CHAPTER 6

Interest Rates and Bond

Valuation

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 Interest Rates and Required Returns:
Interest Rate Fundamentals

• The interest rate is 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.
• The required return is usually applied to equity
instruments such as common stock; the cost of funds
obtained by selling an ownership interest.

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 Interest Rates and Required Returns:
Interest Rate Fundamentals

• Several factors can influence the equilibrium

interest rate:
1. Inflation, which is a rising trend in the prices of
most goods and services.
2. Risk, which leads investors to expect a higher
return on their investment
3. Liquidity preference, which refers to the general
tendency of investors to prefer short-term
securities

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 Interest Rates and Required Returns:
The Real Rate of Interest
• The real rate of interest is the rate that creates
equilibrium between the supply of savings and the
demand for investment funds in a perfect world,
without inflation, where suppliers and demanders of
funds have no liquidity preferences and there is no risk.
• The real rate of interest changes with changing
economic conditions, tastes, and preferences.
• The supply-demand relationship that determines the
real rate is shown in Figure 6.1 on the following slide.

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 Figure 6.1
Supply–Demand Relationship

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 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest is the actual rate

of interest charged by the supplier of funds
and paid by the demander.
• The nominal rate differs from the real rate of
interest, r* as a result of two factors:
– Inflationary expectations reflected in an inflation
premium (IP), and
– Issuer and issue characteristics such as default
risks and contractual provisions as reflected in a
risk premium (RP).
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 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)

• The nominal rate of interest for security 1, r1, is given by the

following equation:

• The nominal rate can be viewed as having two basic

components: a risk-free rate of return, RF, and a risk premium,
RP1:

r1 = RF + RP1

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 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)
• For the moment, ignore the risk premium, RP1, and focus
exclusively on the risk-free rate. The risk free rate can be
represented as:
RF = r* + IP
• The risk-free rate (as shown in the preceding equation)
embodies the real rate of interest plus the expected inflation
premium.
• The inflation premium is driven by investors’ expectations
about inflation—the more inflation they expect, the higher will
be the inflation premium and the higher will be the nominal
interest rate.

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

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 Corporate Bonds
• A bond is 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.
• The bond’s coupon interest rate is the percentage of a bond’s
par value that will be paid annually, typically in two equal
semiannual payments, as interest.
• The bond’s par value, or face value, is the amount borrowed
by the company and the amount owed to the bond holder on
the maturity date.
• The bond’s maturity date is the time at which a bond becomes
due and the principal must be repaid.

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 Valuation Fundamentals
• Valuation is the process that links risk and
return to determine the worth of an asset.
• There are three key inputs to the valuation
process:
1. Cash flows (returns)
2. Timing
3. A measure of risk, which determines the required
return

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 Basic Valuation Model
• 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 value of any asset at time zero, V0, can be expressed as

where
v0 = Value of the asset at time zero
CFT = cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period
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 Bond Valuation: Bond
Fundamentals
• As noted earlier, bonds are long-term debt
instruments used by businesses and
government to raise large sums of money,
typically from a diverse group of lenders.
• Most bonds pay interest semiannually at a
stated coupon interest rate, have an initial
maturity of 10 to 30 years, and have a par value
of $1,000 that must be repaid at maturity.

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 Bond Valuation: Basic Bond
Valuation
The basic model for the value, B0, of a bond is given by
the following equation:

Where
B0 = value of the bond at time zero
I= annual interest paid in dollars
n= number of years to maturity
M= par value in dollars
rd = required return on a bond
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 Bond Valuation: Basic Bond
Valuation (cont.)
• Mills Company, a large defense contractor, on January 1,
2007, issued a 10% coupon interest rate, 10-year bond with a
$1,000 par value that pays interest annually.
• 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) at the end of each year and (2) the
$1,000 par value at the end of the tenth year.
• Assuming that interest on the Mills Company bond issue is
paid annually and that the required return is equal to the
bond’s coupon interest rate, I = $100, rd = 10%, M = $1,000,
and n = 10 years.

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 Bond Valuation: Bond Value
Behavior
In practice, the value of a bond in the marketplace is
rarely equal to its par value.
– 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.

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Table 6.6 Bond Values for Various Required Returns (Mills Company’s
10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1,
2010, Issue Paying Annual Interest)

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 Figure 6.4 Bond Values and
Required Returns

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 Bond Valuation: Bond Value
Behavior (cont.)
• Interest rate risk is 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.
• The shorter the amount of time until a bond’s
maturity, the less responsive is its market value to a
given change in the required return.

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 Bond Yields
• Yields are the returns on bonds based on market
conditions.
• Current Yield is the annual interest payment
divided by the current price.
• Yield To Maturity is the rate of return earned on a
bond if it is held till maturity.
• At the time of issue YTM is equal to coupon rate.

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 Yield to Maturity (YTM)
• The yield to maturity (YTM) is the rate of return that
investors earn if they buy a bond at a specific price
and hold it until maturity. (Assumes that the issuer
makes all scheduled interest and principal payments
as promised.)
• The yield to maturity on a bond with a current price
equal to its par value will always equal the coupon
interest rate.
• When the bond value differs from par, the yield to
maturity will differ from the coupon interest rate.
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 Estimated Yield To Maturity
• Without a financial calculator it is not possible to find
the exact YTM of any bond.
• However YTM can be estimated using the following
formula:

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 Yield to Maturity (YTM): Semiannual
Interest and Bond Values
• The procedure used to value bonds paying interest semiannually is
similar to that shown in Chapter 5 for compounding interest more
frequently than annually, except that here we need to find present
value instead of future value. It involves
1. Converting annual interest, I, to semiannual interest by dividing I by 2.
2. Converting the number of years to maturity, n, to the number of 6-month
periods to maturity by multiplying n by 2.
3. Converting the required stated (rather than effective) annual return for
similar-risk bonds that also pay semiannual interest from an annual rate, rd,
to a semiannual rate by dividing rd by 2.

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 Yield to Maturity (YTM): Semiannual
Interest and Bond Values (cont.)
• Assuming that the Mills Company bond pays interest
semiannually and that the required stated annual
return, rd is 12% for similar risk bonds that also pay
semiannual interest, substituting these values into the
previous equation yields

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