celia has taken the
first step toward placing a value on each of the
assets.

Consider two scenarios:

– Scenario 1—Certainty A major art gallery has contracted to buy
the painting for $85,000 at the end of 5 years. Because this is
considered a certain situation, Celia views this asset as “money in
the bank.” She thus would use the prevailing risk-free rate of 3%
as the required return when calculating the value of the painting.
Oil well Expect to receive cash flow of $2,000 at the end of year 1,
$4,000 at the end of year 2, and $10,000 at the end of year 4,
when the well is to be sold.
– Scenario 2—High Risk The values of original paintings by this
artist have fluctuated widely over the past 10 years. Although
Celia expects to be able to sell the painting for $85,000, she
realizes that its sale price in 5 years could range between
$30,000 and $140,000. Because of the high uncertainty
surrounding the painting’s value, Celia believes that a 15%
required return is appropriate.

Basic Valuation Model
• The value of any asset is the present value of all future cash flows
it is expected to provide over the relevant time period.
• The value of any asset at time zero, V0, can be expressed as
where
v0 = Value of the asset at time zero
CFT = cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period

• In the case of Michaels stock, the annual cash flow is $300,

and Celia decides that a 12% discount rate is appropriate for
this investment. Therefore, her estimate of the value of
Michaels Enterprises stock is
$300 ÷ 0.12 = $2,500
• Using a 20% required return, Celia estimates the oil well’s
value to be
• Finally, Celia estimates the value of the painting by discount

the expected $85,000 lump sum payment in 5 years at 15%
$85,000 ÷ (1 + 0.15)5 = $42,260.02

Bond Valuation: Bond Fundamentals
• As noted earlier, bonds are long-term debt

instruments used by businesses and government to
raise large sums of money, typically from a diverse
group of lenders.
• Most bonds pay interest semiannually at a stated
coupon interest rate, have an initial maturity of 10
to 30 years, and have a par value of $1,000 that
must be repaid at maturity.

Bond Valuation: Basic Bond Valuation
The basic model for the value, B0, of a bond is given

by the following equation:
Where
B0 = value of the bond at time zero

I= annual interest paid in dollars
n= number of years to maturity
M= par value in dollars
rd = required return on a bond

(cont.)
• Mills Company, a large defense contractor, on
January 1, 2016, issued a 10% coupon interest
rate, 10-year bond with a $1,000 par value that
pays interest annually.
• Investors who buy this bond receive the contractual
right to two cash flows: (1) $100 annual interest
(10% coupon interest rate  $1,000 par value) at
the end of each year, and (2) the $1,000 par value
at the end of the tenth year.
• Assuming that interest on the Mills Company bond
issue is paid annually and that the required return
is equal to the bond’s coupon interest rate, I =
$100, rd = 10%, M = $1,000, and n = 10 years.
(cont.)

(cont.)

Bond Valuation: Bond Value Behavior
In practice, the value of a bond in the marketplace is

rarely equal to its par value.
– Whenever the required return on a bond differs from the
bond’s coupon interest rate, the bond’s value will differ
from its par value.
– The required return is likely to differ from the coupon
interest rate because either (1) economic conditions have
changed, causing a shift in the basic cost of long-term
funds, or (2) the firm’s risk has changed.
– Increases in the basic cost of long-term funds or in risk will
raise the required return; decreases in the cost of funds or
in risk will lower the required return.

(cont.)
What if the required rate for Mills Company’s bonds rose to

12% or fell to 8%?
Table 6.6 Bond Values for Various Required Returns (Mills Company’s
10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1,
2014, Issue Date, Paying Annual Interest)

(cont.)

(cont.)

Figure 6.4 Bond Values and Required
Returns

(cont.)
• Interest rate risk is the chance that interest rates
will change and thereby change the required return
and bond value.
• Rising rates, which result in decreasing bond
values, are of greatest concern.
• The shorter the amount of time until a bond’s
maturity, the less responsive is its market value to
a given change in the required return.

