Fundamentals of Corporate

Finance, 2/e

ROBERT PARRINO, PH.D.

DAVID S. KIDWELL, PH.D.
THOMAS W. BATES, PH.D.
Bond Valuation and the Structure of
Interest Rates
 Learning Objectives
1. Describe the market for corporate bonds and three types of corporate
bonds.

2. Explain how to calculate the value of a bond and why bond prices vary
negatively with interest rate movements.

3. Distinguish between a bond’s coupon rate, yield to maturity, and effective

annual yield.

4. Explain why investors in bonds are subject to interest rate risk and why it is
important to understand the bond theorems.

5. Discuss the concept of default risk and know how to compute a default risk
premium.

6. Describe the factors that determine the level and shape of the yield curve.
 Corporate Bonds
o MARKET FOR CORPORATE BONDS (TRÁI
PHIẾU CÔNG TY)
• Life insurance companies and pension funds
buy most corporate bonds
Transactions tend to be in very large dollar amounts.
• Less than 1% of all corporate bonds are traded
on organized exchanges
Most transactions take place through dealers in the
over-the-counter (OTC) market.
 Corporate Bonds
o MARKET FOR CORPORATE BONDS
• At the end of 2007, the amount of corporate and
foreign debt outstanding was $10.1 trillion,
ranking the debt market second behind the
market for corporate equity ($20.8 trillion).
 Corporate Bonds
o MARKET FOR CORPORATE BONDS
• Only a small fraction of the bonds outstanding
are traded each day.
The market is thin compared to markets for money-
market securities and stocks.
Corporate bonds are less marketable than securities
with large daily trading volumes.
Prices in the market tend to be more volatile than
those of securities with greater trading volumes.
 Corporate Bonds
o BOND PRICE INFORMATION
• Corporate bond pricing is not considered
transparent.
It is difficult for investors to obtain important
information on prices and volume.
Many transactions are negotiated directly between
buyer and seller with little centralized reporting of
transaction details.
 Corporate Bonds
o FEATURES OF CORPORATE BONDS
• long-term claims against company assets
• face (par) value is $1,000
• coupon rate is the annual coupon payment (C)
divided by a bond’s face value (F)
• fixed amounts paid to lenders for the life of the
contract
Corporate Bonds – Terminology
Terminology Explanation

Fixed-income securities debt instruments that pay interest in amounts that are fixed for
the life of the contract

Face value, or the amount on which interest is calculated and that is owed to the
Par value bondholder when a bond reaches maturity

Coupon payments the interest payments made to bondholders

Coupon rate the annual coupon payment of a bond divided by the bond’s face
value
 Corporate Bonds - Sample

Issuer

Coupon rate

Maturity

Face value
 Corporate Bonds – Types

Vanilla bond Zero-coupon bond Convertible bonds

• coupon payments fixed for • no coupon payments • may be exchanged for shares
the life of the bond • pays face value at maturity. of the firm’s stock
• repay principal and retire the • sell at deep discount • sells for a higher price than a
bonds at maturity comparable non-convertible
• contracts have the features bond
and provisions found in most • bondholders benefit if the
bond covenants. market value of the
• annual or semiannual coupon company’s stock gets high
payments enough
 Bond Valuation
o BOND PRICE
• In an efficient market, the price of an asset
equals the present value of its future cash flows.
• To calculate a bond’s price, follow the same
process used to value any financial asset.
 IMPORTANT

Bond Valuation
CALCULATE BOND PRICE
• Determine the required rate-of-return
• Determine expected future cash flows – the
coupon payments and par value
• Compute the current market value, or price
(PB) by calculating the present value of the
expected cash flows
PB = PVCoupon Payments+ PVPar Value
Cash Flows for a Three-Year Bond
 Bond Valuation

Present
1 2 3 n
0

Investmen
CF1 CF2 CF3 CFn
t

Value of an investment = PV of expected future benefits

• Value of investment The amount that an investor pays for bonds
• Expected future benefits Bondholders will receive coupon payment (if any) and principal
 Bond Valuation – Steps

