Principles of Managerial Finance

Fifteenth Edition, Global Edition

Chapter 6
Interest Rates and Bond
Valuation

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Learning Goals
LG 1 Describe interest rate fundamentals, the term structure
of interest rates, and risk premiums.
LG 2 Discuss the general features, yields, prices, ratings,
popular types, and international issues of corporate
bonds.
LG 4 Understand basic model used in the bond valuation
process.
LG 5 Explain yield to maturity (YTM), its calculation, and the
procedure used to value bonds that pay interest
semiannually.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.1 Interest Rates and Required Returns

• Interest Rate Fundamentals

– Interest Rate
 Usually applied to debt instruments such as bank loans or
bonds; the compensation paid by the borrower of funds to the
lender; from the borrower’s point of view, the cost of borrowing
funds
 Broadly speaking, interest rates are determined by the
interaction of supply and demand
– Required Return
 Usually applied to equity instruments such as common stock;
the cost of funds obtained by selling an ownership interest

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.1 Interest Rates and Required Returns

• Interest Rate Fundamentals

– Inflation
 A rising trend in the prices of most goods and services
– Liquidity Preference
 A general tendency for investors to prefer short-term (i.e.,
more liquid) securities

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.1 Interest Rates and Required Returns

• Interest Rate Fundamentals

– Nominal and Real Interest Rates
 Nominal Rate of Interest
– The actual rate of interest charged by the supplier of funds
and paid by the demander
 Real Rate of Interest
– The rate of return on an investment measured not in
dollars but in the increase in purchasing power that the
investment provides
– The real rate of interest measures the rate of increase in
purchasing power

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.1 Interest Rates and Required Returns

• Interest Rate Fundamentals

– Nominal Interest Rates, Inflation, and Risk
 RF = Risk-free rate

RF  r *  i (6.2)

 rj = Nominal return on investment j

 RPj = Risk premium above the risk-free rate for investment j

rj  RF  RPj (6.3)

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.1 Interest Rates and Required Returns

• Term Structure of Interest Rates

– Theories of the Term Structure
 Liquidity Preference Theory
– Theory suggesting that long-term rates are generally
higher than short-term rates because investors perceive
short-term investments as more liquid and less risky than
long-term investments
– Borrowers must offer higher rates on long-term bonds to
entice investors away from their preferred short-term
securities

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.1 Interest Rates and Required Returns

• Term Structure of Interest Rates

– Theories of the Term Structure
 Market Segmentation Theory
– Theory suggesting that the market for loans is segmented
on the basis of maturity and that the supply of and demand
for loans within each segment determine its prevailing
interest rate; the slope of the yield curve is determined by
the general relationship between the prevailing rates in
each market segment

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Table 6.1 Debt-Specific Risk Premium
Components
Component Description
Default risk The possibility that the issuer of debt will not pay the
contractual interest or principal as scheduled. The greater the
uncertainty 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.
Contractual provision Conditions that are often included in a debt agreement or a
risk 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.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.2 Government and Corporate Bonds
(1 of 15)

• Municipal Bond
– A bond issued by a state or local government body
• Corporate Bond
– A long-term debt instrument indicating that a corporation has
borrowed a certain amount of money and promises to repay
it in the future under clearly defined terms

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.2 Government and Corporate Bonds
(2 of 15)

• Legal Aspects of Corporate Bonds

– Par Value, Face Value, Principal
 The amount of money the borrower must repay at maturity,
and the value on which periodic interest payments are based
– Coupon Rate
 The percentage of a bond’s par value that will be paid
annually, typically in two equal semiannual payments, as
interest

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Table 6.3 Moody’s and Standard & Poor’s
Bond Ratings
Moody’s Interpretation Standard & Poor’s Interpretation
Aaa Prime quality AAA Investment grade
Aa High grade AA Blank 
A Upper medium grade A Blank 
Baa Medium grade BBB Blank 
Ba Lower medium grade or
speculative BB Speculative
B Speculative B Blank 
Caa From very speculative CCC Blank 
Ca to near or in default CC Blank
C Lowest grade C Income bond
Blank  Blank  D In default
Note: Some ratings may be modified to show relative standing within a major rating category; for example, 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.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.2 Government and Corporate Bonds
(14 of 15)

