Lecture 5

Principles of Managerial Finance
Sixteenth Edition, Global Edition
Chapter 6
Interest Rates and Bond
Valuation
Copyright © 2022 Pearson Education, Ltd.

Learning Goals (1 of 2)
LG 1 Describe interest rate fundamentals, the term structure
of interest rates, and risk premiums.
LG 2 Review the legal aspects of bond financing and bond
cost.
LG 3 Discuss the general features, yields, prices, ratings,
popular types, and international issues of corporate
bonds.
LG 4 Understand the key inputs and basic model used in the
bond valuation process.

Learning Goals (2 of 2)
LG 5 Apply the basic valuation model to bonds, and describe
the impact of required return and time to maturity on
bond prices.
LG 6 Explain yield to maturity (YT M), its calculation, and the
procedure used to value bonds that pay interest
semiannually.

6.1 Interest Rates and Required
Returns (1 of 14)
• 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
 The interaction of supply and demand determines
interest rates
– Required Return
 The return that the supplier of funds requires the
demander to pay
 Applies to almost any kind of investment
Figure 6.1 Supply-Demand
Relationship

Returns (2 of 14)
– 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

Returns (3 of 14)
– Negative Interest Rates
 When a loan carries an interest rate below zero, the
lender essentially pays interest to the borrower
rather than the other way around
 A natural question is, why would anyone buy an
investment if it paid an interest rate below zero?
– The answer is that there is no good, safe
alternative offering a better return

Matter of Fact (1 of 2)
Fear Turns T-Bill Rates Negative
When the coronavirus outbreak reached the United States in
early 2020, financial markets reacted in dramatic fashion. On
March 25, interest rates on one-month and three-month
Treasury bills briefly turned negative, meaning that investors
paid more to the Treasury than the Treasury promised to pay
back. Why would people put their money into an investment
they know will lose money? Fear about the effects of COVID-
19 on the economy sent stock prices tumbling, and investors
moved their money into safer Treasury securities. The
demand for those securities was so high, temporarily, that
investors effectively paid the U.S. Treasury to hold their
funds for a short time.

Returns (4 of 14)
– 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

Returns (5 of 14)
– Nominal and Real Interest Rates
 r = nominal interest rate

 r* = real interest rate
 i = expected inflation rate

Personal Finance Example 6.1 (1 of 3)
Burt Gummer is a survivalist who constantly worries that the
disaster may happen any day now. To be prepared, Burt
stores food with a long shelf life in his basement. Burt has
$100 to add to his food stores, and he is considering the
purchase of 100 cans of Spam for $1 each. Burt expects the
inflation rate over the coming year to be 9%, so a can of
Spam will cost $1.09 each in a year. Burt’s wife, Heather,
has heard of an investment that will pay a 21% nominal
return over the next year, so she thinks Burt should invest
the money rather than use it to buy Spam.

Equation 6.1a says that the approximate real return on Burt’s
potential investment is 12%:
12% ≈ 21% − 9%
On the basis of this calculation, Burt might expect that if he
invests $100, he could buy 112 cans of Spam next year
rather than 100 cans this year (a 12% increase in purchasing
power). Suppose that Burt invests the money, earns a 21%
rate of return, and one year later has $121. By that time, one
can of Spam costs $1.09, so Burt is just barely able to
purchase 111 cans (111 cans × $1.09 = $120.99).

Burt’s purchasing power has increased by 11%, not by the
12% that he expected. Equation 6.1 reveals that the exact
real return on Burt’s investment is 11%:

Returns (6 of 14)
– Nominal Interest Rates, Inflation, and Risk
 RF = Risk-free rate
 rj = Nominal return on investment j

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

Returns (7 of 14)
• Term Structure of Interest Rates
– Yield Curves
 Term Structure of Interest Rates
– The relationship between the maturity and rate of return
for bonds with similar levels of risk
 Yield Curve
– A graphic depiction of the term structure of interest rates
 Yield to Maturity (YTM)
– Compound annual rate of return earned on a debt security
purchased on a given day and held to maturity
– An estimate of the market’s required return on a particular
bond

