. 1
( 2)



>>

Chapter Across the Disciplines


6
Why This Chapter Matters To You
Accounting: You need to understand
interest rates and the various types of
bonds in order to be able to account prop-
erly for amortization of bond premiums
and discounts and for bond purchases and

Interest Rates retirements.
Information systems: You need to under-
stand the data that you will need to track
and Bond in bond amortization schedules and bond
valuation.


Valuation Management: You need to understand the
behavior of interest rates and how they
will affect the types of funds the firm can
raise and the timing and cost of bond
issues and retirements.
Marketing: You need to understand how
the interest rate level and the firm™s ability
to issue bonds may affect the availability
of financing for marketing research proj-
LEARNING GOALS ects and new-product development.
Describe interest rate fundamentals, Operations: You need to understand how
LG2
the term structure of interest rates, the interest rate level may affect the firm™s
and risk premiums. ability to raise funds to maintain and
increase the firm™s production capacity.
Review the legal aspects of bond
LG2
financing and bond cost.
Discuss the general features,
LG3
quotations, ratings, popular types, and
international issues of corporate
bonds.
Understand the key inputs and basic
LG4
model used in the valuation process.
Apply the basic valuation model to
LG5
bonds and describe the impact of
required return and time to maturity
on bond values.
Explain yield to maturity (YTM), its
LG6
calculation, and the procedure used
to value bonds that pay interest
semiannually.




228
229
CHAPTER 6 Interest Rates and Bond Valuation



T he interactions of suppliers and demanders of funds in the financial markets
affect interest rates. The interest rates (returns) required by suppliers of funds
also depend on the perceived risk of an asset. In this chapter, we apply the con-
cepts of risk and return in a process called valuation. This chapter discusses inter-
est rates, describes the key aspects of corporate bonds, and demonstrates the val-
uation process for the easiest financial asset to value, bonds.




Interest Rates and Required Returns
LG2


As noted in Chapter 1, financial institutions and markets create the mechanism
through which funds flow between savers (funds suppliers) and investors (funds
demanders). The level of funds flow between suppliers and demanders can signifi-
cantly affect economic growth. Growth results from the interaction of a variety of
economic factors (such as the money supply, trade balances, and economic poli-
cies) that affect the cost of money”the interest rate or required return. The interest
rate level acts as a regulating device that controls the flow of funds between suppli-
ers and demanders. The Board of Governors of the Federal Reserve System regu-
larly assesses economic conditions and, when necessary, initiates actions to raise or
lower interest rates to control inflation and economic growth. Generally, the lower
the interest rate, the greater the funds flow and therefore the greater the economic
growth; the higher the interest rate, the lower the funds flow and economic growth.
interest rate
The compensation paid by the
borrower of funds to the lender;
Interest Rate Fundamentals
from the borrower™s point of
view, the cost of borrowing
The interest rate or required return represents the cost of money. It is the com-
funds.
pensation that a demander of funds must pay a supplier. When funds are lent, the
required return
cost of borrowing the funds is the interest rate. When funds are obtained by sell-
The cost of funds obtained by
ing an ownership interest”as in the sale of stock”the cost to the issuer (deman-
selling an ownership interest; it
der) is commonly called the required return, which reflects the funds supplier™s
reflects the funds supplier™s level
of expected return. level of expected return. In both cases the supplier is compensated for providing
funds. Ignoring risk factors, the cost of funds results from the real rate of interest
liquidity preferences
adjusted for inflationary expectations and liquidity preferences”general prefer-
General preferences of investors
for shorter-term securities. ences of investors for shorter-term securities.
real rate of interest
The rate that creates an equilib-
The Real Rate of Interest
rium between the supply of
savings and the demand for
Assume a perfect world in which there is no inflation and in which funds suppliers
investment funds in a perfect
world, without inflation, where and demanders are indifferent to the term of loans or investments because they
funds suppliers and demanders
have no liquidity preference and all outcomes are certain.1 At any given point in
are indifferent to the term of
time in that perfect world, there would be one cost of money”the real rate of
loans or investments and have no
interest. The real rate of interest creates an equilibrium between the supply of sav-
liquidity preference, and where
ings and the demand for investment funds. It represents the most basic cost of
all outcomes are certain.




1. These assumptions are made to describe the most basic interest rate, the real rate of interest. Subsequent discus-
sions relax these assumptions to develop the broader concept of the interest rate and required return.
230 PART 2 Important Financial Concepts


FIGURE 6.1
D
Supply“Demand




Real Rate of Interest
S0
Relationship
Supply of savings and
S1
demand for investment funds
k*
0

k*
1
S0

S1
D


S0 = D S1 = D
Funds Supplied/Demanded




money. The real rate of interest in the United States is assumed to be stable and
equal to around 1 percent.2 This supply“demand relationship is shown in Figure
6.1 by the supply function (labeled S0) and the demand function (labeled D). An
equilibrium between the supply of funds and the demand for funds (S0 D)
occurs at a rate of interest k0 , the real rate of interest.
*

Clearly, the real rate of interest changes with changing economic conditions,
tastes, and preferences. A trade surplus could result in an increased supply of
funds, causing the supply function in Figure 6.1 to shift to, say, S1. This could
result in a lower real rate of interest, k1 , at equilibrium (S1 D). Likewise, a
*

change in tax laws or other factors could affect the demand for funds, causing the
real rate of interest to rise or fall to a new equilibrium level.


Inflation and the Cost of Money
Ignoring risk factors, the cost of funds”the interest rate or required return”is
closely tied to inflationary expectations. This can be demonstrated by using the
risk-free rate of interest, RF, which was defined in Chapter 5 as the required
risk-free rate of interest, RF
The required return on a risk-free return on the risk-free asset. The risk-free asset is typically considered to be a 3-
asset, typically a 3-month U.S.
month U.S. Treasury bill (T-bill), which is a short-term IOU issued regularly by
Treasury bill.
the U.S. Treasury. Figure 6.2 illustrates the movement of the rate of inflation and
the risk-free rate of interest during the period 1978“2001. During this period the
two rates tended to move in a similar fashion. Between 1978 and the early 1980s,
inflation and interest rates were quite high, peaking at over 13 percent in
1980“1981. Since 1981 these rates have declined. The historical data clearly
illustrate the significant impact of inflation on the actual rate of interest for the
risk-free asset.



