ch08 Fin202

Fundamentals of Corporate Finance
Fifth Edition, International Adaptation

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.;
Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.
Chapter 8
Bond Valuation and the Structure of
Interest Rates
Copyright ©2022 John Wiley & Sons, Inc.
Chapter 8: Bond Valuation and the
Structure of Interest Rates
Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)
1. Describe the market for corporate bonds and three

types of corporate bonds
2. Explain how to calculate the value of a bond and why
bond prices vary negatively with interest rate
movements
3. Distinguish between a bond’s coupon rate, yield to
maturity, and effective annual yield

Learning Objectives (2 of 2)
4. Explain why investors in bonds are subject to interest

rate risk and why it is important to understand the
bond theorems
5. Discuss the concept of default risk and know how to
compute a default risk premium
6. Describe the factors that determine the level and shape
of the yield curve

8.1 Corporate Bonds
LEARNING OBJECTIVE
Describe the market for corporate bonds and three types of
corporate bonds
• Corporate Bonds
• Market for Corporate Bonds
• Bond Price Information
• Types of Corporate Bonds
L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 5

Corporate Bonds
• Market for Corporate Bonds

• Types of Bonds that Firms Issue

Market for Corporate Bonds
• Value of corporate bonds in the U.S. $16.9 trillion at

the end of the third quarter of 2020
• The most important investors are life insurance
companies, pension funds, and mutual funds
• Transactions tend to be in very large dollar amounts

Bond Price Information
• Only a small fraction of the bonds outstanding are traded each
day
o Most transactions are negotiated directly between the buyer and
seller, with limited centralized reporting of the sales
o They usually take place through dealers in the over-the-counter
(OTC) market
• The market is thin compared to markets for money-market securities
and stocks, so corporate bonds are less marketable than securities with
large daily trading volumes
• The market is also less transparent than the equity market
o Prices in the market tend to be more volatile than those of
securities with greater trading volumes

Types of Corporate Bonds (1 of 3)
• Fixed-income securities are those that pay interest in fixed

amounts for the life of the contract
• Features of Corporate Bonds
o Long-term claims against company assets
o Face, or par, value is $1,000
o Coupon rate is the annual coupon payment (C) divided by a
bond’s face value (F)
o Coupon payment is a fixed amount paid to lenders for the
life of the contract (typically with a semiannual or annual
payment)

• Vanilla bonds, also called debentures, are typically unsecured

o Coupon payments fixed for the life of the bond
o Repay principal and retire the bonds at maturity
o Contracts have the features and provisions found in most bond
covenants
o Annual or semiannual coupon payments
• Zero coupon bond
o No coupon payments
o Pays face value at maturity
o Sell at deep discount

• Convertible bonds
o May be exchanged for shares of the firm’s stock
o Sell for a higher price than a comparable non-
convertible bond
o Bondholders benefit if the market value of the
company’s stock gets high enough

8.2 Bond Valuation
LEARNING OBJECTIVE
Explain how to calculate the value of a bond and why bond prices
vary negatively with interest rate movements
• Bond Valuation
• The Bond Valuation Formula
• Calculator Tip: Bond Valuation Problems
• Par, Premium, and Discount Bonds
• Semiannual Compounding
• Zero Coupon Bonds

Bond Valuation
• The steps necessary to value an asset are as follows:
1. Estimate the expected future cash flows
2. Determine the required rate of return, or discount rate. This rate
depends on the riskiness of the future cash flows
3. Compute the present value of the future cash flows. This present
value is what the asset is worth at a particular point in time
• Given the above information we can compute the current value,
or price, of a bond (PB) by calculating the present value of the
bond’s expected cash flows:
PB = PV (Coupon payments) + PV (Principal payment)

The Bond Valuation Formula
• To calculate bond price, determine

o The required rate of return, i
o Expected future cash flows: coupon payments and principal payment
• The price is the present value of the future cash flows
PB = PVcoupon payments + PVprincipal payment
Equation 8.1
C1 C2 Cn + Fn
PB = + +…+
1+ i  1+ i 2 1+ i 
n

