BUS 320 Lecture 7: Chapter 7
Chapter 7: Bonds and Their Valuation
What is a bond?
• A long-term debt instrument in which a borrower agrees to make payments of principal
and interest, on specific dates, to the holders of the bond
Bond Markets
Key Features of a Bond
Effects of a call provision
• Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the
investor)
• Bond investors require higher yield on callable bonds
• In many cases, callable bonds include a deferred call provision and a declining call
premium
What is a sinking fund?
How are sinking funds executed?
The Value of Financial Assets
Primarily traded in the over-the-counter (OTC)
market.
•Most bonds are owned by and traded among
large financial institutions.
•The Wall Street Journal reports key
developments in the Treasury, corporate, and
municipal markets.
•Par value: face amount of the bond, which
is paid at maturity (assume $1,000).
•Coupon interest rate: stated interest rate (generally fixed)
paid by the issuer. Multiply by par value to get dollar payment
of interest.
•Maturity date: years until the bond must be repaid.
•Issue date: when the bond was issued.
•Yield to maturity: rate of return earned on
a bond held until maturity (also called the “promised yield”).
•Provision to pay off a loan over its life rather than all at
maturity.
•Similar to amortization on a term loan.
•Reduces risk to investor, shortens average maturity.
•But not good for investors if rates decline after issuance.
•Call x% of the issue at par, for sinking fund purposes.
–Likely to be used if rdis below the coupon rate and the bond
sells at a premium.
•Buy bonds in the open market.
–Likely to be used if rdis above the coupon rate and the bond
sells at a discount.
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Other Types (Features) of Bonds
What is the opportunity cost of debt capital?
What is the value of a 10-year, 10% annual coupon bond, if rd = 10%?
Calculating the Value of a Bond
What is the value of a 10-year bond outstanding with the same risk but a 13% annual coupon
rate?
0 1 2 N
r%
CF1CFN
CF2
Value
...
•Convertible bond: may be exchanged for common stock of
the firm, at the holder’s option.
•Warrant: long-term option to buy a stated number of shares
of common stock at a specified price.
•Putable bond: allows holder to sell the bond back to the
company prior to maturity.
•Income bond: pays interest only when interest is earned by
the firm.
•Indexed bond: interest rate paid is based upon the rate of
inflation.
•The discount rate (ri) is the opportunity cost of capital, and is
the rate that could be earned on alternative investments of
equal risk.
ri= r* + IP + MRP + DRP + LP
0 1 2 N
10%
100 100 + 1,000100VB= ?
...
•This bond has a $1,000 lump sum (the par value) due at
maturity (t = 10), and annual $100 coupon payments
beginning at t = 1 and continuing through t = 10. The price
of the bond can be found by solving for the PV of these
cash flows.
INPUTS
OUTPUT
N I/YR PMTPV FV
10 10 100
-1000
1000
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What is the value of a 10-year bond outstanding with the same risk but a 7% annual coupon
rate?
Changing in Bond Value Over Time
• What would happen to the value of these three bonds if the required rate of return
remained at 10%?
Bond Values over Time
• At maturity, the value of any bond must equal its par value
• If rd remains constant:
o The value of a premium bond would decrease over time, until it reached $1,000
o The value of a discount bond would increase over time, until it reached $1,000
o The value of a par bond stays at $1,000
What is the YTM on the following bond?
• 10-year; 9% annual coupon; $1,000 par value; selling for $887
• Must find the rd that solved this model
•The annual coupon payment is $130. Since the risk is the
same it has the same yield to maturity as the previous bond
(10%). This bond sells at a premium because the coupon
rate > the yield to maturity.
INPUTS
OUTPUT
N I/YR PMTPV FV
10 10 130
-1184.34
1000
•The annual coupon payment is $70. Since the risk is the
same it has the same yield to maturity as the previous bonds
(10%). This bond sells at a discount because the coupon
rate < the yield to maturity.
INPUTS
OUTPUT
N I/YR PMTPV FV
10 10 70
-815.66
1000
Years
to Maturity
1,184
1,000
816
10
13% coupon rate
7% coupon rate
10% coupon rate
VB
5 0
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Document Summary
What is a bond: a long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. Primarily traded in the over-the-counter (otc) market: most bonds are owned by and traded among, the wall street journal reports key large financial institutions. developments in the treasury, corporate, and municipal markets. Key features of a bond: par value: face amount of the bond, which, coupon interest rate: stated interest rate (generally fixed) is paid at maturity (assume ,000). paid by the issuer. Effects of a call provision: allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor, bond investors require higher yield on callable bonds. In many cases, callable bonds include a deferred call provision and a declining call premium maturity. How are sinking funds executed: call x% of the issue at par, for sinking fund purposes.