2. Data in Stocks, Bonds, Bills and Inflation, 2001 Yearbook (Chicago: Ibbotson Associates, Inc., 2001), show that
over the period 1926“2000, U.S. Treasury bills provided an average annual real rate of return of about 0.7 percent.
Because of certain major economic events that occurred during the 1926“2000 period, many economists believe that
the real rate of interest during recent years has been about 1 percent.
231
CHAPTER 6 Interest Rates and Bond Valuation


FIGURE 6.2
15
Impact of Inflation
Relationship between annual




Annual Rate (%)
rate of inflation and 3-month
10
U.S. Treasury bill average
T-billsa
annual returns, 1978“2001

5

Inflationb


1993 1998 2001
1978 1983 1988
Year
a Average annual rate of return on 3-month U.S. Treasury bills.
b Annual pecentage change in the consumer price index.

Source: Data from selected Federal Reserve Bulletins.



term structure
of interest rates
The relationship between the
Term Structure of Interest Rates
interest rate or rate of return and
the time to maturity.
For any class of similar-risk securities, the term structure of interest rates relates
the interest rate or rate of return to the time to maturity. For convenience we will
yield to maturity
Annual rate of return earned on a use Treasury securities as an example, but other classes could include securities
debt security purchased on a
that have similar overall quality or risk. The riskless nature of Treasury securities
given day and held to maturity.
also provides a laboratory in which to develop the term structure.
yield curve
A graph of the relationship
between the debt™s remaining
Yield Curves
time to maturity (x axis) and its
yield to maturity (y axis); it
A debt security™s yield to maturity (discussed later in this chapter) represents the
shows the pattern of annual
annual rate of return earned on a security purchased on a given day and held to
returns on debts of equal quality
maturity. At any point in time, the relationship between the debt™s remaining
and different maturities.
time to maturity and its yield to maturity is represented by the yield curve. The
Graphically depicts the term
structure of interest rates. yield curve shows the yield to maturity for debts of equal quality and different
maturities; it is a graphical depiction of the term structure of interest rates. Fig-
inverted yield curve
ure 6.3 shows three yield curves for all U.S. Treasury securities: one at May 22,
A downward-sloping yield curve
1981, a second at September 29, 1989, and a third at March 15, 2002. Note
that indicates generally cheaper
long-term borrowing costs than that both the position and the shape of the yield curves change over time. The
short-term borrowing costs.
yield curve of May 22, 1981, indicates that short-term interest rates at that time
were above longer-term rates. This curve is described as downward-sloping,
normal yield curve
An upward-sloping yield curve reflecting long-term borrowing costs generally cheaper than short-term borrow-
that indicates generally cheaper
ing costs. Historically, the downward-sloping yield curve, which is often called
short-term borrowing costs than
an inverted yield curve, has been the exception. More frequently, yield curves
long-term borrowing costs.
similar to that of March 15, 2002, have existed. These upward-sloping or
flat yield curve
normal yield curves indicate that short-term borrowing costs are below long-
A yield curve that reflects
term borrowing costs. Sometimes, a flat yield curve, similar to that of September
relatively similar borrowing
29, 1989, exists. It reflects relatively similar borrowing costs for both short- and
costs for both short- and longer-
longer-term loans.
term loans.
232 PART 2 Important Financial Concepts


FIGURE 6.3




Yield (annual rate of interest, %)
18
Treasury Yield Curves
16
Yield curves for U.S. Treasury May 22, 1981
14
securities: May 22, 1981;
12
September 29, 1989; and
March 15, 2002 10
September 29, 1989
8
6
March 15, 2002
4
2
0
5 10 15 20 25 30
Time of Maturity (years)
Sources: Data from Federal Reserve Bulletins (June 1981), p. A25 and (December 1989), p. A24;
and U.S. Financial Data, Federal Reserve Bank of St. Louis (March 14, 2002), p. 7.




The shape of the yield curve may affect the firm™s financing decisions. A
financial manager who faces a downward-sloping yield curve is likely to rely more
heavily on cheaper, long-term financing; when the yield curve is upward-sloping,
the manager is more likely to use cheaper, short-term financing. Although a vari-
ety of other factors also influence the choice of loan maturity, the shape of the
yield curve provides useful insights into future interest rate expectations.


Theories of Term Structure
Three theories are frequently cited to explain the general shape of the yield curve.
They are the expectations theory, liquidity preference theory, and market seg-
expectations theory
mentation theory.
The theory that the yield curve
reflects investor expectations
Expectations Theory One theory of the term structure of interest rates, the
about future interest rates; an
expectations theory, suggests that the yield curve reflects investor expectations
increasing inflation expectation
about future interest rates and inflation. Higher future rates of expected inflation
results in an upward-sloping
yield curve, and a decreasing will result in higher long-term interest rates; the opposite occurs with lower
inflation expectation results in a
future rates. This widely accepted explanation of the term structure can be
downward-sloping yield curve
applied to the securities of any issuer.
liquidity preference theory Generally, under the expectations theory, an increasing inflation expectation
Theory suggesting that for any
results in an upward-sloping yield curve; a decreasing inflation expectation results
given issuer, long-term interest
in a downward-sloping yield curve; and a stable inflation expectation results in a
rates tend to be higher than
flat yield curve. Although, as we™ll see, other theories exist, the observed strong
short-term rates because
relationship between inflation and interest rates (see Figure 6.2) supports this
(1) lower liquidity and higher
responsiveness to general widely accepted theory.
interest rate movements of
longer-term securities exists and Liquidity Preference Theory The tendency for yield curves to be upward-
(2) borrower willingness to pay a
sloping can be further explained by liquidity preference theory. This theory holds
higher rate for long-term financ-
that for a given issuer, such as the U.S. Treasury, long-term rates tend to be
ing; causes the yield curve to be
higher than short-term rates. This belief is based on two behavioral facts:
upward-sloping.
233
CHAPTER 6 Interest Rates and Bond Valuation


1. Investors perceive less risk in short-term securities than in longer-term securi-
ties and are therefore willing to accept lower yields on them. The reason is
that shorter-term securities are more liquid and less responsive to general
interest rate movements.3
2. Borrowers are generally willing to pay a higher rate for long-term than for
short-term financing. By locking in funds for a longer period of time, they
can eliminate the potential adverse consequences of having to roll over short-
term debt at unknown costs to obtain long-term financing.

Investors (lenders) tend to require a premium for tying up funds for longer
periods, whereas borrowers are generally willing to pay a premium to obtain
longer-term financing. These preferences of lenders and borrowers cause the yield
curve to tend to be upward-sloping. Simply stated, longer maturities tend to have
higher interest rates than shorter maturities.

