Foundations of Finance

Tenth Edition, Global Edition

Chapter 7
The Valuation and
Characteristics of Bonds

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Learning Objectives
7.1 Distinguish between different kinds of bonds.
7.2 Explain the more popular features of bonds.
7.3 Define the term value as used for several different purposes.
7.4 Explain the factors that determine value.
7.5 Describe the basic process for valuing assets.
7.6 Estimate the value of a bond.
7.7 Compute a bond’s expected rate of return and its current
yield.
7.8 Explain three important relationships that exist in bond
valuation.

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Types of Bonds

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Bonds
• Meaning: A bond is a type of debt or long-term promissory
note, issued by a borrower, promising to its holder a
predetermined and fixed amount of interest per year and
repayment of principal at maturity.
• Bonds are issued by corporations, the U.S. government,
state governments, and local municipalities.

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Debentures
• Debentures are unsecured long-term debt.
• For an issuing firm, debentures provide the benefit of not
tying up property as collateral.
• For bondholders, debentures are more risky than secured
bonds and provide a higher yield than secured bonds.

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Subordinated Debentures
• There is a hierarchy of payout in case of insolvency.
• The claims of subordinated debentures are honored only
after the claims of secured debt and unsubordinated
debentures have been satisfied.

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Mortgage Bonds
• Mortgage bond is secured by a lien on real property.
• Typically, the value of the real property is greater than
that of the bonds issued, providing bondholders a margin
of safety.

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Eurobonds
• Securities (bonds) issued in a country different from the
one in whose currency the bond is denominated.
• For example, a bond issued by an American corporation in
Japan that pays interest and principal in dollars.

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Convertible Bonds
• Convertible bonds are debt securities that can be
converted into a firm’s stock at a prespecified price.

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Terminologies and Characteristics of
Bonds

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Claims on Assets and Income
• Seniority in claims
– In the case of insolvency, claims of debt, including
bonds, are generally honored before those of common
or preferred stock.

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Par Value
• Par value is the face value of the bond, returned to the
bondholder at maturity.
• In general, corporate bonds are issued at denominations
or par value of $1,000.
• Prices are represented as a percentage of face value.
Thus, a bond quoted at 104 can be bought at 104 percent
of its par value in the market. Bonds will return the par
value at maturity, regardless of the price paid at the time
of purchase.

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Coupon Interest Rate
• The percentage of the par value of the bond that will be
paid periodically in the form of interest.
• Example: A bond with a $1,000 par value and 5 percent
annual coupon rate will pay $50 annually (= 0.05×1,000)
or $25 (if interest is paid semiannually).

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Zero Coupon Bonds
• Zero coupon bonds have zero or very low coupon rate.
Instead of paying interest, the bonds are issued at a
substantial discount below the par or face value.

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Maturity
• Maturity of bond refers to the length of time until the bond
issuer returns the par value to the bondholder and
terminates or redeems the bond.

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Call Provision
• Call provision (if it exists on a bond) gives a corporation
the option to redeem the bonds before the maturity date.
For example, if the prevailing interest rate declines, the
firm may want to pay off the bonds early and reissue at a
more favorable interest rate.
• Issuer must pay the bondholders a premium.
• There is also a call protection period where the firm
cannot call the bond for a specified period of time.

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Indenture
• An indenture is the legal agreement between the firm
issuing the bond and the trustee who represents the
bondholders.
• It provides for specific terms of the loan agreement (such
as rights of bondholders and issuing firm).
• Many of the terms seek to protect the status of bonds from
being weakened by managerial actions or by other
security holders.

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Bond Ratings
• Bond ratings reflect the future risk potential of the bonds.
• Three prominent bond rating agencies are Standard &
Poor’s, Moody’s, and Fitch Investor Services.
• A lower bond rating indicates higher probability of default.
It also means that the rate of return demanded by the
capital markets will be higher on such bonds.

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Table 7.1 Standard & Poor’s
Corporate Bond Ratings

Source: Adapted from https://www.globalcreditportal.com, accessed May 20, 2015.

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Factors Having a Favorable Effect on
Bond Rating
• A greater reliance on equity as opposed to debt in
financing the firm
• Profitable operations
• Low variability in past earnings
• Large firm size
• Little use of subordinated debt

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Junk Bonds
• Junk bonds are high-risk bonds with ratings of BB or
below by Moody’s and Standard & Poor’s.
• Junk bonds are also referred to as high-yield bonds
because they pay a high interest rate, generally 3 percent
to 5 percent more than AAA-rated bonds.

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Defining Value

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Defining Value
• Book value: Value of an asset as shown on a firm’s
balance sheet.
• Liquidation value: The dollar sum that could be realized
if an asset were sold individually and not as part of a
going concern.
• Market value: The observed value for the asset in the
marketplace.
• Intrinsic or economic value: Also called fair value—
represents the present value of the asset’s expected
future cash flows.

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Value and Efficient Markets
• In an efficient market, the values of all securities at any
instant fully reflect all available public information.
• If the markets are efficient, the market value and the
intrinsic value will be the same.
• The field of behavioral finance studies the irrationality of
investors.

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What Determines Value?

