Corporate Finance

Lecturer: Dr. Cormac Mac Fhionnlaoich

Bond Valuation
 Bond Introduction

How would you find the Present Value of the following stream of
cash flows?:

Cash received at the end of:

Year 1 = $8 , Year 2 = $8 , Year 3 = $8 , Year 4 = $108 . (Assume
the opportunity cost of capital is 9%).

8 8 8 108
PV      $96.76
1  0.09 1  0.09 1  0.09 1  0.09
1 2 3 4

2
 Bond Introduction

We have essentially just priced a bond!!!

==== Price a bond with the following specifications:

face value (FV) $100,
coupon rate (c) 8%,
time to maturity (T) 4 years,

and yield to maturity (YTM) 9%.

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 Bond Introduction
-We are told that the bond lasts for 4 years.
-At the end of each of those years the bond will pay 8% of $100=$8.
-At the end of the final year the bond will also pay $100.
-To price this bond we simply find the present value of each of these
individual cash flows and sum them all up.

8 8 8 8 100
P (Bond Price)     
1  0.09 1  0.09 1  0.09 1  0.09 1  0.09
1 2 3 4 4

 $96.76

4
 Bond Pricing Formula

cF cF cF F
P   ...  
1  r  1  r  1  r  1  r 
1 2 n n

Where:
P = the price (or value) of the bond
c = the coupon rate
n = the number of years to maturity
F = the face (par) value of the bond
r = the required rate of return

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 Bond Terminology
 A Bond is a security that obligates issuer to make a series of specified
payments to the bondholder.

 Face value (par value or maturity value)

– Payment at the maturity of the bond
– By convention, it is $1,000 or $100

 Coupon rate
– Annual interest payment as a percentage of face value

 Yield to Maturity.
Traders refer to a bond’s required rate of return as its yield to maturity
(YTM). The Yield to Maturity is the interest rate for
which the present value of the bond’s payments equals the price
 Bonds

NOTE
 The coupon rate IS NOT the discount rate used in the
Present Value calculations

 The coupon rate merely tells us what cash flow the bond
will produce
– Since the coupon rate is listed as a %, this misconception is
quite common
 Bond Pricing
Example
What is the price of a 6 % annual coupon bond, with a
$1,000 face value, which matures in 3 years? Assume a yield of
5.6%.

60 60 1,060
P  
(1.056) (1.056) (1.056) 3
1 2

P  $1,010.77

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 Fundamental Features of Bonds:
1. Price vs Interest Rate
 Inverse relationship: if r increases (decreases), then P
decreases (increases)
 If the market offers higher returns, then for a smaller
initial investment, you can obtain the same level of payoffs
 Recall that $100 in one year’s time is worth less today if
the interest rate is 15% than if it were 10%

cF cF cF F
P   ...  
1  r  1  r  1  r  1  r 
1 2 n n
Fundamental Features of Bonds:
1. Price vs Interest Rate
Price
($)

Interest Rate (%)

 Figure 6.5
Plot of bond prices as a function of the interest rate.
the price of long-term bonds is more sensitive to
changes in the interest rate than the price of short-term bonds.
 Figure 6.7
The Yield Curve
Plot of relationship between bond
yields to maturity and time to maturity.
 Fundamental Features of Bonds :
2. Coupon Rate vs Interest Rate

Example
What is the price of a 6 % annual coupon bond, with a $1,000
face value, which matures in 3 years? Assume an interest rate
of 5.6%.
60 60 1,060
P 1
 2
 3
(1.056) (1.056) (1.056)
P  $1,010.77
 Fundamental Features of Bonds :
2. Coupon Rate vs Interest Rate

Example (continued)
What is the price of the bond if the interest rate increases to 6
%?
60 60 1,060
P 1
 2
 3
(1.06) (1.06) (1.06)
P  $1,000
 Fundamental Features of Bonds :
2. Coupon Rate vs Interest Rate

Example (continued)
What is the price of the bond if the interest rate is 15 %?

60 60 1,060
P 1
 2
 3
(1.15) (1.15) (1.15)
P  $794.51
 Relationship between
Yield to Maturity (YTM) Coupon Rate and Bond Price

60 60 1,060
YTM < Coupon Rate P 1
 2
 3
(1.056) (1.056) (1.056)
=> Bond sells Premium P  $1,010.77
60 60 1,060
YTM = Coupon Rate P 1
 2
 3
(1.06) (1.06) (1.06)
=> Bond sells Par P  $1,000
60 60 1,060
YTM > Coupon Rate P 1
 2
 3
(1.15) (1.15) (1.15)
=> Bond sells at discount
P  $794.51
 Fundamental Features of Bonds:
2. Coupon Rate vs Interest Rate

 Coupon rate (c) is the return offered by the bond

whereas the interest rate is the current market return (r)

 If r > c, then P < F

 Otherwise, if r < c, then P > F

cF cF cF F
P   ...  
1  r  1  r  1  r  1  r 
1 2 n n

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 Figure 6.3
The Interest Rate on 10 Year U.S. Treasury Bonds 1900-2010
The cost of money

The price, or cost, of debt capital is the interest

rate.

The price, or cost, of equity capital is the

required return. The required return investors
expect is composed of compensation in the form
of dividends and capital gains.
What four factors affect the cost of
money?
 Production
opportunities
 Time preferences for
consumption
 Risk
 Expected inflation
“Nominal” vs. “Real” rates
k = represents any nominal rate

k* = represents the “real” risk-free rate of

interest. Like a T-bill rate, if there was no
inflation. Typically ranges from 1% to
4% per year.

kRF = represents the rate of interest on

Treasury securities.
Determinants of interest rates
k = k* + IP + DRP + LP + MRP

k = required return on a debt security

k* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Premiums added to k* for
different types of debt

IP MRP DRP LP
S-T Treasury 

L-T Treasury  

S-T Corporate   

L-T Corporate    
Yield curve and the term structure of
interest rates
Term structure –
relationship between
interest rates (or yields)
and maturities.

The yield curve is a

graph of the term
structure.

.
 Hypothetical yield curve
Interest  An upward sloping
Rate (%)
yield curve.
15 Maturity risk premium
 Upward slope due to
an increase in
10 Inflation premium
expected inflation and
increasing maturity
5 risk premium.
Real risk-free rate
0 Years to
1 10 20Maturity
 What is the relationship between the
Treasury yield curve and the yield curves
for corporate issues?

Corporate yield curves are higher than that of Treasury

securities, though not necessarily parallel to the Treasury curve.

The spread between corporate and Treasury yield curves widens

as the corporate bond rating decreases.
Illustrating the relationship between
corporate and Treasury yield curves
Interest
Rate (%)
15

BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%

Years to
0 Maturity
0 1 5 10 15 20
 Table 6.2
Key to Moody’s and Standard & Poor’s bond ratings.
 Table 6.3
Prices and Yields on a sample of
heavily traded corporate bonds
June 1 200
 Fig 6.9
Yield Spreads between
Corporate and 10 year Treasury Bonds.