Interest Rates and

Bond Valuation
Moh Fairuz Akmal 2022-070
Marta Catur Wahyuni 2022-076
Kiki Puspita Anggelia 2022-077
Enggrik Rinaldi 2022-078
INTEREST RATE
FUNDAMENTALS
• The interest rate or required return represents the cost of money.
• Usually the term interest rate is applied to debt instruments such as bank loans or bonds,
whereas the term required return may be applied to almost any kind of investment,
including common stock, which gives the investor an ownership stake in the issuer.
• A variety of factors can influence the equilibrium interest rate:
1. Inflation, a rising trend in the prices of most goods and services.
2. Risk. When people perceive that a particular investment is riskier, they will expect a
higher return on that investment as compensation for bearing the risk.
3. Liquidity preference among investors.
THE REAL RATE OF INTEREST
• The real rate of interest creates equilibrium
between the supply of savings and the
demand for funds. It represents the most basic
cost of money.
• Historically, the real rate of interest in the
United States has averaged about 1 percent
per year, but that figure does fluctuate over
time. This supply–demand relationship is
shown in Figure 6.1 by the supply function
(labeled S0) and the demand function
(labeled D). An equilibrium between the supply
of funds and the demand for funds (S0 = D)
occurs at a rate of interest r0*, the real rate of
interest.
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.
• When people save money and invest it, they are sacrificing
consumption today (that is, they are spending less than they could)
in return for higher future consumption.
• When investors expect inflation to occur, they believe that the price of
consuming goods and services will be higher in the future than in the
present.
• Therefore, they will be reluctant to sacrifice today’s consumption
unless the return they can earn on the money they save (or invest)
will be high enough to allow them to purchase the goods and
services they desire at a higher future price.
TERMS
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 graph
of this relationship is called the yield curve.
 YIELD VALUE
• A bond’s yield to maturity (YTM) represents the
compound annual rate of return that an investor
earns on the bond, assuming that the bond makes all
promised payments and the investor holds the bond
to maturity.
• who faces a downward-sloping yield curve may be
tempted to rely more heavily on cheaper, long-term
financing. However, a risk in following this strategy is
that interest rates may fall in the future, so long-term
rates that seem cheap today may be relatively
expensive tomorrow.
• Likewise, when the yield curve is upward sloping, the
manager may believe that it is wise to use cheaper,
short-term financing. Relying on short-term financing
has its own risks.
 THEORIES OF TERM STRUCTURE
THE EXPECTATIONS THEORY

• The yield curve reflects investor expectations about future interest rates.
• According to this theory, when investors expect short-term interest rates to rise in the future
(perhaps because investors believe that inflation will rise in the future), today’s long-term rates
will be higher than current short-term rates, and the yield curve will be upward sloping.

THE LIQUIDITY PREFERENCE THEORY

• This theory holds that, all else being equal, investors generally prefer to buy short-term securities,
while issuers prefer to sell long-term securities.
• For investors, short-term securities are attractive because they are highly liquid and their prices
are not particularly volatile.
• Hence, investors will accept somewhat lower rates on short-term bonds because they are less
risky than long-term bonds.

THE MARKET SEGMENTATION THEORY

• The market segmentation theory suggests that the market for loans is totally segmented on the
basis of maturity and that the supply of and demand for loans within each segment determine its
prevailing interest rate.
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.

Most bonds are issued with maturities of 10 to 30

years and with a par value, or face value, of $1,000.
The coupon interest rate on a bond represents the
percentage of the bond’s par value that will be
paid annually, typically in two equal semiannual
payments, as interest. The bondholders, who are
the lenders, are promised the semiannual interest
payments and, at maturity, repayment of the
principal amount.
LEGAL ASPECTS OF
CORPORATE BONDS
BOND INDENTURE
A bond indenture is a legal document that specifies both the rights of the bondholders and the duties of
the issuing corporation. The borrower commonly must (1) maintain satisfactory accounting records in
accordance with generally accepted accounting principles (GAAP), (2) periodically supply audited
financial statements, (3) pay taxes and other liabilities when due, and (4) maintain all facilities in good
working order.