Figure 6.5 Time to Maturity and Bond
Values

Yield to Maturity (YTM)
• The yield to maturity (YTM) is the rate of return

that investors earn if they buy a bond at a specific
price and hold it until maturity. (Assumes that the
issuer makes all scheduled interest and principal
payments as promised.)
• The yield to maturity on a bond with a current price
equal to its par value will always equal the coupon
interest rate.
• When the bond value differs from par, the yield to
maturity will differ from the coupon interest rate.

The Mills Company

bond, which currently
sells for $1,080, has a
10% coupon interest
rate and $1,000 par
value, pays interest
annually, and has 10
years to maturity. What
is the bond’s YTM?

Personal Finance Example (cont.)

Personal Finance Example (cont.)

Yield to Maturity (YTM): Semiannual
Interest and Bond Values
• The procedure used to value bonds paying interest
semiannually is similar to that shown in Chapter 5 for
compounding interest more frequently than annually,
except that here we need to find present value instead of
future value. It involves
1. Converting annual interest, I, to semiannual interest by dividing
I by 2.
2. Converting the number of years to maturity, n, to the number of
6-month periods to maturity by multiplying n by 2.
3. Converting the required stated (rather than effective) annual
return for similar-risk bonds that also pay semiannual interest
from an annual rate, rd, to a semiannual rate by dividing rd by 2.

Interest and Bond Values (cont.)
• Assuming that the Mills Company bond pays
interest semiannually and that the required stated
annual return, rd is 12% for similar risk bonds that
also pay semiannual interest, substituting these
values into the previous equation yields

Interest and Bond Values (cont.)

Pembahasan Self Test Problems
(STP)
• Bahas ST6-1: Bond valuation
• Bahas ST6-2: Bond yields
Latihan
• Pilih beberapa soal yang tertera pada teks book utama

pada bagian problems di akhir chapter 6 dan atau
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INTEREST RATE AND BOND VALUATION

Semester: Gasal 2020/2021

Lawrence J. Gitman (2015). Principles of

LG1 Describe interest rate fundamentals, the term

LG2 Review the legal aspects of bond financing and

LG3 Discuss the general features, yields, prices,

© Pearson Education Limited, 2015. 6-3

LG4 Understand the key inputs and basic model

LG5 Apply the basic valuation model to bonds and

LG6 Explain yield to maturity (YTM), its calculation,

© Pearson Education Limited, 2015. 6-4

© Pearson Education Limited, 2015. 6-5

© Pearson Education Limited, 2015. 6-6

Fear Turns T-bill Rates Negative

© Pearson Education Limited, 2015. 6-7

© Pearson Education Limited, 2015. 6-8

© Pearson Education Limited, 2015. 6-9

• The nominal rate of interest is the actual rate of

© Pearson Education Limited, 2015. 6-10

• The nominal rate can be viewed as having two basic

© Pearson Education Limited, 2015. 6-11

© Pearson Education Limited, 2015. 6-12

© Pearson Education Limited, 2015. 6-13

© Pearson Education Limited, 2015. 6-15

• The term structure of interest rates is the

© Pearson Education Limited, 2015. 6-16

© Pearson Education Limited, 2015. 6-17

© Pearson Education Limited, 2015. 6-18

Bond Yield Hits Record Lows

Three theories are frequently cited to explain the

© Pearson Education Limited, 2015. 6-20

© Pearson Education Limited, 2015. 6-21

Expectations Theory (example)

© Pearson Education Limited, 2015. 6-22

Expectations Theory (example)

© Pearson Education Limited, 2015. 6-23

Liquidity Preference Theory

© Pearson Education Limited, 2015. 6-24

Market Segmentation Theory

© Pearson Education Limited, 2015. 6-25

© Pearson Education Limited, 2015. 6-26

The nominal rates on

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© Pearson Education Limited, 2015. 6-28

© Pearson Education Limited, 2015. 6-29

© Pearson Education Limited, 2015. 6-30

© Pearson Education Limited, 2015. 6-31

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© Pearson Education Limited, 2015. 6-33

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The three most widely cited yields are:

© Pearson Education Limited, 2015. 6-37

• Because most corporate bonds are purchased and

© Pearson Education Limited, 2015. 6-38

© Pearson Education Limited, 2015. 6-39

© Pearson Education Limited, 2015. 6-40

Can We Trust the Bond Raters?