MABALACAT CITY COLLEGE

Rizal St. Brgy. Dolores, Mabalacat City, Pampanga

CYCLE 1
1st Semester | A.Y. 2021-2022

October 11 - October 19,

2021

FINMAN
Financial Management
1
Ian Paulo N. Punsalan,
MM

Institute of Business and Computing Education

BSA 2-A

Start Here, Be Successful Page 1 of 8

 MABALACAT CITY COLLEGE
Institute of Business and Computing
Education Cycle 1, 1st Semester, Academic
Year 2021-2022

FINMAN: FINANCIAL MANAGEMENT 1

MODULE 6: INTEREST RATES AND BOND
VALUATION

1. LEARNING OBJECTIVES:
After this module, you should be able to:
1. Describe interest rate fundamentals, the term structure of interest rates, and risk
premiums.
2. Review the legal aspects of bond financing and bond cost.
3. Discuss the general features, yield, prices, ratings, and popular types of
corporate bonds.
4. Understand the key inputs and basic model used in the bond valuation process.
5. Apply the basic valuation model to bonds, and describe the impact of required
return and time to maturity on bond values.

II. TOPIC OUTLINE:

 Interest Rate Fundamentals
 Legal Aspects of Bond Financing and Bond Cost
 Types of Bonds
 Bond Valuation

III. LESSON PROPER

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(other term).

The term required return is usually applied to equity instruments such as common stock;
the cost of funds obtained by selling an ownership interest.

Several factors can influence the equilibrium interest rate:

1. Inflation, which is a rising trend in the prices of most goods and services(may entail higher
interest rate).
2. Risk, which leads investors to expect a higher return on their investment (higher risk means
higher interest)
3. Liquidity preference, which refers to the general tendency of investors to prefer
short- term securities(short term securities entail higher interest rate)

The Real Rate of Interest(the three factor will not happen)

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.

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Nominal or Actual Rate of Interest (or 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).

The nominal rate of interest can be solved using the Capital Asset Pricing Model (CAPM).

𝑟 = 𝑅𝐹 + [𝛽 × (𝑟𝑚 − 𝑅𝐹)]
Where:
r = required return (nominal
rate) RF = risk-free rate
𝛽 = beta coefficient, a relative measure of non-diversifiable risk (unavoidable risk)
rm = market return

Example: Benjamin Corporation, a growing computer software developer, wishes to

determine the required return on asset Z, which has a beta of 1.5. The risk-free rate of
return is 7%; the return on the market portfolio of assets is 11%. Substituting bz -1.5, rF -
7%, and rm 11%.

𝑟 = 𝑅𝐹 + [𝛽 × (𝑟𝑚 − 𝑅𝐹)]

𝑟 = 7% + [1.5 × (11% − 7%)]

𝑟 = 13%

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.

Legal Aspects of Corporate Bonds

The bond indenture is a legal document that specifies both the rights of the
bondholders(creditor) and the duties of the issuing corporation(debtor).

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.

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The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan default(doesn’t miss the payment
for the interest and par value of bond).
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(first debts).
5. Limit the firm’s annual cash dividend payments to a specified percentage or amount.

Sinking fund requirements are a restrictive provision often included in a bond

indenture, providing for the systematic retirement of bonds(the payment is needed)
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(middleman) 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.

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 for determining a bond’s coupon
interest rate.

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(convertible bond).
 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(difference between call price and par value).

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.
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



𝐵0 = 𝐼 × [∑ ] +1𝑀 × [ 1
(1 + 𝑟 )
𝑡 ]
𝑛
𝑑
𝑡=1 (1 + 𝑟𝑑 )

𝐵0 = 𝑃𝑉 𝑜𝑓 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝑃𝑉 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

 𝐼 = 𝑃𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 × 𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝐼 = $1,000 × 10%
𝐼 = $100

𝐶𝐹 1
𝑃𝑉𝑛 = ( ) × [1 − ]
𝑟 (1 + 𝑟 )𝑛
$100 1
𝑃𝑉𝑛 = ( ) × [1 − ]
0.10 (1 + 0.10)10

𝑃𝑉𝑛 = $614.46

𝑃𝑉 = 𝐹𝑉𝑛
(1 + 𝑟)𝑛

$1,000
𝑃𝑉 =
(1
+ .10)10

𝑃𝑉 = $385.54

𝐵0 = 𝑃𝑉 𝑜𝑓 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝑃𝑉 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

𝐵0 = $614.46 + $385.54

𝐵0 = $1,000
 𝐼 = 𝑃𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 × 𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝐼 = $1,000 × 10%
𝐼 = $100

𝐶𝐹 1
𝑃𝑉𝑛 = ( ) × [1 − ]
𝑟 (1 + 𝑟 )𝑛
$100 1
𝑃𝑉𝑛 = ( ) × [1 − ]
0.12 (1 + 0.12)10

𝑃𝑉𝑛 = $565.02

𝑃𝑉 = 𝐹𝑉𝑛
(1 + 𝑟)𝑛

$1,000
𝑃𝑉 =
(1
+ .12)10

𝑃𝑉 = $321.97

𝐵0 = 𝑃𝑉 𝑜𝑓 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝑃𝑉 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

𝐵0 = $565.02 + $321.97

𝐵0 = $886.99
Required rate of return>coupon interest rate=
Par Value > value of the bond

Required rate of return<coupon interest rate=

Par Value < value of the bond
 IV. REFERENCES

Brigham, E.F. & Houston, J.F. (2009). Fundamentals of Financial Management. Mason,
Ohio: South- Western Cengage Learning.

Gitman, LJ., & Zutter, T.J. (2012). Principles of Managerial Finance. Boston, Massachusetts:
Pearson Education, Inc.

V. DISCLAIMER

OFFICIAL MCC MODULE DISCLAIMER

It is not the intention of the author/s nor the publisher of this module to have monetary gain
in using the textual information, imageries, and other references used in its production. This
module is only for the exclusive use of a bona fide student of Mabalacat City College.

In addition, this module or no part of it thereof may be reproduced, stored in a retrieval

system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, and/or otherwise, without the prior permission of Mabalacat City
College.

Prepared by:

IAN PAULO N. PUNSALAN, MM

Instructor

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