Cash Flows for a Three-Year Bond
Exhibit 8.1 The exhibit shows a time line for a three-year bond that pays an 8
percent coupon rate and has a face value of $1,000. How much should we pay for
such a bond if the market rate of interest is 10 percent? To solve this problem, we
discount the promised cash flows to the present and then add them up.
Calculating the Price of the Three-
Year Bond
• To calculate the bond price, determine
PB = PVcoupon payments + PVprincipal payment
C1 C2 C3 F3
PB = + + +
1+ i  1+ i 2 1+ i 3 1+ i 3
$80 $80 $80 $1,000
= + + +
1.10  1.10  1.10  1.10 3
2 3
= $72.73 + $66.11+ $60.10 + $751.30 = $950.24

Calculator Tip: Bond Valuation
Problems
• Determine the price of the bond in Exhibit 8.1 with a
financial calculator:

Par, Premium, and Discount Bonds
• Par bond
o If a bond’s coupon rate is equal to its yield, the price will equal
the face value
• Premium bond
o If a bond’s coupon rate is more than its yield, the price will be
higher than the face value
o Likely to happen when interest rates are falling
• Discount bond
o If a bond’s coupon rate is less than its yield, the price will be less
than the face value
o Likely to happen when interest rates are rising

Bond Prices and Yields
Calculating bond prices and yields using a spreadsheet may seem
daunting at first. However, understanding the terminology used in
the formulas will make the calculations a matter of common sense:
Settlement date—the date a buyer purchases the bond
Maturity date—the date the bond expires. If you know only the “n”
(number of years remaining) of the bond, use a date that is n years
in the future in this field
Redemption—the security’s redemption value per $10 face value. In
other words, if the bond has a par value of $1,000, you enter 100 in
this field
Frequency—the number of coupon payments per year

Using Excel
We first use the =PRICE(settlement, maturity, rate, yield, redemption, frequency)
formula in Excel to calculate the bond price as a percentage of par. We then
multiply this percentage (77.18 percent in the above example) by $1,000 to
obtain the bond price in dollars. A bond yield, which is discussed in the next
section, is calculated in a similar manner, using the “=YIELD (settlement,
maturity, rate, price, redemption, frequency)”formula

Semiannual Compounding
• Most bonds issued in Europe pay annual coupons, but

bonds issued in the U.S. usually pay semi-annual
coupons
Equation 8.2
C C C C
+ Fmn
PB = m + m + m +…+ m
i  i
2
  i 
3
 i 
mn
1+ 1+ 1+ 1+
 
m  m  m    
 m

Semiannual Compounding -
Calculator Example
• What is the price of a three-year, 5% coupon bond with a market yield
of 8% and semi-annual coupon payments?
8%
Semi-annual yield   4%
2
$50
Semi-annual coupon payment   $25
2
Number of periods  3  2  6

Zero Coupon Bonds
• Zero Coupon bonds pay face value at maturity, but do not make
coupon payments
• The yield of a zero coupon bond is therefore the present value of
the par value
• Zero coupon bonds pay cash only at maturity; they sell for less
than similar bonds which make periodic interest payments
Equation 8.3
Fmn
PB = mn
 i 
 1+ 
 m

Calculator Example – Zero Coupon
Bond
• What is the price of a zero coupon bond with a $1,000 face value, 10-
year maturity, and semi-annual compounding? The market rate on
similar bonds is 12%
$1000 $1000
PZ    $311.80
1  .06 
20 20
 0.12 
1  
 2 

8.3 Bond Yields
LEARNING OBJECTIVE
Distinguish between a bond’s coupon rate, yield to maturity, and
effective annual yield
• Bond Yields
• Yield to Maturity
• Effective Annual Yield
• Realized Yield

Bond Yields
• Bond price can be gauged from an offer to sell it

• But the yield to maturity must be computed
• Some other important bond yields are computed

Yield to Maturity
• Yield to Maturity (YTM) is the rate that makes the

present value of the bond’s cash flows equal to the
price of the bond
o i.e., YTM is the rate a bondholder earns if the bond is
held to maturity and all coupon and principal payments
are made as promised
• YTM changes daily as interest rates change

Effective Annual Yield
• In bond trading, the effective annual rate (EAR) is called the

effective annual yield (EAY)
m
 Quoted interest rate 
EAY = 1+  1
 m 
• The quoted interest rate is the simple annual yield which is the
yield per period multiplied by the number of compounding
periods; for bonds with semi-annual interest payments, simple
annual yield is two times the semi-annual yield