Market Segmentation Theory The market segmentation theory suggests
market segmentation theory
Theory suggesting that the that the market for loans is segmented on the basis of maturity and that the sup-
market for loans is segmented on
ply of and demand for loans within each segment determine its prevailing interest
the basis of maturity and that the
rate. In other words, the equilibrium between suppliers and demanders of short-
supply of and demand for loans
term funds, such as seasonal business loans, would determine prevailing short-
within each segment determine
term interest rates, and the equilibrium between suppliers and demanders of
its prevailing interest rate; the
slope of the yield curve is long-term funds, such as real estate loans, would determine prevailing long-term
determined by the general
interest rates. The slope of the yield curve would be determined by the general
relationship between the prevail-
relationship between the prevailing rates in each market segment. Simply stated,
ing rates in each segment.
low rates in the short-term segment and high rates in the long-term segment cause
the yield curve to be upward-sloping. The opposite occurs for high short-term
rates and low long-term rates.

All three theories of term structure have merit. From them we can conclude
that at any time, the slope of the yield curve is affected by (1) inflationary expec-
tations, (2) liquidity preferences, and (3) the comparative equilibrium of supply
and demand in the short- and long-term market segments. Upward-sloping yield
curves result from higher future inflation expectations, lender preferences for
shorter-maturity loans, and greater supply of short-term loans than of long-term
loans relative to demand. The opposite behaviors would result in a downward-
sloping yield curve. At any time, the interaction of these three forces determines
the prevailing slope of the yield curve.


Risk Premiums: Issuer and Issue Characteristics
So far we have considered only risk-free U.S. Treasury securities. We now add the
risk premium
The amount by which the interest element of risk, in order to assess what effect it has on the cost of funds. The
rate or required return on a
amount by which the interest rate or required return exceeds the risk-free rate of
security exceeds the risk-free
interest, RF, is a security™s risk premium. The risk premium varies with specific
rate of interest, RF; it varies
issuer and issue characteristics. It causes securities that have similar maturities to
with specific issuer and issue
have differing rates of interest.
characteristics.



3. Later in this chapter we demonstrate that debt instruments with longer maturities are more sensitive to changing
market interest rates. For a given change in market rates, the price or value of longer-term debts will be more signif-
icantly changed (up or down) than the price or value of debts with shorter maturities.
234 PART 2 Important Financial Concepts


TABLE 6.1 Debt-Specific Issuer- and Issue-Related Risk
Premium Components

Component Description

Default risk The possibility that the issuer of debt will not pay the contrac-
tual interest or principal as scheduled. The greater the uncer-
tainty as to the borrower™s ability to meet these payments, the
greater the risk premium. High bond ratings reflect low
default risk, and low bond ratings reflect high default risk.
Maturity risk The fact that the longer the maturity, the more the value of a
security will change in response to a given change in interest
rates. If interest rates on otherwise similar-risk securities sud-
denly rise as a result of a change in the money supply, the
prices of long-term bonds will decline by more than the prices
of short-term bonds, and vice versa.a

Contractual provision risk Conditions that are often included in a debt agreement or a
stock issue. Some of these reduce risk, whereas others may
increase risk. For example, a provision allowing a bond issuer
to retire its bonds prior to their maturity under favorable
terms increases the bond™s risk.
aA detailed discussion of the effects of interest rates on the price or value of bonds and other fixed-income
securities is presented later in this chapter.




The risk premium consists of a number of issuer- and issue-related compo-
nents, including interest rate risk, liquidity risk, and tax risk, which were defined
in Table 5.1 on page 191, and the purely debt-specific risks”default risk, matu-
rity risk, and contractual provision risk, briefly defined in Table 6.1. In general,
the highest risk premiums and therefore the highest returns result from securities
issued by firms with a high risk of default and from long-term maturities that
have unfavorable contractual provisions.


Review Questions

6“1 What is the real rate of interest? Differentiate it from the risk-free rate of
interest for a 3-month U.S. Treasury bill.
6“2 What is the term structure of interest rates, and how is it related to the
yield curve?
6“3 For a given class of similar-risk securities, what does each of the following
yield curves reflect about interest rates: (a) downward-sloping; (b) upward-
sloping; and (c) flat? Which form has been historically dominant?
6“4 Briefly describe the following theories of the general shape of the yield
curve: (a) expectations theory; (b) liquidity preference theory; and (c) mar-
ket segmentation theory.
6“5 List and briefly describe the potential issuer- and issue-related risk compo-
nents that are embodied in the risk premium. Which are the purely debt-
specific risks?
235
CHAPTER 6 Interest Rates and Bond Valuation


Corporate Bonds
LG2 LG3

A corporate bond is a long-term debt instrument indicating that a corporation has
corporate bond
A long-term debt instrument borrowed a certain amount of money and promises to repay it in the future under
indicating that a corporation has
clearly defined terms. Most bonds are issued with maturities of 10 to 30 years and
borrowed a certain amount of
with a par value, or face value, of $1,000. The coupon interest rate on a bond rep-
money and promises to repay it in
resents the percentage of the bond™s par value that will be paid annually, typically
the future under clearly defined
in two equal semiannual payments, as interest. The bondholders, who are the
terms.
lenders, are promised the semiannual interest payments and, at maturity, repay-
coupon interest rate
ment of the principal amount.
The percentage of a bond™s par
value that will be paid annually,
typically in two equal semian-
nual payments, as interest.
Legal Aspects of Corporate Bonds
Certain legal arrangements are required to protect purchasers of bonds. Bond-
holders are protected primarily through the indenture and the trustee.

Bond Indenture
A bond indenture is a legal document that specifies both the rights of the bond-
bond indenture
A legal document that specifies holders and the duties of the issuing corporation. Included in the indenture are
both the rights of the bondhold-
descriptions of the amount and timing of all interest and principal payments, var-
ers and the duties of the issuing
ious standard and restrictive provisions, and, frequently, sinking-fund require-
corporation.
ments and security interest provisions.

Standard Provisions The standard debt provisions in the bond indenture
standard debt provisions
Provisions in a bond indenture specify certain record-keeping and general business practices that the bond issuer
specifying certain record- must follow. Standard debt provisions do not normally place a burden on a
keeping and general business
financially sound business.
practices that the bond issuer
The borrower commonly must (1) maintain satisfactory accounting records
must follow; normally, they do
in accordance with generally accepted accounting principles (GAAP); (2) periodi-
not place a burden on a
financially sound business. cally supply audited financial statements; (3) pay taxes and other liabilities when
due; and (4) maintain all facilities in good working order.