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What Determines Value?
• Value of an asset = present value of its expected future
cash flows using the investor’s required rate of return as
the discount rate.
• Thus value is affected by three elements:
– Amount and timing of the asset’s expected future cash
flows
– Riskiness of the cash flows
– Investor’s required rate of return for undertaking the
investment

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Figure 7.1 Basic Factors Determining
an Asset’s Value

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Valuation: The Basic Process

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Bond Valuation (1 of 2)
• The value of a bond (V) is a combination of:
– C: Future expected cash flows in the form of interest
and repayment of principal
– n: The time to maturity of the loan
– r: The investor’s required rate of return

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Bond Valuation (2 of 2)

cash flow in year 1 cash flow in year 2

Asset value = +
(1 + required rate of return ) (1 + required rate of return )
1 2

cash flow in year n

+... +
(1 + required rate of return )
n

Or stated in symbols we have:

C1 C2 Cn
v= + + ... +
(1 + r ) (1 + r ) (1 + r )
1 2 n

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Valuing Bonds

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Figure 7.2 Data Requirements for
Bond Valuation

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Example on Bond Valuation
• Consider a bond issued by Toyota with a maturity date of
2022 and a stated coupon of 3.4 percent. In 2017, with 5
years left to maturity, investors owning the bonds are
requiring a 2.7 percent rate of return.

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Toyota Bond Example
• Step 1 (CF): Estimate amount and timing of the expected
future cash flows:
a. Annual interest payments
0.034 × $1,000 = $34 every year for five years
b. Face value to be received in 2022
$1,000

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Summary of Cash Flows (For One
Bond)
Time Bondholder Corporation
0 Price = ? Price = ?

1–5 $34 −$34

5 +1,000 −1,000

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Toyota Bond Example (1 of 3)
• Step 2 (r) Determine the investor’s required rate of return
by evaluating the riskiness of the bond’s future cash flows.
Remember: the investors required rate of return equals
the risk-free rate plus a risk premium. Here, the required
rate of return (r) is given as 2.7 percent.

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Toyota Bond Example (2 of 3)
• Step 3: Calculate the intrinsic value of the bond.
• Bond Value
– = PV (Interest, received every year)
– + PV (Par, received at maturity)

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Toyota Bond Example (3 of 3)
• Using calculator:
– Annual interest payments (PMT) = $34
– Par value (FV) = $1,000
– Years until maturity (N) = 5
– Required rate of return (I) = 2.7%
• Solve for PV = $1,032.33

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Bond Yields

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Bond Yields (1 of 2)
• Yield to Maturity (YTM) refers to the rate of return the
investor will earn if the bond is held to maturity. YTM is
also known as bondholder’s expected rate of return.
• YTM = Discount rate that equates the present value of the
future cash flows with the current market price of the bond

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Bond Yields (2 of 2)
To find YTM, we need to know:
a. current price
b. time left to maturity
c. par value, and
d. annual interest payment

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Computing YTM (1 of 2)
• What is the yield to maturity (YTM) on a 6 percent bond
that is currently trading for $1,100 and matures in 10
years?
• Current price = $1,100
Coupon = $60
Time = 10 years
Par value = $1,000

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Computing YTM (2 of 2)

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Current Yield
• Current yield is the ratio of the interest payment to the
bond’s current market price.

annual interest payment

Current yield =
current market price of the bond

• Example: The current yield on a $1,000 par value bond

with 4 percent coupon rate and market price of $920

0.04 × $1, 000 $40

Current yield = = = 0.0435 = 4.35%
$920 $920

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Bond Valuation: Three Important
Relationships

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Bond Valuation: Three Important
Relationships (1 of 2)
Relationship 1
• The value of a bond is inversely related to changes in the
investor’s present required rate of return (the current
interest rate).
• As interest rates increase (decrease), the value of the
bond decreases (increases).

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Bond Valuation: Three Important
Relationships (2 of 2)
Relationship 2
• The market value of a bond will be less than the par value
if the investor’s required rate of return is above the coupon
interest rate.
• Bond will be valued above par value if the investor’s
required rate of return is below the coupon interest rate.

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Discount Bonds
• The market value of a bond will be below the par when the
investor’s required rate is greater than the coupon interest
rate. These bonds are known as discount bonds.

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Premium Bonds
• The market value of a bond will be above the par or face
value when the investor’s required rate is lower than the
coupon interest rate. These bonds are known as premium
bonds.
• If investor’s required rate of return is equal to the coupon
interest rate, the bonds will trade at par.

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Figure 7.3 Value and Required Rates
for a 5-Year Bond at a 5 Percent
Coupon Rate

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Bond Valuation: Three Important
Relationships (3 of 3)
Relationship 3
• Long-term bonds have greater interest rate risk than do
short-term bonds.
• In other words, a change in interest rate will have
relatively greater impact on long-term bonds.

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Figure 7.4 The Market Values of a 5-
Year and a 10-Year Bond at Different
Required Rates of Return

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Main Risks for Bondholders
• Interest rate risk: if interest rates rise, the market value of
bonds will fall
• Default risk: this may mean no or partial payment on debt
as in bankruptcy cases
• Call risk: if bonds are called before maturity date; bonds
are generally called when interest rates decrease. Thus,
investors will have to reinvest the money received from
the corporation at a lower rate.

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Key Terms (1 of 4)
• Behavioral finance
• Bond
• Book value
• Callable bond (redeemable bond)
• Call protection period
• Convertible bond
• Coupon interest rate
• Current yield

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Key Terms (2 of 4)
• Debenture
• Discount bond
• Efficient market
• Eurobond
• Expected rate of return
• Fixed-rate bond
• Fair value
• High-yield bond

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Key Terms (3 of 4)
• Indenture
• Interest rate risk
• Intrinsic, or economic (fair) value
• Junk bond (high-yield bond)
• Liquidation value
• Market value
• Maturity
• Mortgage bond

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Key Terms (4 of 4)
• Par value
• Premium bond
• Subordinated debentures
• Yield to maturity
• Zero coupon bond

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