STEP 2:
Determine expected future cash
flows – the coupon payments and
principal (par value)
STEP 3:
Compute the current market value,
or price (PB) by calculating the
present value of the expected cash
flows
PB = PVCoupon Payments+ PVPar Value
STEP 1:
Determine the required
rate-of-return
 Bond Valuation
o GENERAL EQUATION FOR THE PRICE OF A
BOND
C C C F
P  1
 2
 ...  n n
(8.1)
(1  i ) (1  i ) (1  i )
B 1 2 n
 Bond Valuation
o BOND VALUATION EXAMPLE
• Calculator solution
Determine the price of the bond in Exhibit 8.1 with a
financial calculator

3 10 80 1,000
Enter
N i PV PMT FV
Answer -950.26
Using Excel – Calculate Bond Price
 Bond Valuation
o PAR, PREMIUM, AND DISCOUNT BONDS
• If a bond’s coupon rate is equal to the its yield,
its price equals its face value; it is a par bond
• If a bond’s coupon rate is less than its yield, its
price is less than its face value; it is a discount
bond
• If a bond’s coupon rate is greater than its yield,
its price is greater than its face value; it is a
premium bond
Bond Valuation – Examples

Example 1 (Ex8.5 ):
Trojan Corp. has issued seven-year bonds with a 7 percent annual coupon payment. If the opportunity cost
for an investor is 8.25 percent, what is the maximum price that this investor would pay?
Face value = 1,000
n = 7 years, m=1
i = 8.25%
𝑃 𝐵 =𝐶 × ¿
Coupon rate = 7% Ans: The investor should pay no more than $935.47.
Example 2:
Rockwell Industries has a three-year bond outstanding that pays a 7.25 percent coupon and is currently
priced at $913.88. What is the yield to maturity of this bond? Assume annual coupon payments.
Face value = 1,000 = 913.88
n = 3 years,
Coupon rate = 7.25%
 YTM=i = ? Ans: YTM is approximately 10.75 percent
 Bond Valuation
o SEMIANNUAL COMPOUNDING
• Most bonds issued in Europe pay annual
coupons, most issued in the U.S. pay
semiannual coupons
• Eq. 8.2 shows how to value bonds that pay semi-
annual coupons

C m C m C m C mF
P     ...  mn
( 8 .2 )
(1  i m ) (1  i m ) (1  i m ) (1  i m )
B 1 2 3 mn
 Bond Valuation
o SEMIANNUAL COMPOUNDING EXAMPLE
• What is the price of a three-year, 5% coupon
bond with a market yield of 8% and semi-
annual coupon payments?
Semi-annual market yield = 8%/2 = 4%
Semi-annual coupon payment = $50/2 = $25
$25 $25 $25 $25 $25 $25  $1000
P      
(1.04) (1.04) (1.04) (1.04) (1.04) (1.04)
B 1 2 3 4 5 6

 $24.04  $23.11  $22.22  $21.37  $20.55  $810.07

 $921.36
 Bond Valuation
o CALCULATOR SOLUTION
• Semiannual Compounding Example

6 4 25 1,000
Enter
N i PV PMT FV
Answer -921.37
 Bond Valuation – Examples

o EXAMPLE 1 (EX8.5 ):
o TROJAN CORP. HAS ISSUED SEVEN-YEAR BONDS WITH A 7 PERCENT SEMIANNUAL COUPON PAYMENT.
IF THE OPPORTUNITY COST FOR AN INVESTOR IS 8.25 PERCENT, WHAT IS THE MAXIMUM PRICE THAT
THIS INVESTOR WOULD PAY?

Face value = 1,000

70
𝑃 𝐵= ׿
n = 7 years,
i = 8.25%
Coupon rate = 7%
m=2
 Price of bond = ?
2
Ans: The investor should pay no more than $934.52.
 Bond Valuation
o ZERO-COUPON BONDS

• Zero coupon bonds do not make coupon payments but pay their
face value at maturity
• The price (or yield) of a zero coupon bond is a special case of
Equation 8.2, where all coupon payments equal zero
• Pricing equation for a zero coupon bond
PB = PVCoupon Payments+ PVPar Value 𝐹 𝑚𝑛
𝑃 𝐵=
= 0 + PVPar Value ¿¿

• Zero-coupon bonds pay cash only at maturity and must sell for
less than similar bonds which make periodic interest payments
 Bond Valuation
o ZERO COUPON BOND PRICE EXAMPLE
• What is the price of a zero coupon bond with a
$1,000 face value, 10-year maturity, and
semiannual compounding? The market rate on
similar bonds is 12%.