Returns (8 of 14)
– Yield Curves
 Normal Yield Curve
– An upward-sloping yield curve indicates that long-
term interest rates are generally higher than short-
term interest rates
 Inverted Yield Curve
– A downward-sloping yield curve indicates that short-
term interest rates are generally higher than long-term
interest rates
 Flat Yield Curve
– A yield curve that indicates that interest rates do not
vary much at different maturities
Returns (9 of 14)
– Yield Curves
 Deflation
– A general trend of falling prices
 The shape of the yield curve may affect the firm’s
financing decisions
– A financial manager who faces a downward-sloping
yield curve may be tempted to rely more heavily on
cheaper, long-term financing
– When the yield curve is upward sloping, the manager
may believe it wise to use cheaper, short-term
financing

Figure 6.4 The Slope of the Yield Curve
and the Business Cycle

Returns (10 of 14)
– Theories of the Term Structure
 Expectations Theory!!!!!
– The theory that the yield curve reflects investor
expectations about future interest rates; an
expectation of rising interest rates results in an
upward-sloping yield curve, and an expectation
of declining rates results in a downward-sloping
yield curve

Example 6.2 (1 of 3)
Suppose that a one-year T-bill currently offers a 3.5% return
and a two-year Treasury note offers a 3.0% annual return.
Thus, the short-term rate is higher than the long-term rate
and the yield curve slopes down. According to the
expectations theory, what belief must investors hold about
the rate of return that a one-year T-bill will offer next year?
First, recognize that by purchasing the two-year note,
investors can earn a return of 6.09% over two years:
(1 + 0.030)2 = 1.0609

If the market is in equilibrium, then the expected return on a
strategy of purchasing a sequence of two one-year T-bills
must offer the same return, so we have
(1 + 0.035)(1 + E(r)) = 1.0609
1 + E(r) = 1.0609 ÷ 1.035
E(r) = 0.025 = 2.5%

Investors believe the T-bill will offer a 2.5% return next year,
which is lower than the 3.0% return currently offered by one-
year T-bills. In other words, investors are indifferent between
earning 3.0% for two consecutive years on the Treasury note
or earning 3.5% this year and 2.5% next year on a sequence
of two one-year T-bills. Thus, today’s downward-sloping yield
curve implies that investors expect falling rates.

Returns (11 of 14)
 Liquidity Preference Theory
– Theory suggesting that long-term rates are
generally higher than short-term rates (hence,
the yield curve is upward sloping) 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
Returns (12 of 14)
 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

Returns (13 of 14)
• Risk Premiums: Issuer and Issue Characteristics
– The nominal rate of interest for security j is equal to the
risk-free rate, consisting of the real rate of interest plus
the expected inflation rate, plus the risk premium
– The risk premium varies with characteristics of the
company that issued the security as well as
characteristics of the security itself

The nominal interest rates on a number of classes of long-
term securities in April 2020 were as follows:
Security Nominal interest rate

One-Year U.S. Treasury bills 0.2%
Corporate bonds:
Investment grade 3.0%
High-yield 8.0%

Using the one-year Treasury bill rate as our benchmark risk-
free rate, we can calculate the risk premium of the other
securities by subtracting the risk-free rate, 0.2%, from rates
offered by each of the other corporate securities:
Security Risk premium
Corporate bonds:
Investment grade 3.0% − 0.2% = 2.8%
High-yield 8.0% − 0.2% = 7.8%

Investment grade bonds pay a risk premium over Treasury
bills in part because of their term (investment grade bonds
have a longer term than Treasury bills), but also because
they are issued by corporations and are not backed by the
full faith and credit of the U.S. government as are Treasury
securities. High-yield bonds pay an even larger risk premium
because they are issued by less creditworthy corporations.

