Chapter 3

VALUING BONDS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS

C1 C2 1,000  C N
PV  1
 2
 ...  N
(1  r ) (1  r ) (1  r )

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3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
• Example
• Today is October 1, 2010; what is the value of the
following bond? An IBM bond pays $115 every
September 30 for five years. In September 2015 it
pays an additional $1,000 and retires the bond. The
bond is rated AAA (WSJ AAA YTM is 7.5%).

115 115 115 115 1,115

PV     
1.075 1.075 1.075 1.075 1.0755
2 3 4

 $1,161.84

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3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
• Example: France
• In October 2011 you purchase 100 euros of
bonds in France which pay a 5% coupon every
year. If the bond matures in 2016 and the YTM
is 3.0%, what is the value of the bond?

5 5 5 5 105.0
PV     
1.024 1.0242 1.0243 1.0244 1.0245
 €112.11

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3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
• Another Example: Japan
• In July 2010 you purchase 200 yen of bonds in
Japan which pay an 8% coupon every year. If
the bond matures in 2015 and the YTM is
4.5%, what is the value of the bond?

16 16 16 16 216
PV     
1.045 1.0452
1.045 1.045 1.0455
3 4

 ¥243.57

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3-1 USING THE PRESENT VALUE FORMULA TO
VALUE BONDS
• Example: USA
• In February 2012 you purchase a three-year
U.S. government bond. The bond has an annual
coupon rate of 11.25%, paid semiannually. If
investors demand a 0.085% semiannual return,
what is the price of the bond?

56.25 56.25 56.25 56.25 56.25 1056.25

PV      
1.00085 1.000852 1.000853 1.000854 1.000855 1.000856
 $1,331.40

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3-2 HOW BOND PRICES VARY WITH INTEREST
RATES
• Example, Continued: USA
• Take the same three-year U.S. government
bond. If investors demand a 4.0% semiannual
return, what is the new price of the bond?

PV  56.25  56.25 56 . 25 56. 25 56. 25 1056 .25

2  3  4  5 
1.04 1.04 1.04 1.04 1.04 1.046

 $1203.05

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FIGURE 3.1 INTEREST RATE ON 10-YEAR
TREASURIES
Yield, %

Year
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3-2 HOW BOND PRICES VARY WITH INTEREST
RATES
115.00

110.00

105.00

100.00

95.00

90.00

85.00

80.00

Interest rate, %

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FIGURE 3.2 MATURITY AND PRICES

When interest rate =

11.25% coupon, both
bonds sell for face
value

Interest rate, %
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3-2 HOW BOND PRICES VARY WITH INTEREST
RATES

1 PV(C1 ) 2  PV(C2 ) 3 PV(C3 ) T  PV(CT )

Duration     ... 
PV PV PV PV

duration
Modified duration  volatility (%) 
1  yield

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3-2 DURATION CALCULATION
Year Payment PV(Ct) at Fraction of Total Year × fraction of
Ct 4.0% Value total value
[PV(Ct)/V] [t × PV(Ct)/PV]

1 $90 $86.54 0.0666 0.0666

2 90 83.21 0.0640 0.1280
3 90 80.01 0.0615 0.1846
4 90 76.93 0.0592 0.2367
5 90 73.97 0.0569 0.2845
6 90 71.13 0.0547 0.3283
7 1090 828.31 0.6371 4.4598

PV = Total = duration =
$1300.10 5.60

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3-3 TERM STRUCTURE OF INTEREST
RATES
• Short- and long-term rates are not always parallel
• September 1992–April 2000: U.S. short-term
rates rose sharply while long-term rates declined

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3-3 TERM STRUCTURE OF INTEREST
RATES
YTM (r)

1981
1987 & Normal

1976
1 5 10 20 30 Year

• Spot Rate: Actual interest rate today (t = 0)

• Yield To Maturity (YTM): IRR on interest-bearing instrument

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FIGURE 3.4 SPOT RATES ON U.S. TREASURY
STRIPS, 02/2012

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3-3 LAW OF ONE PRICE
• All interest-bearing instruments priced to fit
term structure
• Accomplished by modifying asset price
• Modified price creates new yield, which fits
term structure
• New yield called yield to maturity (YTM)

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3-3 YIELD TO MATURITY

• Example
• $1,000 Treasury bond expires in 5
years. Pays coupon rate of 10.5%.
What is YTM if market price is 107.88?