$1000 $1000
PB    $311 .80
(1  0.12 2) 20
(1  0.06) 20
 IMPORTANT

Bond Yields
o YIELD TO MATURITY (YTM)
• YTM
the rate that makes the present value of the bond’s
cash flows equal the price of bond
the rate a bondholder earns if the bond is held to
maturity and all coupon and principal payments are
made as promised
– changes daily as interest rates change
 Bond Yields
o EFFECTIVE ANNUAL YIELD
• In bond trading, the EAR is called the effective
annual yield (EAY). The way to annualize a
bond yield
EAY  (1  Quoted rate/m) m
-1
• Simple annual yield is yield per period
multiplied by the number of compounding
periods; for bonds with annual compounding,
simple annual yield = semiannual yield  2
 Bond Yields
o YIELD TO MATURITY AND EFFECTIVE ANNUAL
YIELD EXAMPLE
• An investor buys a 30-year bond with a $1,000
face value for $800. The bond’s coupon rate is
8% and interest payments are made semi-
annually. What are the bond’s yield to maturity
and effective annual yield?
 Bond Yields
o YIELD TO MATURITY AND EFFECTIVE ANNUAL
YIELD EXAMPLE
• Step 1:

60 -800 40 1,000
Enter
N i PV PMT FV
Answer 5.07
 Bond Yields
o YIELD TO MATURITY AND EFFECTIVE ANNUAL
YIELD EXAMPLE
• Step 2:
Calculate YTM

.0507 2
Enter
x =
Answer .1014
 Bond Yields
o YIELD TO MATURITY AND EFFECTIVE ANNUAL
YIELD EXAMPLE
• Step 3:
Calculate EAY

1.0507 - =
Enter
X2 1

Answer .1040
 Bond Yields
o REALIZED YIELD
• The return earned on a bond given the cash
flows actually received by investor
• The interest rate at which the present value of
actual cash flows generated by the investment
equals bond’s price
• The realized yield is important because it allows
investors to see what they actually earned on
their investments.
 Interest Rate Risk
o BOND THEOREMS
• Bond theorems are statements about the math
used in bond pricing.
Bond prices are inversely related to interest rate
movements.
As interest rates decline, prices of bonds rise; as interest
rates rise, prices of bonds decline.
For a given change in interest rates, prices of longer-term
bonds change more than prices of shorter-term bonds.
Interest rate risk increases as maturity increases, but at a
decreasing rate.
Relation Between Bond Price
Volatility and Maturity
Exhibit 8.2 Relation Between Bond Price Volatility and Maturity
 Interest Rate Risk
o BOND THEOREMS
• For a given change in interest rates, prices of
lower-coupon bonds change more than prices of
higher-coupon bonds.
Relation Between Bond Price Volatility and
the Coupon Rate
 Interest Rate Risk
o BOND THEOREM APPLICATIONS
• If interest rates are expected to increase, avoid
long-term bonds – they will experience the
largest price declines.
• If interest rates are expected to decline, buy
zero-coupon bonds. Their prices will increase
more than those of coupon-paying bonds.
 The Structure of Interest Rates
o RISK CHARACTERISTICS OF BONDS
• Four features of debt instruments are responsible
for most of the differences in corporate
borrowing costs and determine the level and
structure of interest rates:
Marketability
Call feature (điều khoản chuộc lại)