Standard Provisions - The standard debt provisions in the bond indenture specify certain record-keeping
and general business practices that the bond issuer must follow.
Restrictive Provisions - Bond indentures also normally include certain restrictive covenants, which place
operating and financial constraints on the borrower.
Sinking-Fund - To carry out this requirement, the corporation makes semiannual or annual payments
that are used to retire bonds by purchasing them in the marketplace.
Security Interest - The bond indenture identifies any collateral pledged against the bond and specifies
how it is to be maintained.
LEGAL ASPECTS OF
CORPORATE BONDS
TRUSTEE
A trustee is a third party to a bond indenture. The trustee can be
an individual, a corporation, or (most often) a commercial bank
trust department. The trustee is paid to act as a “watchdog” on
behalf of the bondholders and can take specified actions on
behalf of the bondholders if the terms of the indenture are
violated.
COST OF BONDS TO
THE ISSUER

The cost of bond financing is generally greater than

the issuer would have to pay for short-term borrowing.
The major factors that affect the cost, which is the rate
of interest paid by the bond issuer, are the bond's
maturity, the size of the offer-ing, the issuer's risk, and
the basic cost of money.
COST OF BONDS TO THE
ISSUER

• Impact of Bond Maturity

• Impact of Offering Size
• Impact of Issuer's Risk
• Impact of the Cost of Money
GENERAL FEATURES OF
A BOND ISSUE
Three features sometimes included in a
corporate bond issue are a conversion feature, a
call feature, and stock purchase warrants. These
features provide the issuer or the purchaser with
certain opportunities for replacing or retiring the
bond or supplementing it with some type
of equity issue.

• Convertible Bonds
• call feature
• Stock Purchase Warrant
VALUATION
FUNDAMENTALS
There are three key inputs to the valuation process:
1. Cash flows (returns)
The value of any asset depends on the cash flow(s) it is expected to
provide over the ownership period. To have value, an asset does not have
to provide an annual cash flow; it can provide an intermittent cash flow or
even a single cash flow over the period.
2. Timing
In addition to making cash flow estimates, we must know the timing of the
cash flows.
3. A measure of risk
The level of risk associated with a given cash flow can significantly affect its
value. In general, the greater the risk of (or the less certain) a cash flow, the
lower its value. Greater risk can be incorporated into a valuation analysis
by using a higher required return or discount rate. The higher the risk, the
greater the required return, and the lower the risk, the less the required
return.
BASIC VALUATION
MODEL
Simply stated, 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
time period can be any length, even infinity. The value of an asset is
therefore determined by discounting the expected cash flows back to
their present value, using the required return commensurate with the
asset’s risk as the appropriate discount rate.
BOND VALUE
BEHAVIOUR
Required Returns and Bond Values
• 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 since the bond was issued, causing a shift in the
cost of funds; or (2) the firm’s risk has changed. Increases
in the cost of funds or in risk will raise the required return;
decreases in the cost of funds or in risk will lower the
required return.

Time to Maturity and Bond Values

Whenever the required return is different from the coupon
interest rate, the amount of time to maturity affects bond
value. An additional factor is whether required returns are
constant or change over the life of the bond.
Constant Required Returns
When the required return is different from the coupon
interest rate and is constant until maturity, the value of the
bond will approach its par value as the passage of time
moves the bond’s value closer to maturity. (Of course,
when the required return equals the coupon interest rate,
the bond’s value will remain at par until it matures.)

Changing Required Returns

The chance that interest rates will change and thereby
change the required return and bond value is called
interest rate risk. Bondholders are typically more
concerned with rising interest rates because a rise in
interest rates, and therefore in the required return, causes
a decrease in bond value. 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.
YIELD TO MATURITY (YTM)
When investors evaluate bonds, they commonly consider yield to maturity
(YTM), which is the compound annual rate of return earned on a debt
security purchased on a given day and held to maturity. The yield to
maturity on a bond with a current price equal to its par value (that is, B0 =
M) 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
YTM can be found by using a financial calculator, by using an Excel
spreadsheet, or by trial and error. The calculator provides accurate YTM
values with minimum effort.
THANKYOU!