Restrictive Provisions Bond indentures also normally include certain
restrictive covenants, which place operating and financial constraints on the
restrictive covenants
Provisions in a bond indenture borrower. These provisions help protect the bondholder against increases in bor-
that place operating and rower risk. Without them, the borrower could increase the firm™s risk but not
financial constraints on the
have to pay increased interest to compensate for the increased risk.
borrower.
The most common restrictive covenants do the following:

1. Require a minimum level of liquidity, to ensure against loan default.
2. Prohibit the sale of accounts receivable to generate cash. Selling receivables
could cause a long-run cash shortage if proceeds were used to meet current
obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a specified level
of fixed assets to guarantee its ability to repay the bonds.
4. Constrain subsequent borrowing. Additional long-term debt may be prohib-
ited, or additional borrowing may be subordinated to the original loan.
236 PART 2 Important Financial Concepts


Subordination means that subsequent creditors agree to wait until all claims
subordination
In a bond indenture, the stipula- of the senior debt are satisfied.
tion that subsequent creditors 5. Limit the firm™s annual cash dividend payments to a specified percentage or
agree to wait until all claims of
amount.
the senior debt are satisfied.

Other restrictive covenants are sometimes included in bond indentures.

The violation of any standard or restrictive provision by the borrower gives
the bondholders the right to demand immediate repayment of the debt. Gener-
ally, bondholders evaluate any violation to determine whether it jeopardizes the
loan. They may then decide to demand immediate repayment, continue the loan,
or alter the terms of the bond indenture.

Sinking-Fund Requirements Another common restrictive provision is a
sinking-fund requirement. Its objective is to provide for the systematic retirement
sinking-fund requirement
A restrictive provision often of bonds prior to their maturity. To carry out this requirement, the corporation
included in a bond indenture, makes semiannual or annual payments that are used to retire bonds by purchas-
providing for the systematic
ing them in the marketplace.
retirement of bonds prior to their
maturity.
Security Interest The bond indenture identifies any collateral pledged
against the bond and specifies how it is to be maintained. The protection of bond
collateral is crucial to guarantee the safety of a bond issue.

Trustee
A trustee is a third party to a bond indenture. The trustee can be an individual, a
trustee
corporation, or (most often) a commercial bank trust department. The trustee is
A paid individual, corporation, or
commercial bank trust depart- paid to act as a “watchdog” on behalf of the bondholders and can take specified
ment that acts as the third party
actions on behalf of the bondholders if the terms of the indenture are violated.
to a bond indenture and can take
specified actions on behalf of the
bondholders if the terms of the
Cost of Bonds to the Issuer
indenture are violated.

The cost of bond financing is generally greater than the issuer would have to pay
for short-term borrowing. The major factors that affect the cost, which is the rate
of interest paid by the bond issuer, are the bond™s maturity, the size of the offer-
ing, the issuer™s risk, and the basic cost of money.

Impact of Bond Maturity on Bond Cost
Generally, as we noted earlier, long-term debt pays higher interest rates than
short-term debt. In a practical sense, the longer the maturity of a bond, the less
accuracy there is in predicting future interest rates, and therefore the greater the
bondholders™ risk of giving up an opportunity to lend money at a higher rate. In
addition, the longer the term, the greater the chance that the issuer might default.

Impact of Offering Size on Bond Cost
The size of the bond offering also affects the interest cost of borrowing, but in
an inverse manner: Bond flotation and administration costs per dollar borrowed
are likely to decrease with increasing offering size. On the other hand, the risk to
237
CHAPTER 6 Interest Rates and Bond Valuation



In Practice
FOCUS ON PRACTICE Ford Cruises the Debt Markets
Ford and Ford Motor Credit Co. maturities remained attractively one rating class. The lower ratings
(FMCC), its finance unit, were fre- low for corporations. Unlike some contributed to the higher yields on
quent visitors to the corporate other auto companies who limited Ford™s October debt. For example,
debt markets in 2001, selling over the size of their debt offerings, in April FMCC™s 10-year notes
$22 billion in long-term notes and FMCC decided to borrow as much yielded 7.1 percent, about 2 points
bonds. Despite the problems in as possible to lock in the very wide above U.S. Treasury bonds. In
the auto industry, investors ner- spread between its lower borrow- October, 10-year FMCC notes
vous about stock market volatility ing costs and what its auto loans yielded 7.3 percent, or 2.7 points
were willing to accept the credit yielded. above U.S. Treasury bonds.
risk to get higher yields. The com- All this debt came at a price, For corporations like Ford,
pany™s 2001 offerings had some- however. Both major bond-rating deciding when to issue debt and
thing for all types of investors, agencies”Moody™s Investors selecting the best maturities
ranging from 2- to 10-year notes Service and Standard & Poor™s requires knowledge of interest
to 30-year bonds. Demand for (S&P)”downgraded Ford™s debt rate fundamentals, risk premiums,
Ford™s debt was so high that in quality ratings in October 2001. issuance costs, ratings, and simi-
January the company increased Moody™s lowered Ford™s long-term lar features of corporate bonds.
the size of its issue from $5 billion debt rating by one rating class but
to $7.8 billion, and October™s plan did not change FMCC™s quality rat- Sources: Adapted from Jonathan Stempel,
to issue $3 billion turned into a ing. Ford spokesman Todd Nissen “˜Buy My Product, Buy My Bonds,™ U.S.Com-
panies Say,” Reuters, April 10, 2001, “Ford
$9.4 billion offering. was pleased that Moody™s con-
Sells $9.4 Bln Bonds, Offers Big Yields,
The world™s second largest firmed the FMCC ratings. “It will Reuters, October 22, 2001, and “Moodys Cuts
auto manufacturer joined other help us keep our costs of borrow- Ford, but Not Ford Credit, Ratings,” Reuters
Business Report, October 18, 2001, all down-
corporate bond issuers to take ing down, which benefits Ford loaded from eLibrary, ask.elibrary.com; Ed
advantage of strengthening bond Credit and ultimately Ford Motor,” Zwirn, “Ford to Issue $7.8 Billion and Count-
ing,” CFO.com, January 24, 2001, and “Full
markets. Even though the Federal he said. S&P™s outlook for Ford
Speed Ahead for Auto Bonds,” CFO.com,
Reserve began cutting short-term was more negative; the agency cut January 19, 2001, both downloaded from
rates, interest rates for the longer ratings on all Ford and FMCC debt www. cfo.com.




the bondholders may increase, because larger offerings result in greater risk of
default.

Impact of Issuer™s Risk
The greater the issuer™s default risk, the higher the interest rate. Some of this risk
can be reduced through inclusion of appropriate restrictive provisions in the
bond indenture. Clearly, bondholders must be compensated with higher returns
for taking greater risk. Frequently, bond buyers rely on bond ratings (discussed
later) to determine the issuer™s overall risk.

