1. © 2012 McGrawHill Ryerson Ltd. Chapter 6 -  The coupon rate is the annual interest payment divided by the face value of the bond  The interest rate (or discount rate) is the rate at which the cash flows from the bond are discounted to determine its present value  The coupon rate and the discount rate are NOT necessarily the same! When they are not, the price of the bond is not the same as its face value 1 LO2

2. © 2012 McGrawHill Ryerson Ltd. Chapter 6 -  The price of a bond is the present value of all its future cash flows, that is, it is the present value of the coupon payments and the face value of the bond. In calculating the PV, the ‘appropriate’ opportunity cost has to be used.  Example: Calculate the current price of a 6.5 % annual coupon bond, with a $1,000 face value which matures in 3 years. Assume a required return of 5.1%. ◦ In this case, the first coupon payment is $65 (6.5% of $1,000), the second payment is the same and the third payment is the final payment: a coupon of $65 plus the face value $1,000. 2 LO2

3. © 2012 McGrawHill Ryerson Ltd. Chapter 6 - 0 1 2 $65 3 $1,065 3 LO2

4. © 2012 McGrawHill Ryerson Ltd.  Example Calculate the current price of a 6.5 % annual coupon bond, with a $1,000 face value which matures in 3 years. Assume a required return of 6.5%. 0 1 2 $65 3 $1,065 Chapter 6 -4 LO2

5. © 2012 McGrawHill Ryerson Ltd.  Example Calculate the current price of a 6.5 % annual coupon bond, with a $1,000 face value which matures in 3 years. Assume a required return of 15%. 0 1 2 $65 3 $1,065 Chapter 6 -5 LO2

6. © 2012 McGrawHill Ryerson Ltd Chapter 6 -  From the three examples shown, notice how bond price varies with interest rates. When interest rate goes up, bond price decreases. Coupon RateInterest RatePrice of Bond 6.5% 5.1%$1,038.05 6.5% 6.5%$1,000.00 6.5% 15.0%$ 805.93 6 LO2

7. © 2012 McGrawHill Ryerson Ltd. Chapter 6 -  When the coupon rate is equal to the required return, the bond sells at face value (at par)  When the coupon rate is higher than the required return, the bond sells above face value (at a premium)  When the coupon rate is lower than the required return, the bond sells below face value (at a discount) 7 LO2

8. © 2012 McGrawHill Ryerson Ltd. Chapter 6 -  The relationship between bond price and the discount rate 8 LO2

9. © 2012 McGrawHill Ryerson Ltd. Chapter 6 -  Semi-annual payments: ◦ Semi-annual coupon payments implies that the annual coupon payment is paid in two equal installments, every six months ◦ Thus, the time line must be in six-month periods ◦ And, you need to compute the six-month required return  Example: Calculate the current price of a 6.5 % semi-annual coupon bond, with a $1,000 face value which matures in 3 years. Assume a required return of 6% 9 LO2

10. © 2012 McGrawHill Ryerson Ltd. Chapter 6 - 0 2 4 $32.50 6 1 3 5 $1,032.50 10 LO2