• Common Types of Bonds

– Debentures
– Subordinated Debentures
– Income Bonds
– Mortgage Bonds
– Collateral Trust Bonds
– Equipment Trust Certificates
– Zero- (or Low-) Coupon Bonds
– Junk (High-Yield) Bonds
– Floating Rate Bonds
– Extendible Notes
– Putable Bonds
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.
Table 6.4 Characteristics and Priority of
Lender’s Claim of Traditional Types of
Bonds (1 of 2)
Bond type Characteristics Priority of lender’s claim

Unsecured bonds Blank Blank

Debentures Unsecured bonds that only Claims are the same as those of
creditworthy firms can issue. any general creditor. May have
Convertible bonds are normally other unsecured bonds
debentures. subordinated to them.

Subordinated debentures Claims are not satisfied until Claim is that of a general
those of the creditors holding creditor but not as good as a
certain (senior) debts have been senior debt claim.
fully satisfied.

Income bonds Payment of interest is required Claim is that of a general

only when earnings are creditor. Are not in default when
available. Commonly issued in interest payments are missed
reorganization of a failing firm. because they are contingent
only on earnings being available.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Table 6.4 Characteristics and Priority of
Lender’s Claim of Traditional Types of
Bonds (2 of 2)
Bond type Characteristics Priority of lender’s claim
Secured Bonds Blank Blank
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 Claim is on proceeds from stock and/or
bonds owned by the issuer. Collateral value is bond collateral; if not fully satisfied, the
generally 25% to 35% greater than bond lender becomes a general creditor.
value.
Equipment trust Used to finance “rolling stock,” such as Claim is on proceeds from the sale of the
certificates airplanes, trucks, boats, railroad cars. A asset; if proceeds do not satisfy outstanding
trustee buys the asset with funds raised debt, trust certificate lenders become
through the sale of trust certificates and general creditors.
then leases it to the firm; after making the
final scheduled lease payment, the firm
receives title to the asset. A type of leasing.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Table 6.5 Characteristics of Contemporary
Types of Bonds (1 of 2)
Bond type Characteristicsa
Zero- (or low-) Issued with no (zero) or a very low coupon (stated interest) rate and sold at a
coupon bonds large discount from par. A 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.
Junk (high-yield) Debt rated Ba or lower by Moody’s or BB or lower by Standard & Poor’s.
bonds Commonly used 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
bonds changes in specified money 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.

Short maturities, typically 1 to 5 years, that can be renewed for a similar period
Extendible notes
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.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Table 6.5 Characteristics of Contemporary
Types of Bonds (2 of 2)
Bond type Characteristicsa
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.

a
The claims 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.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.3 Valuation Fundamentals
• Valuation
– The process that links risk and return to determine the worth
of an asset
• Key Inputs
– Cash Flows
– Timing
– Risk and Required Return

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.3 Valuation Fundamentals
• Basic Valuation Model

CF1 CF2 CFn

V0     (6.4)
 1 r   1 r   1 r 
1 2 n

 V0 = value of the asset at time zero

 CFt = cash flow expected in year t
 r = required return (discount rate)
 n = time period (investment’s life or investor’s holding period)

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation
• Bond Fundamentals
– 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 at a stated
coupon rate; have an initial maturity of 10 to 30 years; and
have a par value of $1,000 that the borrower must repay at
maturity

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation (2 of 9)
• Bond Valuation
C C C C M
B0     
 1 r   1 r   1 r   1 r   1 r 
1 2 3 n n

 n C   M 
B0    t 
 n 
(6.5)
 t 1  1  r     1  r  

 B0 = value (or price) of the bond at time zero

 C = annual coupon interest payment in dollars
 n = number of years to maturity
 M = par value in dollars
 r = required return on the bond
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.
Example 6.8 (1 of 4)
Tim Sanchez wishes to determine the current value of the Mills
Company bond. If the bond pays interest annually and the
required return on the bond is 6% (equal to its coupon rate),
then we can calculate the bond’s value using Equation 6.5a:

 $60   1  $1, 000

B0    1  10 

 0.06   (1  0.06)  (1  0.06)
10

B0  $1, 000 [0.44161]  $558.39  $441.61  $558.39  $1, 000.00

The timeline below depicts the computations involved in

finding the bond value.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

BOND VALUATION
•  
Bo =

PVIFA PVIF
Bo =

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation (6 of 9)
• Semiannual Interest Rates and Bond Values

 
 
C / 2 1  M
Bo    1   (6.6a)
 r   r
2n 2n
 r / 2 
 1    1  
  2   2

 B0 = value (or price) of the bond at time zero

 C = annual coupon interest payment in dollars
 n = number of years to maturity
 M = par value in dollars
 r = required return on the bond

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation
• Semiannual Interest Rates and Bond Values

C C C C
2 2 2 2 M
B0  1
 2
 3
  2n
 2n
 r  r  r  r  r
 1+   1+   1+   1+  1  
 2  2  2  2  2
 C   
 2n   
M
B0    2 t     (6.6)
 t 1  r     r  
2n

 1+    1   
  2    2  

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation
•  
Bo =

Bo =

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation
• Changes in Bond Values
– When the required return rises, the bond price falls, and
when the required return falls, the bond price rises
– Required Returns and Bond Values
 Discount
– The amount by which a bond sells below its par value
• When the required return is greater than the coupon
rate, the bond’s value will be less than its par value
 Premium
– The amount by which a bond sells above its par value
• When the required return falls below the coupon rate,
the bond’s value will be greater than par

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Table 6.6 Bond Values for Various Required
Returns (Mills Company’s 6% Coupon
Interest Rate, 10-Year Maturity, $1,000 Par,
January 1, 2018, Issue Date, Paying Annual
Interest)
Required return, r Bond value, B0 Status

8% $ 865.80 Discount

6 1,000.00 Par value

4 1,162.22 Premium

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation (8 of 9)
• Changes in Bond Values
– Time to Maturity and Bond Values
 Constant Required Returns
– When the required return is different from the coupon rate
and is constant until maturity, the value of the bond will
approach its par value as the passage of time brings the
bond’s maturity date closer
 Changing Required Returns
– Interest Rate Risk
• The chance that interest rates will change and thereby
change the required return and bond value; rising
rates, which result in decreasing bond values, are of
greatest concern

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

6.4 Bond Valuation (9 of 9)
• Yield to Maturity (YTM)
– The compound annual rate of return earned on a bond
purchased on a given day and held to maturity
– Mathematically, a bond’s YTM is the discount rate that
equates the bond’s market price to the present value of the
cash flows paid by the bond to investors

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Yield To Maturity
•  

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Latihan Soal :
1. PT. Krisna menerbitkan obligasi dengan nilai nominal $ 150.000
dengan waktu jatuh tempo selama 10 tahun dan coupon interest rate
ditetapkan sebesar 14%.
Pertanyaan :
Berapa nilai yang wajar dari obligasi tersebut jika required rate
of bond sebesar 12% dan 16%

2. PT. Jethro menerbitkan obligasi dengan nilai nominal $ 25.000.000

dengan waktu jatuh tempo selama 5 tahun dan tingkat suku bunga
obligasi ditetapkan sebesar 12%. Required return 16% . Berapakah
nilai yang wajar dari obligasi PT. Jethro jika bunga dibayarkan :
a. Tahunan / Annually
b. Tengah Tahunan/Semi Annually
c. Triwulan/Quarterly

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Latihan Soal :
3. Mr. Kira dihadapkan pada 2 obligasi dengan nilai
nominal $ 10.000.000 yaitu obligasi Alfa jatuh tempo
akhir tahun 2025 dengan coupon rate sebesar 12%
dibayar semiannually & obligasi Beta jatuh tempo akhir
tahun 2030 dengan coupon rate sebesar 8%/tahun
dibayar annually
Pertanyaan :
Berapa nilai yang wajar dari kedua obligasi tersebut
andaikata Mr. Kira akan membeli pada akhir tahun 2020
dengan required rate of return sebesar 10% ?

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Latihan Soal :
4. Johnson Co. menerbitkan obligasi dengan nilai nominal $
150,000 dengan coupon rate 10% selama 10 tahun .
Hitunglah yield to maturity obligasi Johnson Co. jika
harga jual obligasi sebesar $142.500 ?

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.