Impact of the Cost of Money
The cost of money in the capital market is the basis for determining a bond™s
coupon interest rate. Generally, the rate on U.S. Treasury securities of equal
maturity is used as the lowest-risk cost of money. To that basic rate is added a
risk premium (as described earlier in this chapter) that reflects the factors men-
tioned above (maturity, offering size, and issuer™s risk).
238 PART 2 Important Financial Concepts


General Features of a Bond Issue
Three features sometimes included in a corporate bond issue are a conversion fea-
ture, a call feature, and stock purchase warrants. These features provide the
issuer or the purchaser with certain opportunities for replacing or retiring the
bond or supplementing it with some type of equity issue.
Convertible bonds offer a conversion feature that allows bondholders to
conversion feature
A feature of convertible bonds change each bond into a stated number of shares of common stock. Bondholders
that allows bondholders to convert their bonds into stock only when the market price of the stock is such
change each bond into a stated
that conversion will provide a profit for the bondholder. Inclusion of the conver-
number of shares of common
sion feature by the issuer lowers the interest cost and provides for automatic con-
stock.
version of the bonds to stock if future stock prices appreciate noticeably.
The call feature is included in nearly all corporate bond issues. It gives the
call feature
A feature included in nearly all issuer the opportunity to repurchase bonds prior to maturity. The call price is the
corporate bond issues that gives stated price at which bonds may be repurchased prior to maturity. Sometimes the
the issuer the opportunity to
call feature can be exercised only during a certain period. As a rule, the call price
repurchase bonds at a stated
exceeds the par value of a bond by an amount equal to 1 year™s interest. For
call price prior to maturity.
example, a $1,000 bond with a 10 percent coupon interest rate would be callable
call price
for around $1,100 [$1,000 (10% $1,000)]. The amount by which the call
The stated price at which a bond
price exceeds the bond™s par value is commonly referred to as the call premium.
may be repurchased, by use of a
This premium compensates bondholders for having the bond called away from
call feature, prior to maturity.
them; to the issuer, it is the cost of calling the bonds.
call premium
The call feature enables an issuer to call an outstanding bond when interest
The amount by which a bond™s
rates fall and issue a new bond at a lower interest rate. When interest rates rise,
call price exceeds its par value.
the call privilege will not be exercised, except possibly to meet sinking-fund
requirements. Of course, to sell a callable bond in the first place, the issuer must
pay a higher interest rate than on noncallable bonds of equal risk, to compensate
bondholders for the risk of having the bonds called away from them.
Bonds occasionally have stock purchase warrants attached as “sweeteners”
stock purchase warrants
Instruments that give their to make them more attractive to prospective buyers. Stock purchase warrants are
holders the right to purchase a instruments that give their holders the right to purchase a certain number of
certain number of shares of the
shares of the issuer™s common stock at a specified price over a certain period of
issuer™s common stock at a
time. Their inclusion typically enables the issuer to pay a slightly lower coupon
specified price over a certain
interest rate than would otherwise be required.
period of time.



Interpreting Bond Quotations
The financial manager needs to stay abreast of the market values of the firm™s
outstanding securities, whether they are traded on an organized exchange, over
the counter, or in international markets. Similarly, existing and prospective
investors in the firm™s securities need to monitor the prices of the securities they
own because these prices represent the current value of their investment. Infor-
mation on bonds, stocks, and other securities is contained in quotations, which
quotations
Information on bonds, stocks, include current price data along with statistics on recent price behavior. Security
and other securities, including
price quotations are readily available for actively traded bonds and stocks. The
current price data and statistics
most up-to-date “quotes” can be obtained electronically, via a personal com-
on recent price behavior.
puter. Price information is available from stockbrokers and is widely published in
news media. Popular sources of daily security price quotations include financial
newspapers, such as the Wall Street Journal and Investor™s Business Daily, and
239
CHAPTER 6 Interest Rates and Bond Valuation


FIGURE 6.4
Bond Quotations
Selected bond quotations for
April 22, 2002

IBM




Source: Wall Street Journal, April 23,
2002, p. C14.



the business sections of daily general newspapers. Here we focus on bond quota-
tions; stock quotations are reviewed in Chapter 7.
Figure 6.4 includes an excerpt from the New York Stock Exchange (NYSE)
bond quotations reported in the April 23, 2002, Wall Street Journal for trans-
actions through the close of trading on Monday, April 22, 2002. We™ll look at the
corporate bond quotation for IBM, which is highlighted in Figure 6.4. The
numbers following the company name”IBM”represent the bond™s coupon inter-
est rate and the year it matures: “7s25” means that the bond has a stated coupon
interest rate of 7 percent and matures sometime in the year 2025. This information
allows investors to differentiate between the various bonds issued by the corpora-
tion. Note that on the day of this quote, IBM had four bonds listed. The next col-
umn, labeled “Cur Yld.,” gives the bond™s current yield, which is found by dividing
its annual coupon (7%, or 7.000%) by its closing price (100.25), which in this case
turns out to be 7.0 percent (7.000 100.25 0.0698 7.0%).
The “Vol” column indicates the actual number of bonds that traded on the
given day; 10 IBM bonds traded on Monday, April 22, 2002. The final two
columns include price information”the closing price and the net change in clos-
ing price from the prior trading day. Although most corporate bonds are issued
240 PART 2 Important Financial Concepts


with a par, or face, value of $1,000, all bonds are quoted as a percentage of par.
A $1,000-par-value bond quoted at 110.38 is priced at $1,103.80 (110.38%
$1,000). Corporate bonds are quoted in dollars and cents. Thus IBM™s closing
price of 100.25 for the day was $1,002.50”that is, 100.25% $1,000. Because
a “Net Chg.” of 1.75 is given in the final column, the bond must have closed at
102 or $1,020 (102.00% $1,000) on the prior day. Its price decreased by 1.75,
or $17.50 (1.75% $1,000), on Tuesday, April 22, 2002. Additional informa-
tion may be included in a bond quotation, but these are the basic elements.



Bond Ratings
Independent agencies such as Moody™s and Standard & Poor™s assess the riski-
ness of publicly traded bond issues. These agencies derive the ratings by using
financial ratio and cash flow analyses to assess the likely payment of bond inter-
est and principal. Table 6.2 summarizes these ratings. Normally an inverse rela-
tionship exists between the quality of a bond and the rate of return that it must
provide bondholders: High-quality (high-rated) bonds provide lower returns
than lower-quality (low-rated) bonds. This reflects the lender™s risk-return trade-
off. When considering bond financing, the financial manager must be concerned
with the expected ratings of the bond issue, because these ratings affect salability
and cost.