Returns (14 of 14)
• Risk Premiums: Issuer and Issue Characteristics
– Several factors influence a bond’s risk premium
 Default risk or credit risk
– The likelihood that a corporation will fail to make interest
payments or principle repayments on its bonds
 Bond characteristics
– e.g., Time to maturity
 Interest rate risk
– When interest rates in the economy change, bond prices
move in the opposite direction
– Some bonds are more sensitive to interest rate risk and
therefore pay higher risk premiums to compensate
investors
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

(2 of 15)
• 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

(3 of 15)
• Legal Aspects of Corporate Bonds

– Bond Indenture/agreement
 A legal document that specifies both the rights of the
bondholders and the duties of the issuing corporation
– Standard Debt Provisions
 Provisions in a bond agreement specifying certain record-
keeping and general business practices that the bond
issuer must follow; normally, they do not place a burden
on a financially sound business
– Restrictive Covenants/contracts
 Provisions in a bond indenture that place operating and
financial constraints on the borrower

(4 of 15)

– Subordination
 In a bond indenture, the stipulation that subsequent
creditors agree to wait until all claims of the senior
debt are satisfied
– Sinking-Fund Requirement
 A restrictive provision often included in a bond
indenture, providing for the systematic retirement of
bonds prior to their maturity

(5 of 15)
– Collateral
 A specific asset against which bondholders have a
claim in the event that a borrower defaults on a
bond
– Secured Bond
 A bond backed by some form of collateral
– Unsecured Bond
 A bond backed only by the borrower’s ability to
repay the debt

6.2 Government and Corporate
Bonds (6 of 15)
– Trustee
 A paid individual, corporation, or commercial bank
trust department that acts as the third party to a
bond indenture and can take specified actions on
behalf of the bondholders if the terms of the
indenture are violated

(7 of 15)
• Cost of Bonds to the Issuer

– Impact of Bond Maturity
 Usually, long-term debt pays higher interest rates than short-
term debt
– Impact of Offering Size
 Bond flotation and administration costs per dollar borrowed are
likely to decrease as offering size increases
 However, the risk to the bondholders may increase, because
larger offerings result in greater risk of default, all other factors
held constant
– Impact of the Issuer’s Risk
 The greater the issuer’s default risk, the higher the interest rate

(8 of 15)
• Cost of Bonds to the Issuer

– Impact of the Risk-free Rate
 The risk-free rate in the capital market determines a
floor on the cost of a bond offering
 Generally, the rate on U.S. Treasury securities of
equal maturity is the lowest cost of borrowing money
– To that basic rate is added a risk premium that
reflects the factors mentioned prior (maturity,
offering size and issuer’s risk)

(9 of 15)
• General Features of a Bond Issue

– Conversion Feature
 A feature of convertible bonds that allows bondholders to
change each bond into a stated number of shares of
common stock
– Call Feature
 A feature included in nearly all corporate bond issues that
gives the issuer the opportunity to repurchase bonds at a
stated call price prior to maturity
– Call Price
 The stated price at which a bond may be repurchased, by
use of a call feature, prior to maturity

(10 of 15)
• General Features of a Bond Issue

– Call Premium
 The amount by which a bond’s call price exceeds its
par value
– Stock Purchase Warrants
 Instruments that give their holders the right to
purchase a certain number of shares of the issuer’s
common stock at a specified price over a certain
period of time

Bonds (11 of 15)
• Bond Yields
– Current Yield
 A measure of a bond’s cash return for the year
 Calculated by dividing the bond’s annual interest
payment by its current price
– Yield to Maturity (YT M)
– Yield to Call (YT C)

Bonds (12 of 15)
• Bond Prices
– Though corporate bonds are held mostly by institutional
investors and are not as actively traded as stocks, it is
still important to understand market conventions for
quoting bond prices and yields.
– Basis points
 A way of quoting an interest rate such that 100 basis
points equals one percentage point

Table 6.1 Data on Selected Bonds
Company Coupon Maturity Price Yield (YTM)
Verizon 5.050% Mar. 15, 2034 123.88 2.915%
Apple 3.850 Aug. 4, 2046 124.36 2.554
Tesla 5.300 Aug. 15, 2025 94.50 6.542
Safeway 7.450 Sep. 15, 2027 105.10 6.566
Amazon 4.250 Aug. 22, 2057 99.98 4.251
Bond data from http://finra-markets.morningstar.com/BondCenter/ActiveUSCorpBond.jsp, accessed on April 23, 2020 .