C0 C1 C2 C3 C4 C5
−1078.80 105 105 105 105 1105

Calculate IRR = 8.5%

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3-4 TERM STRUCTURE

• Expectations Theory
• Term Structure and Capital Budgeting
• CF should be discounted using term
structure info
• When rate incorporates all forward
rates, use spot rate that equals project
term
• Take advantage of arbitrage

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3-5 DEBT AND INTEREST RATES
• Classical Theory of Interest Rates
(Economics)
• Developed by Irving Fisher:
• Nominal Interest Rate = Actual rate paid when
borrowing money
• Real Interest Rate = Theoretical rate paid when
borrowing money; determined by supply and demand
r
Supply

Real r

Demand
$ Qty 3-19
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FIGURE 3.5 ANNUAL U.S. INFLATION RATES,
1900-2011

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FIGURE 3.6 GLOBAL INFLATION RATES, 1900-
2011

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3-5 DEBT AND INTEREST RATES
• Nominal r = Real r + expected inflation
(approximation)
• Real r theoretically somewhat stable
• Inflation is a large variable
• Term structure of interest rates shows
cost of debt

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3-5 DEBT AND INTEREST RATES
• Debt and Interest Formula:

1  rnominal  (1  rreal )(1  i)

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FIGURE 3.7 UK BOND YIELDS

10-year nominal interest rate

Interest rate, %

10-year real interest rate

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FIGURE 3.8 GOVT. BILLS VS. INFLATION,
1953-2011

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FIGURE 3.8 GOVT. BILLS VS. INFLATION,
1953-2011

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FIGURE 3.8 GOVT. BILLS VS. INFLATION,
1953-2011

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3-6 THE RISK OF DEFAULT
• Corporate Bonds and Default Risk
• Payments promised to bondholders
represent best-case scenario
• Most bonds’ safety judged by bond ratings

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TABLE 3.6 PRICES AND YIELDS OF CORPORATE
BONDS, 01/2011

Price, % of Yield to
Issuer Coupon Maturity S&P Rating Face Value Maturity
Johnson &
Johnson 5.15% 2017 AAA 122.88% 1.27%
Walmart 5.38 2017 AA 117.99 1.74
Walt Disney 5.88 2017 A 121.00 2.07
Suntrust Banks 7.13 2017 BBB 109.76 4.04
U.S. Steel 6.05 2017 BB 97.80 6.54
American
Stores 7.90 2017 B 97.50 8.49
Caesars
Entertainment 5.75 2017 CCC 41.95 25.70

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TABLE 3.7 BOND RATINGS

Standard & Poor's

Moody's
and Fitch
Investment grade bonds
Aaa AAA
Aa AA
A A
Baa BBB
Junk bonds
Ba BB
B B
Caa CCC
Ca CC
C C

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3-6 THE RISK OF DEFAULT
• Sovereign Bonds and Default Risk
• Sovereign debt is generally less risky than
corporate debt
• Inflationary policies can reduce real value
of debts

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3-6 THE RISK OF DEFAULT
• Sovereign Bonds and Default Risk
• Foreign Currency Debt
• Default occurs when foreign government
borrows dollars
• If crisis occurs, governments may run out of
taxing capacity and default
• Affects bond prices, yield to maturity

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3-6 THE RISK OF DEFAULT
• Sovereign Bonds and Default Risk
• Own Currency Debt
• Less risky than foreign currency debt
• Governments can print money to repay bonds

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3-6 THE RISK OF DEFAULT
• Sovereign Bonds and Default Risk
• Eurozone Debt
• Can’t print money to service domestic debts
• Money supply controlled by European Central
Bank

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