TABLE 6.2 Moody™s and Standard & Poor™s Bond
Ratingsa

Standard
Moody™s Interpretation & Poor™s Interpretation

Aaa Prime quality AAA Bank investment quality
Aa High grade AA

A Upper medium grade A
Baa Medium grade BBB

Ba Lower medium grade BB Speculative
or speculative B
B Speculative

Caa From very speculative CCC
Ca to near or in default CC
C Lowest grade C Income bond
D In default
aSome ratings may be modified to show relative standing within a major rating category; for exam-
ple, Moody™s uses numerical modifiers (1, 2, 3), whereas Standard & Poor™s uses plus ( ) and
minus ( ) signs.
Sources: Moody™s Investors Service, Inc. and Standard & Poor™s Corporation.
241
CHAPTER 6 Interest Rates and Bond Valuation


TABLE 6.3 Characteristics and Priority of Lender™s Claim of Traditional
Types of Bonds

Bond type Characteristics Priority of lender™s claim

Unsecured Bonds
Debentures Unsecured bonds that only creditworthy firms Claims are the same as those of any general
can issue. Convertible bonds are normally creditor. May have other unsecured bonds
debentures. subordinated to them.
Subordinated Claims are not satisfied until those of the Claim is that of a general creditor but not as good
debentures creditors holding certain (senior) debts have been as a senior debt claim.
fully satisfied.
Income bonds Payment of interest is required only when Claim is that of a general creditor. Are not in
earnings are available. Commonly default when interest payments are missed,
issued in reorganization of a failing firm. because they are contingent only on earnings
being available.
Secured Bonds
Mortgage bonds Secured by real estate or buildings. Claim is on proceeds from sale of mortgaged
assets; if not fully satisfied, the lender becomes a
general creditor.The first-mortgage claim must be
fully satisfied before distribution of proceeds to
second-mortgage holders, and so on. A number
of mortgages can be issued against the same
collateral.
Collateral trust Secured by stock and (or) bonds that are owned Claim is on proceeds from stock and (or) bond
bonds by the issuer. Collateral value is generally 25% to collateral; if not fully satisfied, the lender becomes
35% greater than bond value. a general creditor.
Equipment trust Used to finance “rolling stock””airplanes, trucks, Claim is on proceeds from the sale of the asset; if
certificates boats, railroad cars. A trustee buys such an asset proceeds do not satisfy outstanding debt, trust
with funds raised through the sale of trust cer- certificate lenders become general creditors.
tificates and then leases it to the firm, which,
after making the final scheduled lease payment,
receives title to the asset. A type of leasing.




Popular Types of Bonds
Bonds can be classified in a variety of ways. Here we break them into traditional
bonds (the basic types that have been around for years) and contemporary bonds
debentures
(newer, more innovative types). The traditional types of bonds are summarized in
subordinated debentures
terms of their key characteristics and priority of lender™s claim in Table 6.3. Note
income bonds
that the first three types”debentures, subordinated debentures, and income
mortgage bonds
collateral trust bonds bonds”are unsecured, whereas the last three”mortgage bonds, collateral trust
equipment trust certificates
bonds, and equipment trust certificates”are secured.
See Table 6.3
Table 6.4 describes the key characteristics of five contemporary types of
zero- (or low-) coupon bonds bonds: zero-coupon or low-coupon bonds, junk bonds, floating-rate bonds,
junk bonds extendible notes, and putable bonds. These bonds can be either unsecured or
floating-rate bonds
secured. Changing capital market conditions and investor preferences have
extendible notes
spurred further innovations in bond financing in recent years and will probably
putable bonds
continue to do so.
See Table 6.4
242 PART 2 Important Financial Concepts


TABLE 6.4 Characteristics of Contemporary Types of Bonds

Characteristicsa
Bond type

Zero- (or low-) Issued with no (zero) or a very low coupon (stated interest) rate and sold at a large discount from par. A
coupon bonds significant portion (or all) of the investor™s return comes from gain in value (i.e., par value minus purchase
price). Generally callable at par value. Because the issuer can annually deduct the current year™s interest
accrual without having to pay the interest until the bond matures (or is called), its cash flow each year is
increased by the amount of the tax shield provided by the interest deduction.

Junk bonds Debt rated Ba or lower by Moody™s or BB or lower by Standard & Poor™s. Commonly used during the 1980s
by rapidly growing firms to obtain growth capital, most often as a way to finance mergers and takeovers.
High-risk bonds with high yields”often yielding 2% to 3% more than the best-quality corporate debt.

Floating-rate Stated interest rate is adjusted periodically within stated limits in response to changes in specified money
bonds market or capital market rates. Popular when future inflation and interest rates are uncertain. Tend to sell
at close to par because of the automatic adjustment to changing market conditions. Some issues provide
for annual redemption at par at the option of the bondholder.

Extendible notes Short maturities, typically 1 to 5 years, that can be renewed for a similar period at the option of holders.
Similar to a floating-rate bond. An issue might be a series of 3-year renewable notes over a period of
15 years; every 3 years, the notes could be extended for another 3 years, at a new rate competitive with
market interest rates at the time of renewal.
Putable bonds Bonds that can be redeemed at par (typically, $1,000) at the option of their holder either at specific dates
after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions, such
as being acquired, acquiring another company, or issuing a large amount of additional debt. In return for
its conferring the right to “put the bond” at specified times or when the firm takes certain actions, the
bond™s yield is lower than that of a nonputable bond.
aTheclaims of lenders (i.e., bondholders) against issuers of each of these types of bonds vary, depending on the bonds™ other features. Each of these
bonds can be unsecured or secured.




International Bond Issues
Companies and governments borrow internationally by issuing bonds in two prin-
cipal financial markets: the Eurobond market and the foreign bond market. Both
give borrowers the opportunity to obtain large amounts of long-term debt financ-
ing quickly, in the currency of their choice and with flexible repayment terms.
A Eurobond is issued by an international borrower and sold to investors in
Eurobond
A bond issued by an international countries with currencies other than the currency in which the bond is denomi-
borrower and sold to investors in
nated. An example is a dollar-denominated bond issued by a U.S. corporation
countries with currencies other
and sold to Belgian investors. From the founding of the Eurobond market in the
than the currency in which the
1960s until the mid-1980s, “blue chip” U.S. corporations were the largest single
bond is denominated.
class of Eurobond issuers. Some of these companies were able to borrow in this
market at interest rates below those the U.S. government paid on Treasury bonds.
As the market matured, issuers became able to choose the currency in which they
borrowed, and European and Japanese borrowers rose to prominence. In more
recent years, the Eurobond market has become much more balanced in terms of
the mix of borrowers, total issue volume, and currency of denomination.
foreign bond
In contrast, a foreign bond is issued in a host country™s financial market, in the
A bond issued in a host country™s
host country™s currency, by a foreign borrower. A Swiss-franc“denominated bond
financial market, in the host
issued in Switzerland by a U.S. company is an example of a foreign bond. The
country™s currency, by a foreign
three largest foreign-bond markets are Japan, Switzerland, and the United States.
borrower.
243
CHAPTER 6 Interest Rates and Bond Valuation


Review Questions

6“6 What are typical maturities, denominations, and interest payments of a
corporate bond? What mechanisms protect bondholders?
6“7 Differentiate between standard debt provisions and restrictive covenants
included in a bond indenture. What are the consequences of violation of
them by the bond issuer?
6“8 How is the cost of bond financing typically related to the cost of short-
term borrowing? In addition to a bond™s maturity, what other major fac-
tors affect its cost to the issuer?
6“9 What is a conversion feature? A call feature? Stock purchase warrants?
6“10 What information is found in a bond quotation? How are bonds rated,
and why?
6“11 Compare the basic characteristics of Eurobonds and foreign bonds.


