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Chapter 3

VALUING BONDS

Brealey, Myers, and Allen


Principles of Corporate Finance
11th Edition
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
3-1 USING THE PRESENT VALUE FORMULA TO VALUE
BONDS

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

3-2
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 2
1.075 1.075 1.075 5
3 4

 $1,161.84

3-3
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


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

 $1203.05

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FIGURE 3.1 INTEREST RATE ON 10-YEAR TREASURIES

16

14

12

10
Yield, %

0
00 04 08 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20

Year
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3-2 HOW BOND PRICES VARY WITH INTEREST RATES

115.00

110.00

105.00

B
o 100.00

n
d 95.00

90.00
p
r
85.00
i
c
80.00
e

Interest rate, %

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FIGURE 3.2 MATURITY AND PRICES
5000

4500

4000
When interest rate =
3500
11.25% coupon, both
B 3000 bonds sell for face
on value
2500
d
pri 2000
ce
1500

1000

500

0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28

Interest rate, %
3-10
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

3-11
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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3-2 DURATION & BOND PRICES
Bond price, %

Interest rate, %

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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)

• Forward Rate: Interest rate, fixed today, on future loan at


fixed time
• Future Rate: Spot rate expected in future
• Yield To Maturity (YTM): IRR on interest-bearing instrument
3-15
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 3-20
Annual inflation, %

-15
-10
-5
10
15
20
25

0
5
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
FIGURE 3.5 ANNUAL U.S. INFLATION RATES, 1900-2011

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Average inflation, %

10
12

0
2
4
6
8
Switzerland

Netherlands

U.S.

Canada

Sweden

New Zealand

Norway

Australia

Denmark

U.K.

Ireland

Average

South Africa

Germany ex...

Belgium

Spain

France

Finland

Japan

Italy
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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Interest rate, %

-4
-2
0
2
4
6
8
10
12
14
16
31-Ja...
30-No...
30-Se...
31-Ju...
31-Ma...
31-Ma...
31-Ja...
30-No...
30-Se...
31-Ju...
31-Ma...
31-Ma...
31-Ja...
30-No...
30-Se...

10-year real interest rate


31-Ju...
31-Ma...
31-Ma...
31-Ja...
30-No...
30-Se...
FIGURE 3.7 UK BOND YIELDS

31-Ju...
31-Ma...
10-year nominal interest rate

31-Ma...
31-Ja...
30-No...
30-Se...
31-Ju...
31-Ma...
31-Ma...
31-Ja...
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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

3-29
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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