Bonds (13 of 15)
• Bond Ratings
– Independent agencies such as Moody’s, Fitch, and
Standard & Poor’s assess the riskiness of publicly
traded bond issues
– These agencies derive their ratings by using financial
ratio and cash flow analyses to assess the likely
payment of bond interest and principal
– Normally an inverse relationship exists between the
quality of a bond and the rate of return that it must
provide bondholders

Table 6.2 Moody’s and Standard &
Poor’s Bond Ratings
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: Based on Moody’s Investors Service, Inc., and based on Standard & Poor’s Corporation.

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
Table 6.3 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
Debentures Unsecured bonds that only Claims are the same as those
creditworthy firms can issue. of any general creditor. May
Convertible bonds are have other unsecured bonds
normally 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 senior debt claim.
been fully satisfied.
Income bonds Payment of interest is required Claim is that of a general

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

Table 6.3 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
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 bond
bonds owned by the issuer. Collateral value is collateral; if not fully satisfied, the lender
generally 25% to 35% greater than bond value. becomes a general creditor.
Equipment trust Used to finance “rolling stock,” such as Claim is on proceeds from the sale of the asset;
certificates airplanes, trucks, boats, railroad cars. A trustee if proceeds do not satisfy outstanding debt, trust
buys the asset with funds raised through the certificate lenders become general creditors.
sale of trust certificates and then leases it to the
firm; after making the final scheduled lease
payment, the firm receives title to the asset. A
type of leasing.

Table 6.4 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 one to five years, that can be renewed for a similar
Extendible notes
period at the option of holders. Similar to a floating-rate bond. An issue might be a
series of three-year renewable notes over a period of 15 years; every three
years, the notes could be extended for another three years, at a new rate
competitive with market interest rates at the time of renewal.

Table 6.4 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 one to five
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.

Bonds (15 of 15)
• International Bond Issues
– Eurobond
 A bond issued by an international borrower and sold to
investors in countries with currencies other than the currency
in which the bond is denominated
– Foreign Bond
 A bond that is issued by a foreign corporation or government
and is denominated in the investor’s home currency and sold
in the investor’s home market
– Bulldog Bond
• Foreign bond issued in Britain
– Samurai Bond
• Foreign bond issued in Japan

6.3 Valuation Fundamentals (1 of 2)
• Valuation
– The process that links risk and return to determine the
worth of an asset
• Key Inputs
– Cash Flows
– Timing
– Risk and Required Return

Celia Sargent wishes to estimate the value of three 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: Expects to receive cash
dividends of $300 per year indefinitely starting in one year.
Oil well: Expects to receive cash flows of $2,000 after one
year, $4,000 after two years, and $10,000 after four years,
when the well will run dry.

Original painting: Expects to sell the painting in five years
for $85,000.
With these cash flow estimates, Celia has taken the first step
in valuation.

Let’s return to Celia Sargent’s task of placing a value on the
original painting and consider two scenarios.
Scenario 1: Certainty A major art gallery has contracted to
buy the painting for $85,000 after five years. Because this
contract is already signed and the art gallery is well
established and reliable, Celia views this asset as “money in
the bank,” and uses something close to the prevailing risk-
free rate of 3% as the required return when calculating the
painting’s value today.

Scenario 2: High risk The values of original paintings by this
artist have fluctuated widely over the past 10 years. Although
Celia expects to sell the painting for $85,000, she realizes
that its sale price could range between $30,000 and
$140,000. Because of the high uncertainty surrounding the
painting’s value, Celia believes that a 15% required return is
appropriate.
These two estimates illustrate how the valuation process
accounts for risk through the discount rate. Although
adjusting the discount rate for risk has a subjective element,
analysts use historical data and forward-looking models to
estimate the required return with as much precision as
possible.

6.3 Valuation Fundamentals (2 of 2)
• Basic Valuation Model
– The value of an asset is the present value of all the
future cash flows it is expected to provide.
 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)

Celia Sargent values each asset by discounting its cash
flows using Equation 6.4. Because Michael’s stock pays a
perpetual stream of $300 dividends, Equation 6.4 reduces to
Equation 5.7, which says that the present value of a
perpetuity equals the dividend payment divided by the
required return. Celia decides that a 12% discount rate is
appropriate for this investment, so her estimate of the value
of Michael’s Enterprises stock is
$300 ÷ 0.12 = $2,500

Next, Celia values the oil well investment, which she
believes is the most risky of the three investments.
Discounting the oil well’s cash flows using a 20% required
return, Celia estimates the well’s value to be

Finally, Celia estimates the value of the painting by
discounting the expected $85,000 cash payment in five
years at 15%:
$85,000 ÷ (1 + 0.15)5 = $42,260.02
Note that, regardless of the pattern of the asset’s expected
cash flows, Celia can use the basic valuation equation to
determine the asset’s value.