Valuation Fundamentals
LG4


Valuation is the process that links risk and return to determine the worth of an
valuation
The process that links risk and asset. It is a relatively simple process that can be applied to expected streams of
return to determine the worth of benefits from bonds, stocks, income properties, oil wells, and so on. To deter-
an asset.
mine an asset™s worth at a given point in time, a financial manager uses the time-
value-of-money techniques presented in Chapter 4 and the concepts of risk and
return developed in Chapter 5.


Key Inputs
There are three key inputs to the valuation process: (1) cash flows (returns), (2)
timing, and (3) a measure of risk, which determines the required return. Each is
described below.

Cash Flows (Returns)
The value of any asset depends on the cash flow(s) it is expected to provide over
the ownership period. To have value, an asset does not have to provide an annual
cash flow; it can provide an intermittent cash flow or even a single cash flow over
the period.

Celia Sargent, financial analyst for Groton Corporation, a diversified holding
EXAMPLE
company, wishes to estimate the value of three of its assets: common stock in
Michaels Enterprises, an interest in an oil well, and an original painting by a well-
known artist. Her cash flow estimates for each are as follows:
Stock in Michaels Enterprises Expect to receive cash dividends of $300 per
year indefinitely.
Oil well Expect to receive cash flow of $2,000 at the end of year 1, $4,000 at
the end of year 2, and $10,000 at the end of year 4, when the well is to be sold.
Original painting Expect to be able to sell the painting in 5 years for
$85,000.
244 PART 2 Important Financial Concepts


With these cash flow estimates, Celia has taken the first step toward placing a
value on each of the assets.


Timing
In addition to making cash flow estimates, we must know the timing of the cash
flows.4 For example, Celia expects the cash flows of $2,000, $4,000, and $10,000
for the oil well to occur at the ends of years 1, 2, and 4, respectively. The combina-
tion of the cash flow and its timing fully defines the return expected from the asset.

Risk and Required Return
The level of risk associated with a given cash flow can significantly affect its
value. In general, the greater the risk of (or the less certain) a cash flow, the
lower its value. Greater risk can be incorporated into a valuation analysis by
using a higher required return or discount rate. As in the previous chapter, the
higher the risk, the greater the required return, and the lower the risk, the less the
required return.

Let™s return to Celia Sargent™s task of placing a value on Groton Corporation™s
EXAMPLE
original painting and consider two scenarios.

Scenario 1”Certainty A major art gallery has contracted to buy the paint-
ing for $85,000 at the end of 5 years. Because this is considered a certain sit-
uation, Celia views this asset as “money in the bank.” She thus would use the
prevailing risk-free rate of 9% as the required return when calculating the
value of the painting.

Scenario 2”High Risk The values of original paintings by this artist have
fluctuated widely over the past 10 years. Although Celia expects to be able to
get $85,000 for the painting, she realizes that its sale price in 5 years could
range between $30,000 and $140,000. Because of the high uncertainty sur-
rounding the painting™s value, Celia believes that a 15% required return is
appropriate.

These two estimates of the appropriate required return illustrate how this
rate captures risk. The often subjective nature of such estimates is also clear.


The Basic Valuation Model
Simply stated, the value of any asset is the present value of all future cash flows it
is expected to provide over the relevant time period. The time period can be any
length, even infinity. The value of an asset is therefore determined by discounting
the expected cash flows back to their present value, using the required return
commensurate with the asset™s risk as the appropriate discount rate. Utilizing the
present value techniques explained in Chapter 4, we can express the value of any
asset at time zero, V0, as


4. Although cash flows can occur at any time during a year, for computational convenience as well as custom, we
will assume they occur at the end of the year unless otherwise noted.
245
CHAPTER 6 Interest Rates and Bond Valuation


CF1 CF2 CFn
...
V0 (6.1)
(1 k)1 (1 k2) (1 k)n
where
V0 value of the asset at time zero
CFt cash flow expected at the end of year t
k appropriate required return (discount rate)
n relevant time period
Using present value interest factor notation, PVIFk,n from Chapter 4, Equation
6.1 can be rewritten as
...
V0 [CF1 (PVIFk,1)] [CF2 (PVIFk,2)] [CFn (PVIFk,n)] (6.2)
We can use Equation 6.2 to determine the value of any asset.

Celia Sargent used Equation 6.2 to calculate the value of each asset (using present
EXAMPLE
value interest factors from Table A“2), as shown in Table 6.5. Michaels
Enterprises stock has a value of $2,500, the oil well™s value is $9,262, and the
original painting has a value of $42,245. Note that regardless of the pattern of
the expected cash flow from an asset, the basic valuation equation can be used to
determine its value.


TABLE 6.5 Valuation of Groton Corporation™s Assets by Celia Sargent

Valuationa
Asset Cash flow, CF Appropriate required return

Michaels Enterprises stockb $300/year indefinitely 12% V0 $300 (PVIFA12%,∞)
1
$300 $2,500
0.12

Oil wellc Year (t) CFt 20% V0 [$2,000 (PVIF20%,1)]
[$4,000 (PVIF20%,2)]
1 $ 2,000
[$0 (PVIF20%,3)]
2 4,000
[$10,000 (PVIF20%,4)]
3 0
[$2,000 (0.833)]
4 10,000
[$4,000 (0.694)]
[$0 (0.579)]
[$10,000 (0.482)]
$1,666 $2,776
$0 $4,820
$9,262

Original paintingd $85,000 at end of year 5 15% V0 $85,000 (PVIF15%,5)
$85,000 (0.497)
$42,245

aBased on PVIF interest factors from Table A“2. If calculated using a calculator, the values of the oil well and original painting would have been
$9,266.98 and $42,260.03, respectively.
bThis is a perpetuity (infinite-lived annuity), and therefore the present value interest factor given in Equation 4.19 is applied.
cThis is a mixed stream of cash flows and therefore requires a number of PVIFs, as noted.
dThis is a single-amount cash flow and therefore requires a single PVIF.
246 PART 2 Important Financial Concepts


Review Questions

6“12 Why is it important for financial managers to understand the valuation
process?
6“13 What are the three key inputs to the valuation process?
6“14 Does the valuation process apply only to assets that provide an annual
cash flow? Explain.
6“15 Define and specify the general equation for the value of any asset, V0.




