1. 6- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Slides by Matthew Will Chapter 5 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Valuing Bonds

2. 6- 2 Topics Covered  The Bond Market  Interest Rates and Bond Prices  Current Yield and Yield to Maturity  Bond Rates and Returns  The Yield Curve  Corporate Bonds and the Risk of Default

3. 6- 3 Bonds Terminology  Bond - Security that obligates the issuer to make specified payments to the bondholder.  Coupon - The interest payments made to the bondholder.  Face Value (Par Value or Principal Value) - Payment at the maturity of the bond.  Coupon Rate - Annual interest payment, as a percentage of face value.

4. 6- 4 Bonds WARNING 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.

5. 6- 5 Bond Pricing The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return.

6. 6- 6 Bond Cash Flows

7. 6- 7 Bond Pricing Example What is the price of a 5.0 % annual coupon bond, with a $1,000 face value, which matures in 3 years? Assume a required return of 2.15%.

8. 6- 8 Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?

9. 6- 9 Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 2.15% AND the coupons are paid semi- annually?

10. 6- 10 Treasury Yields  The interest rate on 10-year U.S. Treasury bonds

11. 6- 11 Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 5.0 %?

12. 6- 12 Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 8 %?

13. 6- 13 Bond Pricing Example (continued) Q: How did the calculation change, given semi- annual coupons versus annual coupon payments? Time Periods Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula. Discount Rate Since the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate.

14. 6- 14 Interest Rate Risk  The value of the 5% bond falls as interest rates rise

15. 6- 15 Interest Rate Risk 30 yr bond 3 yr bond When the interest rate equals the 5.0% coupon rate, both bonds sell at face value

16. 6- 16 Bond Yields  Current Yield - Annual coupon payments divided by bond price.  Yield To Maturity - Interest rate for which the present value of the bond’s payments equal the price.

17. 6- 17 Bond Yields Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.

18. 6- 18 Bond Yields Example What is the YTM of a 5.0 % annual coupon bond, with a $1,000 face value, which matures in 3 years? The market price of the bond is $1,081.95. YTM = 2.15%

19. 6- 19 Bond Yields WARNING Calculating YTM by hand can be very tedious. It is highly recommended that you learn to use the “IRR” or “YTM” or “i” functions on a financial calculator.

20. 6- 20 Bond Yields Rate of Return - Earnings per period per dollar invested.

21. 6- 21 Bond Valuation Spreadsheet Esc and Double click on spreadsheet to access

22. 6- 22 Interest Rate Risk Price path for Premium Bond Price path for Discount Bond Today Maturity

23. 6- 23 Bond Yield Spreadsheet Esc and Double click on spreadsheet to access

24. 6- 24 The Yield Curve Term Structure of Interest Rates - A listing of bond maturity dates and the interest rates that correspond with each date. Yield Curve - Graph of the term structure.

25. 6- 25 The Yield Curve Treasury strips are bonds that make a single payment. The yields on Treasury strips in February 2008 show that investors received a higher yield on longer term bonds.

26. 6- 26 Corporate Bonds  Zero coupons  Floating rate bonds  Convertible bonds

27. 6- 27 Nominal and Real rates Yield on UK nominal bonds Yield on UK indexed bonds

28. 6- 28 Default Risk  Credit risk  Default premium  Investment grade  Junk bonds

29. 6- 29 Default Risk

30. 6- 30 Default Risk Yield spreads between corporate and 10-year Treasury bonds

31. 6- 31 Web Resources