6.4 Bond Valuation (1 of 11)
• 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 (every six months) at a
stated coupon rate
 have an initial maturity of 10 to 30 years
 and have a par value, principal, or face value, of
$1,000 that the borrower must repay at maturity

Example 6.7
The Mills Company just issued a 6% coupon 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 types of cash flows: (1) $60 annual interest (6% coupon
rate × $1,000 par value) distributed at the end of each year
and (2) the $1,000 par value at the end of the tenth year.

• Bond Values for Annual Coupons
 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 = annual required return on the bond

• Bond Values for Annual Coupons


• Bond Values for Semiannual Coupons
– As a practical matter, most bonds make semiannual rather
than annual interest payments
– Calculating the value for a bond paying semiannual interest
requires three changes to the approach we’ve used so far:
1.Convert the annual coupon payment, C, to a semiannual
payment by dividing C by 2
2.Recognize that if the bond has n years to maturity it will
make 2n coupon payments (i.e., in n years there are 2n
semiannual periods)
3.Discount each payment by using the semiannual
required return calculated by dividing the annual required
return, r, by 2




• Changes in Bond Prices
– When the required return rises, the bond price falls, and
when the required return falls, the bond price rises
– Required Returns and Bond Prices
 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
Let’s reconsider the Mills Company bond paying a 6%
coupon rate and maturing in 10 years (assume annual
interest payments for simplicity). Initially, we assumed that
the required return on this bond was 6%, so the bond’s value
was equal to par value, $1,000. Let’s see what happens to
the bond’s value if the required return is higher or lower than
the coupon rate. Table 6.5 shows that at an 8% required
return, the bond sells at a discount with a value of $865.80,
but if the required return is 4%, the bond sells at a premium
with a value of $1,162.22.

Table 6.5 Bond Values for Various
Required Returns (Mills Company’s
6% Annual Coupon Bond with a 10-
Year Maturity and $1,000 Par Value)
Required return, r Bond value, B0 Status
8% $ 865.80 Discount
6 1,000.00 Par value
4 1,162.22 Premium

Figure 6.5 Bond Values and Required
Returns

– Interest Rate Risk
 The chance that a bond’s required return will
change and thereby cause a change in the bond’s
price
 Other things being equal, Long-term bond prices
move more when rates change whereas short-term
bond prices are less sensitive to rate changes
– Long-term bonds are associated with more
interest rate risk

– Interest Rate Risk
 Other things being equal, higher coupon bonds have
less interest rate risk exposure compared to lower
coupon bonds
 Other things being equal, a bond with lower required
return has greater interest rate risk compared with a
bond that has a higher required return

– The Passage of Time and Bond Prices
 If a bond trades at a premium, and its required
return remains constant, as the bond gets closer to
maturity its price will fall, eventually reaching par
value at maturity
 If a bond sells at a discount and its required return
remains fixed, as time passes the bond’s price will
rise, eventually reaching par value at the moment
before the bond matures
 Bonds trading at par will remain at that value until
maturity as long as the required return does not
deviate from the coupon rate

• Yield to Maturity (YTM)
– The compound annual rate of return earned on a bond
purchased assuming that all payments arrive on time
and that the investor holds the bond to maturity
– Mathematically, a bond’s YTM is the discount rate that
equates the bond’s market price to the present value of
its cash flows

Review of Learning Goals (1 of 10)
• LG 1
– Describe interest rate fundamentals, the term structure of
interest rates, and risk premiums.
 Equilibrium in the flow of funds between savers and
borrowers produces the interest rate or required return
 Most interest rates are expressed in nominal terms
 The nominal interest rate represents the rate at which
money grows over time, whereas the real interest rate
represents the rate at which purchasing power grows
over time
 The difference between the nominal rate and the real
rate is (approximately) the inflation rate (or the expected
inflation rate)

