1. Chapter 5 Fundamentals of Corporate Finance Fourth Edition Valuing Bonds Slides by Matthew Will McGraw Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved

2. 5- 2 McGraw Hill/Irwin Topics Covered  Bond Characteristics  reading the financial pages  Bond Prices and Yields  Bond prices and interest rates  YTM vs. current yield  Rate of Return  Interest Rate Risk  The Yield Curve  Nominal and Real Rates of Interest  Default Risk  Variations in Corporate Bonds

3. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 3 McGraw Hill/Irwin 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 Maturity Value) - Payment at the maturity of the bond.  Coupon Rate - Annual interest payment, as a percentage of face value.

4. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 4 McGraw Hill/Irwin Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations.

5. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 5 McGraw Hill/Irwin 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.

6. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 6 McGraw Hill/Irwin 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.

7. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 7 McGraw Hill/Irwin Bond Pricing Example What is the price of a 6.5 % annual coupon bond, with a $1,000 face value, which matures in 3 years? Assume a required return of 3.9%.

8. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 8 McGraw Hill/Irwin Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 6.5 %?

9. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 9 McGraw Hill/Irwin Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 15 %?

10. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 10 McGraw Hill/Irwin Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 6.0% AND the coupons are paid semi-annually?

11. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 11 McGraw Hill/Irwin Bond Pricing Example (continued) Q: How did the calculation change, given semi- annual coupons versus annual coupon payments?

12. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 12 McGraw Hill/Irwin 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.

13. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 13 McGraw Hill/Irwin 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.

14. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 14 McGraw Hill/Irwin 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.

15. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 15 McGraw Hill/Irwin Bond Yields Example What is the YTM of a 6.5 % annual coupon bond, with a $1,000 face value, which matures in 3 years? The market price of the bond is $1,072.29.

16. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 16 McGraw Hill/Irwin 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.

17. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 17 McGraw Hill/Irwin Bond Yields Rate of Return - Earnings per period per dollar invested.

18. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 18 McGraw Hill/Irwin Bond Valuation Spreadsheet Esc and Double click on spreadsheet to access

19. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 19 McGraw Hill/Irwin Bond Yield Spreadsheet Esc and Double click on spreadsheet to access

20. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 20 McGraw Hill/Irwin Interest Rate Risk Price path for Premium Bond Price path for Discount Bond Today Maturity

21. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 21 McGraw Hill/Irwin Interest Rate Risk 30 yr bond 3 yr bond When the interest rate equals the 6.5% coupon rate, both bonds sell at face value

22. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 22 McGraw Hill/Irwin Nominal and Real rates Yield on UK nominal bonds Yield on UK indexed bonds

23. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 23 McGraw Hill/Irwin Default Risk  Credit risk  Default premium  Investment grade  Junk bonds

24. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 24 McGraw Hill/Irwin Default Risk

25. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 25 McGraw Hill/Irwin Corporate Bonds  Zero coupons  Floating rate bonds  Convertible bonds

26. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 26 McGraw Hill/Irwin 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.

27. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved 5- 27 McGraw Hill/Irwin Web Resources www.investinginbonds.com www.moodys.com/cust/default.asp www.standardandpoor.com http://gozips.uakron.edu/~drd/ratings.html www.smartmoney.com/bonds www.ustreas.gov www.ustreas.gov/offices/domestic-finance/debt-management/interest- rate/index.html www.bondmarkets.com www.publicdebt.treas.gov/sec/sec.htm www.bondsonline.com/asp/research/glossary.asp Click to access web sites Internet connection required