Interest rates, bill and bond valuation Chapter 6.

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Presentation transcript:

Interest rates, bill and bond valuation Chapter 6

Key concepts and skills Know the important features and different types of bills and bonds Understand how bills and bonds are valued and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates Understand the term structure of interest rates and the determinants of bond yields 6-2 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline Bills of exchange and bill valuation Other short-term funding instruments Bonds and bond valuation More on bond features Bond ratings Some different types of bonds Bond markets Inflation and interest rates Determinants of bond yields 6-3 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bills of exchange and bill valuation A bill is defined as: – ‘unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to bearer’ Face value – The principal amount that is repaid at the end of the term. Also called par value. Maturity – Date on which the principal amount is paid. 6-4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bill values and yields If a bill has: – a face value of F paid at maturity – t periods to maturity; and – a yield of r per period 6-5 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bill pricing— Example Suppose the Edna Data Company was to issue a bill with a face value of $ and 90 days to maturity, with a yield of 6.5%. The acquirer of the bill will receive $ in 90 days’ time. What would this bill sell for? – PV = /(1+0.06/365*90)=$ Calculator: – [N] (90/365) – 6[I/Y] – [+/-][FV] – [CPT][PV]= Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

More on bill features Three parties to a bill of exchange: 1. The drawer 2. The acceptor 3. The discounter (or endorser) The amount of funds the drawer will receive depends on the face value of the bill and the prevailing market rates (discount rate). The original discounter may hold the bill to maturity or sell it in the market before the maturity date. At the maturity date, the current holder of the bill will approach the acceptor for repayment. The acceptor is liable to pay the face value of the bill to the current holder and will recover the money from the drawer. 6-7 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

More on bill features (cont.) Figure 6.1 Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Other short-term funding instruments Promissory notes – Promises to pay a lender an amount of money in the future; and – issued for short terms. Bank overdraft – An agreement under which a firm is authorised to overdraw its bank account up to a specified amount. 6-9 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond definitions Bond – Debt contract – Interest-only loan Par value (face value) ~ $1000 Coupon rate Coupon payment Maturity date Yield to maturity 6-10 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Key features of a bond Par value: – Face amount – Repaid at maturity – Assume $1000 for corporate bonds Coupon interest rate: – Stated interest rate – Usually = YTM at issue – Multiply by par value to get coupon payment 6-11 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Key features of a bond (cont.) Maturity: – Years until bond must be repaid Yield to maturity (YTM): – The market required rate of return for bonds of similar risk and maturity – The discount rate used to value a bond – Return if bond held to maturity – Usually = coupon rate at issue – Quoted as an APR 6-12 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond value 6-13 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The bond-pricing equation PV(Annuity) PV(lump sum) C = Coupon payment; F = Face value, r= YTM 6-14 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond pricing—Calculator keys [N]= Number of periods to maturity [I/Y]= Period interest rate = YTM [PV]= Present value = Bond value [PMT]= Coupon payment [FV]= Future value = Face value = Par value 6-15 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Spreadsheet formulas =FV(Rate,Nper,Pmt,PV,0/1) =PV(Rate,Nper,Pmt,FV,0/1) =RATE(Nper,Pmt,PV,FV,0/1) =NPER(Rate,Pmt,PV,FV,0/1) =PMT(Rate,Nper,PV,FV,0/1) Inside parens: (RATE,NPER,PMT,PV,FV,0/1) ‘0/1’ Ordinary annuity = 0 (default) Annuity due = 1 (must be entered) 6-16 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond value ─ Example Barramundi Fishing Co. issue a bond with: – Face value = $1000 – 10 years to maturity – Annual coupon = $80 – Yield to maturity = 8% What would this bond sell for? Bond involves an annuity of $80 in form of coupon for 10 years and $1000 as final payment. Using the formula: – PV of face value =1000/(1.08) 10 = – PV of $80 annuity =80(1-1/ )/0.08 = – Total = = Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond value ─ Example (cont.) Cash flow for Barramundi Co Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Valuing a discount bond with annual coupons Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? – Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.11) 5 ] / / (1.11) 5 B = = $ – Using the calculator: [N] = 5; I/Y = 11; [PMT] = 100; [FV] = 1000 [CPT] [PV] = – Using Excel: =PV(0.11, 5, 100, 1000, 0) 6-19 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Valuing a premium bond with annual coupons Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond? – Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.08) 20 ] / / (1.08) 20 B = = $ – Using the calculator: [N ]= 20; [I/Y] = 8; [PMT]= 100; [FV] = 1000 [CPT][PV] = – Using Excel: =PV(0.08, 20, 100, 1000, 0) 6-20 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Graphical relationship between price and yield-to-maturity 6-21 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond prices: Relationship between coupon and yield If YTM = coupon rate, then par value = bond price. If YTM > coupon rate, then par value > bond price. – Why? – Selling at a discount, called a discount bond. If YTM < coupon rate, then par value < bond price. – Why? – Selling at a premium, called a premium bond Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The bond-pricing equation adjusted for semi-annual coupons C = Annual coupon payment  C/2 = Semi-annual coupon YTM = Annual YTM (as an APR)  YTM/2 = Semi-annual YTM t = Years to maturity  2t = Number of 6-month periods to maturity 6-23 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Semi-annual bonds Example 6.2 Coupon rate = 7% - semi-annual YTM = 8% (APR) Maturity = 7 years – Number of coupon payments? (t or [N]) 14 = 2 x 7 years – Semiannual coupon payment?(C or [PMT]) $35 = (7% x face value)/2 – Semiannual yield? (YTM or[I/Y]) 4% = 8%/ Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Example 6.2 (cont.) Semiannual coupon = $35 Semiannual YTM = 4% Periods to maturity = 14 Bond value = – 35[1 – 1/(1.04) 14 ] / / (1.04) 14 = – Effective Annual Yield= (1+0.04) 2 -1=8.16% Using the calculator: 14 [N] 4 [I/Y] 35 [PMT] 1000 [FV] [CPT][PV] Using Excel: =PV(0.08, 14, 70, 1000, 0) 6-25 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Interest rate risk Price risk – Change in price owing to changes in interest rates. – Long-term bonds have more price risk than short-term bonds. – Low coupon rate bonds have more price risk than high coupon rate bonds Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Interest rate risk (cont.) Reinvestment rate risk – Uncertainty concerning rates at which cash flows can be reinvested. – Short-term bonds have more reinvestment rate risk than long-term bonds. – High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Interest rate risk and time to maturity Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Computing yield to maturity (YTM) Yield-to-maturity is the rate implied by the current bond price. Finding the YTM is a process of trial and error if you do not have a financial calculator, and is similar to the process for finding r with an annuity. With a financial calculator: – Enter[N], [PV], [PMT] and [FV] – Remember the sign convention [PMT] and [FV] need to have the same sign (+) [PV]the opposite sign (-) [CPT][I/Y] 6-29 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