Bond Valuation
LG5 LG6


The basic valuation equation can be customized for use in valuing specific securi-
ties: bonds, common stock, and preferred stock. Bond valuation is described in
this chapter, and valuation of common stock and preferred stock is discussed in
Chapter 7.



Bond Fundamentals
As noted earlier in this chapter, bonds are long-term debt instruments used by
business and government to raise large sums of money, typically from a diverse
group of lenders. Most corporate bonds pay interest semiannually (every 6
months) at a stated coupon interest rate, have an initial maturity of 10 to
30 years, and have a par value, or face value, of $1,000 that must be repaid at
maturity.

Mills Company, a large defense contractor, on January 1, 2004, issued a 10%
EXAMPLE
coupon interest rate, 10-year bond with a $1,000 par value that pays interest
semiannually. Investors who buy this bond receive the contractual right to two
cash flows: (1) $100 annual interest (10% coupon interest rate $1,000 par
value) distributed as $50 (1/2 $100) at the end of each 6 months, and (2) the
$1,000 par value at the end of the tenth year.

We will use data for Mills™s bond issue to look at basic bond valuation.



Basic Bond Valuation
The value of a bond is the present value of the payments its issuer is contractually
obligated to make, from the current time until it matures. The basic model for the
value, B0, of a bond is given by Equation 6.3:
n
1 1
B0 I M (6.3)
kd)t (1 kd)n
1 (1
t

I (PVIFAk ) M (PVIFk ) (6.3a)
d ,n d,n
247
CHAPTER 6 Interest Rates and Bond Valuation


where
B0 value of the bond at time zero
I annual interest paid in dollars5
n number of years to maturity
M par value in dollars
kd required return on a bond
We can calculate bond value using Equation 6.3a and the appropriate financial
tables (A“2 and A“4) or by using a financial calculator.

Assuming that interest on the Mills Company bond issue is paid annually and
EXAMPLE
that the required return is equal to the bond™s coupon interest rate, I $100, kd
10%, M $1,000, and n 10 years.
The computations involved in finding the bond value are depicted graphi-
cally on the following time line.


End of Year
Time line for bond
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
valuation (Mills
Company™s 10%
$100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $1,000
coupon interest rate,
10-year maturity,
$1,000 par, January 1,
2004, issue paying
annual interest;
required return 10%)
$ 614.50




386.00
B0 = $1,000.50



Table Use Substituting the values noted above into Equation 6.3a yields
B0 $100 (PVIFA10%,10yrs) $1,000 (PVIF10%,10yrs)
$100 (6.145) $1,000 (0.386)
$614.50 $386.00 $1,000.50
The bond therefore has a value of approximately $1,000.6



5. The payment of annual rather than semiannual bond interest is assumed throughout the following discussion.
This assumption simplifies the calculations involved, while maintaining the conceptual accuracy of the valuation
procedures presented.
6. Note that a slight rounding error ($0.50) results here from the use of the table factors, which are rounded to the
nearest thousandth.
248 PART 2 Important Financial Concepts


Calculator Use Using the Mills Company™s inputs shown at the left, you should
Input Function
find the bond value to be exactly $1,000. Note that the calculated bond value is
10 N
equal to its par value; this will always be the case when the required return is
I
10
equal to the coupon interest rate.
100 PMT
FV
1000
CPT
Bond Value Behavior
PV

Solution In practice, the value of a bond in the marketplace is rarely equal to its par value.
1000
In bond quotations (see Figure 6.4), the closing prices of bonds often differ from
their par values of 100 (100 percent of par). Some bonds are valued below par
(quoted below 100), and others are valued above par (quoted above 100). A vari-
ety of forces in the economy, as well as the passage of time, tend to affect value.
Although these external forces are in no way controlled by bond issuers or
investors, it is useful to understand the impact that required return and time to
maturity have on bond value.


Required Returns and Bond Values
Whenever the required return on a bond differs from the bond™s coupon interest
rate, the bond™s value will differ from its par value. The required return is likely
to differ from the coupon interest rate because either (1) economic conditions
have changed, causing a shift in the basic cost of long-term funds, or (2) the
firm™s risk has changed. Increases in the basic cost of long-term funds or in risk
will raise the required return; decreases in the cost of funds or in risk will lower
the required return.
discount
Regardless of the exact cause, what is important is the relationship between
The amount by which a bond
the required return and the coupon interest rate: When the required return is
sells at a value that is less than
greater than the coupon interest rate, the bond value, B0, will be less than its par
its par value.
value, M. In this case, the bond is said to sell at a discount, which will equal
premium
M B0. When the required return falls below the coupon interest rate, the bond
The amount by which a bond
value will be greater than par. In this situation, the bond is said to sell at a
sells at a value that is greater
premium, which will equal B0 M.
than its par value.


The preceding example showed that when the required return equaled the
EXAMPLE
coupon interest rate, the bond™s value equaled its $1,000 par value. If for the
same bond the required return were to rise or fall, its value would be found as fol-
lows (using Equation 6.3a):

Table Use
Required Return 12% Required Return 8%

B0 $100 (PVIFA12%,10yrs) $1,000 B0 $100 (PVIFA8%,10yrs) $1,000
(PVIF12%,10yrs) (PVIF8%,10yrs)
$887.00 $1,134.00

Calculator Use Using the inputs shown on the next page for the two different
required returns, you will find the value of the bond to be below or above par. At
249
CHAPTER 6 Interest Rates and Bond Valuation


TABLE 6.6 Bond Values for Various
Required Returns (Mills
Company™s 10% Coupon
Interest Rate, 10-Year
Maturity, $1,000 Par,
January 1, 2004, Issue
Paying Annual Interest)

Required return, kd Bond value, B0 Status

12% $ 887.00 Discount
10 1,000.00 Par value
8 1,134.00 Premium




a 12% required return, the bond would sell at a discount of
Input Function Input Function
$113.00 ($1,000 par value $887.00 value). At the 8%
10 N 10 N
required return, the bond would sell for a premium of about
I I
12 8
$134.00 ($1,134.00 value $1,000 par value). The results of
100 PMT 100 PMT
this and earlier calculations for Mills Company™s bond values
FV FV
1000 1000 are summarized in Table 6.6 and graphically depicted in Figure
CPT CPT 6.5. The inverse relationship between bond value and required
return is clearly shown in the figure.
PV PV

Solution Solution
887.00 1134.20




FIGURE 6.5
Bond Values and

. 1
( 2)



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