Default risk
Term-to-maturity
 The Structure of Interest Rates
o MARKETABILITY
• How quickly and easily a security can be sold at
at low transaction cost and at fair market value
The selling price varies directly with the degree of
marketability.
The transaction cost varies inversely with the degree of
marketability.
The yield-to-maturity varies inversely with the degree
of marketability.
 The Structure of Interest Rates
o MARKETABILITY
• The difference in yields between a highly
marketable security (ihigh mkt) and a less
marketable security (ilow mkt) is the marketability
risk premium (MRP)
MRP  ihigh mkt - ilow mkt  0
• U.S. Treasury bills are considered the most
marketable of all securities
 The Structure of Interest Rates
o CALL PROVISION
• Bond issuer’s option to purchase a bond from
the bondholder at a predetermined price before
maturity.
When bonds are called, bondholders suffer financial
loss because they must surrender higher-yield bonds
and replace them with lower-yield bonds.
 The Structure of Interest Rates
o CALL PROVISION
• The difference in interest rates between a callable
bond and a non-callable bond is the call premium
(CIP)
CIP  i call -i no call 0

• Callable bonds sell for lower prices and higher yields

than non-callable bonds
• Bonds paying high yields are more likely to be called
when interest rates decline; these bonds have a high
CIP
 The Structure of Interest Rates
o DEFAULT RISK
• Risk that a borrower may not make payments
as promised
• Lenders are paid a default risk premium for
purchasing securities with default risk
• The default risk premium (DRP) is the
difference between the yield on a security with
default risk, idr, and the risk-free rate, irf
• Yield on T-bills is a proxy for the risk-free rate.
 The Structure of Interest Rates
o BOND RATINGS
• Individuals and small businesses rely on outside
agencies for information on the default
potential of bonds.
The two most prominent credit rating agencies are
Moody’s Investors Service (Moody’s) and Standard &
Poor’s (S&P).
– Both services rank bonds in order of probability of default and
publish ratings as letter grades.
 The Structure of Interest Rates
o BOND RATINGS
• The highest grade bonds have the lowest default
risk and are rated Aaa or AAA.
Investment grade bonds are rated Aaa to Baa.
State and federal laws typically require commercial
banks, insurance companies, pension funds, certain
other financial institutions, and government agencies
to purchase only investment-grade securities.
Corporate Bond Rating Systems
Default Risk Premiums for Selected Bond
Ratings
Exhibit 8.5 Default Risk Premiums for Selected Bond Ratings
 The Structure of Interest Rates
o TERM STRUCTURE OF INTEREST RATES
• The term structure of interest rates
the relationship between yield to maturity and term-to-
maturity on a bond
the graph of the term structure of interest rates is a
yield curve
– The shape and position of the yield curve are not constant.
– As the overall level of interest rates changes, the yield curve
shifts up and down and changes its shape and slope.
 The Structure of Interest Rates
o BASIC SHAPES (SLOPES) OF YIELD CURVES
1. Ascending or normal yield curves slope
upward from left to right and imply higher
interest rates are likely
2. Descending or inverted yield curves slope
downward from left to right and imply lower
interest rates are likely
3. Flat yield curves imply interest rates unlikely
to change
 The Structure of Interest Rates
o SHAPE OF THE YIELD CURVE
• Three factors that influence the shape of the
yield curve
1) Real rate of interest
2) Expected rate of inflation
3) Interest rate risk
 The Structure of Interest Rates
o THE REAL RATE OF INTEREST
• The real rate of interest changes with the
business cycle.
Highest rates occur at the end of an economic
expansion.
Lowest rates occur at the end of an economic
contraction.
Changes in the expected future real rate of interest can
affect the slope of the yield curve.
 The Structure of Interest Rates
o THE EXPECTED RATE OF INFLATION
• If higher inflation is forecast, the yield curve
will slope upward because longer-term yields
will contain a larger inflation premium than
shorter-term yields
• If investors believe inflation will subside, the
yield curve will slope downward
 The Structure of Interest Rates
o INTEREST RATE RISK
• The longer the maturity of a security, the
greater its interest rate risk – the risk of selling
the security at a lower price - and the higher its
yield-to-maturity
• The interest rate risk premium adds upward
bias to the slope of the yield curve
Yield Curves for Treasury Securities at Three
Different Points in Time
Exhibit 8.6
 The Structure of Interest Rates
o CUMULATIVE EFFECT OF FACTORS
• In an economic expansion, the real rate of
interest and the inflation premium increase
monotonically . Interest rate risk increases.
• In an economic contraction, the real rate of
interest and inflation premium decrease
monotonically. Interest rate risk decreases.