• LG 1 (Cont.)
– Describe interest rate fundamentals, the term structure of
interest rates, and risk premiums.
 For risky assets, the nominal interest rate is the sum of
the risk-free rate and a risk premium reflecting issuer and
issue characteristics
 The risk-free rate is the real rate of interest plus an
inflation premium
 For any class of similar-risk bonds, the term structure of
interest rates is the relation between the rate of return
and the time to maturity
 Yield curves plot this relation on a graph and can be
downward sloping (inverted), upward sloping (normal), or
flat

• LG 1 (Cont.)
– Describe interest rate fundamentals, the term structure
of interest rates, and risk premiums.
 The expectations theory, liquidity preference theory,
and market segmentation theory offer different
explanations of the shape of the yield curve
 Risk premiums for non-Treasury debt issues result
from default or credit risk and other features such as
maturity and exposure to interest rate risk

• LG 2
– Review the legal aspects of bond financing and bond cost.
 Corporate bonds are long-term debt instruments that the
company must repay under clearly defined terms
 Most bonds are issued with maturities of 10 to 30 years
and a par value of $1,000
 The bond indenture, enforced by a trustee, states all
conditions of the bond issue
 It contains both standard debt provisions and restrictive
covenants, which may include a sinking-fund
requirement and/or a security interest
 The cost of a bond to an issuer depends on its maturity,
offering size, and issuer risk and on the risk-free rate

• LG 3
– Discuss the general features, yields, prices, ratings,
bonds.
 A bond issue may include a conversion feature, a
call feature, or stock purchase warrants
 The return on a bond can be measured by its
current yield, yield to maturity (YT M), or yield to call
(YT C)
 Bond prices are typically reported along with their
coupon, maturity date, and yield to maturity (YT M).
 Bond ratings by independent agencies indicate the
risk of a bond issue

• LG 3 (Cont.)
– Discuss the general features, yields, prices, ratings,
bonds.
 Various types of traditional and contemporary bonds
are available
 Eurobonds and foreign bonds enable established
creditworthy companies and governments to borrow
large amounts internationally

• LG 4
– Understand the key inputs and basic model used in the
bond valuation process.
 Key inputs to the valuation process include cash
flows, timing, risk, and the required return
 The value of any asset is equal to the present value
of all future cash flows it is expected to provide over
the relevant time period

• LG 5
– Apply the basic valuation model to bonds, and describe
bond prices.
 The value of a bond is the present value of its
coupon payments plus the present value of its par
value
 The discount rate used to determine bond value is
the required return, which may differ from the bond’s
coupon rate
 A bond can sell at a discount, at par, or at a
premium, depending on whether the required return
is greater than, equal to, or less than its coupon rate

• LG 5 (Cont.)
– Apply the basic valuation model to bonds, and describe
bond values.
 The chance that interest rates will change and
thereby alter the required return and bond value is
called interest rate risk.
 The shorter the amount of time until a bond’s
maturity, the higher its coupon rate, or the higher its
required return, the less responsive is its market
value to a change in the required return.
 The passage of time affects bond prices. The price
of a bond will approach its par value as the bond
moves closer to maturity.

• LG 6
– Explain yield to maturity (YT M), its calculation, and the
procedure used to value bonds that pay interest
semiannually.
 Yield to maturity is the rate of return investors earn if they buy
a bond at a specific price and hold it until maturity
 YT M can be calculated by using a financial calculator or by
using an Excel spreadsheet
 Bonds that pay interest semiannually are valued by using the
same procedure used to value bonds paying annual interest
except that the interest payments are one-half of the annual
interest payments, the number of periods is twice the number
of years to maturity, and the required return is one-half of the
stated annual required return on similar-risk bonds

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Principles of Managerial Finance

Sixteenth Edition, Global Edition

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 r = nominal interest rate

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 rj = Nominal return on investment j

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Security Nominal interest rate

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• Par Value, Face Value, Principal

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• Legal Aspects of Corporate Bonds

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• Legal Aspects of Corporate Bonds

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• Cost of Bonds to the Issuer

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• Cost of Bonds to the Issuer

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• General Features of a Bond Issue

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• General Features of a Bond Issue

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

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