YTM with annual coupons Consider a bond with a 10% annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $ – Will the yield be more or less than 10%? Calculator solution: 15 [N] [+/-][PV] 1000[FV] 100[PMT] [CPT][I/Y] 11%  Result = YTM Spreadsheet solution: – =RATE(15, 100, , 1000, 0) 6-30 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

YTM with semi-annual coupons Suppose a bond with a 10% coupon rate and semi- annual coupons has a face value of $1000, 20 years to maturity and is selling for $ – Is the YTM more or less than 10%? – What is the semi-annual coupon payment? – How many periods are there? 40 [N] [+/-][PV] 1000 [FV] 50 [PMT] [CPT][I/Y]4% YTM = 4%*2 = 8% (Result is doubled to get the annual YTM.) Excel solution =RATE(40, 50, , 1000, 0) = 4% 6-31 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Summary of bond valuation Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Spreadsheet strategies There is a specific formula for finding bond prices on a spreadsheet: – PRICE (Settlement, Maturity, Rate, Yld, Redemption, Frequency, Basis) – YIELD (Settlement, Maturity, Rate, Pr, Redemption, Frequency, Basis) – Settlement and maturity need to be actual dates – The redemption and Pr need to given as % of par value Double-click on the Excel icon for an example 6-33 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Differences between debt and equity Debt Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy Equity Ownership interest Ordinary shareholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm and shareholders have no legal recourse if dividends are not paid An all-equity firm cannot go bankrupt 6-34 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The bond trust deed The trust deed is the written legal agreement between the corporation (the borrower) and its creditors. The document includes: – the basic terms of the bonds – the total amount of bonds issued – a description of property used as security, if applicable – sinking fund provisions – call provisions – details of protective covenants 6-35 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond classifications Registered vs bearer forms Security – Collateral ─ secured by financial securities – Mortgage ─ secured by real property, normally land or buildings – Debentures ─ unsecured – Notes ─ secured debt with original maturity less than 10 years Seniority – Senior versus junior, subordinated Repayment – Sinking fund The call provision Protective covenant – Negative covenant, positive covenant 6-36 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond characteristics and required returns Coupon rate –  (risk characteristics of the bond when issued) – Usually ≈ yield at issue Which bonds will have the higher coupon, all else equal? – Secured debt versus a note – Subordinated note versus senior debt – A bond with a sinking fund versus one without – A callable bond versus a non-callable bond 6-37 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond ratings ─ Investment quality High grade – Moody’s Aaa, Fitch AAA and S&P AAA ─ capacity to pay is extremely strong. – Moody’s Aa, Fitch AA and S&P AA ─ capacity to pay is very strong. Medium grade – Moody’s A, Fitch A and S&P A ─ capacity to pay is strong, but more susceptible to changes in circumstances. – Moody’s Baa, Fitch BBB and S&P BBB ─ capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond ratings—Speculative Low grade – Moody’s Ba, B,Caa and Ca – Fitch BB, B, CCC and CC – S&P BB, B, CCC – Considered speculative with respect to capacity to pay. The ‘B’ ratings are the lowest degree of speculation. Very low grade – Moody’s C, Fitch C and S&P C—income bonds with no interest being paid. – Moody’s D, Fitch DDD, DD and D, and S&P D—in default with principal and interest in arrears Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Government bonds Treasury securities Bank bills—pure discount debt with original maturity of one year or less State government securities Debt of state and local governments Varying degrees of default risk, rated similar to corporate debt 6-40 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Zero coupon bonds Make no periodic interest payments – (coupon rate = 0%) The entire yield-to-maturity comes from the difference between the purchase price and the face value. Cannot sell for more than face value. Sometimes called zeroes, or deep discount bonds. Bank bills are good examples of zeroes Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Floating rate bonds Coupon rate floats depending on some index value. Examples—adjustable rate mortgages and inflation-linked bonds. There is less price risk with floating rate bonds – The coupon floats, so it is less likely to differ substantially from the yield-to-maturity. Coupons may have a ‘collar’—the rate cannot go above a specified ‘ceiling’ or below a specified ‘floor’ Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Other bond types Subordinated bonds Convertible bonds Put bond There are many other types of provisions that can be added to a bond and many bonds have several provisions—it is important to recognise how these provisions affect required returns Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond markets Primarily over-the-counter transactions with dealers connected electronically. Extremely large number of bond issues, but generally low daily volume in single issues. Getting up-to-date prices is difficult, particularly on small company or municipal issues. Treasury securities are an exception Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bond price reporting Corporate bond market associated with Australian Securities Exchange (ASX). Click on information; which leads to Detailed search—prices, charts and announcements section for interest rate and hybrid security prices. The chart gives the buy/bid, sell/ask prices and other figures for corporate bonds Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Treasury quotes Table Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Treasury quotes Example 6.5 In Table 6.3, for bond maturing Feb-2017 – Coupon rate? – Yield to maturity based on ask price (sell price)? – Bond trading at discount? Bond we are looking at: 6.00% Feb – YTM at last sale = 5.25% (Sale price > Face value) – Bond’s years to maturity = 7 (Assume today as 15/02/2010) – Coupon rate = 6% (half yearly) = $3 – YTM = 5.25/2=2.625 – PV=3[1-1/( )14]/ /( )14= The bond maturing in April 2020 is selling at discount Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Work the Web—Example Bond quotes are available online. One good site is Bloomberg.com. Go to Bloomberg’s website. Follow the bond search. Search a bond issue and see what you can find! 6-48 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Inflation and interest rates Real rate of interest—change in purchasing power. Nominal rate of interest—quoted rate of interest, change in purchasing power and inflation. The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The Fisher effect The Fisher effect defines the relationship between real rates, nominal rates and inflation: (1 + R) = (1 + r)(1 + h) R = nominal rate (quoted rate) r = real rate h = expected inflation rate Approximation: R = r + h 6-50 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The Fisher effect Example 6.6 If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? R = (1.1)(1.08) – 1 =.188 = 18.8% Approximation: R = 10% + 8% = 18% Because the real return and expected inflation are relatively high, there is a significant difference between the actual Fisher effect and the approximation Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Determinants of bond yields Term structure of interest rates Term structure is the relationship between time to maturity and yields, all else being equal. It is important to recognise that we pull out the effect of default risk, different coupons, etc. Yield curve—graphical representation of the term structure – Normal—upward-sloping, long-term yields are higher than short-term yields – Inverted—downward-sloping, long-term yields are lower than short-term yields 6-52 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Upward-sloping yield curve— Figure 6.8A 6-53 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Downward-sloping yield curve— Figure 6.8B 6-54 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Government bond yield curve— Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Factors affecting required return Default risk premium—bond ratings. Taxability premium—municipal versus taxable. Liquidity premium—bonds that have more frequent trading will generally have lower required returns. Maturity premium—longer term bonds will tend to have higher required returns. Anything else that affects the risk of the cash flows to the bondholders will affect the required returns Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Quick quiz How do you find the value of a bond and why do bond prices change? What is a bond trust deed and what are some of its important features? What are bond ratings and why are they important? How does inflation affect interest rates? What is the term structure of interest rates? What factors determine the required return on bonds? 6-57 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter 6 END 6-58