Calculator Example – YTM and EAY
(1 of 2)
• An investor buys a 30-year bond with a $1,000 face value for
$800. The bond’s coupon rate is 8% and interest payments are
made semi-annually. What are the bond’s yield to maturity and
effective annual yield?
Step 1:

Calculator Example – YTM and EAY
(2 of 2)
Step 2: Calculate YTM
Step 3: Calculate Effective Annual Yield (EAY)

Realized Yield
• Realized yield is the return earned on a bond given the

cash flows actually received by the investor
o It represents the interest rate at which the present value
of actual cash flows generated by the investment equals
the bond’s price
• The realized yield is important because it allows
investors to see what they actually earned on their
investments

Calculator Example – Realized Yield
• An investor buys a 3-year bond with a 6% coupon, purchased for

$960.99 with a promised yield of 7.5%. Suppose interest rates
decrease and the investor sold the bond for $750.79 after two
years. What is the realized yield?

8.4 Interest Rate Risk
LEARNING OBJECTIVE
Explain why investors in bonds are subject to interest rate risk and
why it is important to understand the bond theorems
• Interest Rate Risk

• Bond Theorems
• Bond Theorem Applications

Interest Rate Risk
• Interest rate risk: uncertainty about future bond values
due to the unpredictability of interest rates
• A number of relations exist between bond prices and

changes in interest rates. These are often called the bond
theorems, but they apply to all fixed-income securities
• It is important that investors and financial managers

understand these theorems.

Bond Theorems
• Bond theorems are statements about the math used in bond
pricing
o Bond prices are inversely related to interest rate movements
• As interest rates decline, prices of bonds rise
• As interest rates rise, prices of bonds decline
o For a given change in interest rates, prices on longer-term bonds
change more than prices of shorter-term bonds
• Interest rate risk increases as maturity increases, but at a decreasing
rate
o For a given change in interest rates, prices of lower-coupon bonds
change more than prices of higher-coupon bonds

Exhibit 8.2: Relation between Bond
Price Volatility and Maturity
Note: Plots are for a 1-year bond and a 30-year bond with a 10 percent coupon rate and annual payment

Exhibit 8.3: Relationship between Bond
Price Volatility and the Coupon Rate
Price Change If Yield Price Change If Yield
Increases from 5% to 6% Decreases from 5% to 4%
(1) (2) (3) (4) (5) (6) (7) (8)
Bond Price Loss from Gain from

Coupon at 5% Bond Price Increase in % Price Bond Price Decrease in % Price
Rate Yield at 6% Yield Change at 4% Yield Change
0% $ 613.91 $ 588.39 $25.52 −9.04% $ 675.56 $ 61.65 10.04%
5% $1,000.00 $ 926.40 $73.60 −7.36% $1,081.11 $ 81.11 8.11%
10% $1,386.09 $1,294.40 $91.69 −6.62% $1,486.65 $100.56 7.25%
Note: Calculations are based on a bond with a $1,000 face value and a 10-year maturity and assume annual
compounding.

Bond Theorem Applications
• If interest rates are expected to increase, avoid long-term bonds

- they will experience the largest prices declines
• If interest rates are expected to decrease, buy zero-coupon
bonds - their prices will increase more than those of coupon-
paying bonds

8.5 The Determinants of Corporate Borrowing Costs
LEARNING OBJECTIVE
Discuss the concept of default risk and how to compute a default
risk premium
• The Determinants of Corporate Borrowing Costs

• Marketability
• Call Provision
• Default Risk

The Determinants of Corporate
Borrowing Costs
• Market analysts have identified three characteristics of
debt instruments that are responsible for many of the
differences in corporate borrowing costs: the
security’s:
o Marketability
o Call provision
o Default risk

Marketability
• How quickly and easily a security can be sold at a low transaction
cost and at fair market value
o The selling price varies directly with the degree of marketability
o The transaction cost varies inversely with the degree of marketability
o The yield-to-maturity varies inversely with the degree of
marketability
• The difference in yields between a highly marketable security and
a less marketable security is the marketability risk premium (MRP)
MRP = ilow market  ihigh market > 0
• U.S. Treasury bills are considered the most marketable of all

securities

Call Provision
• The call provision is the bond issuer’s option to purchase a bond from
the bondholder at a predetermined price before maturity
o When bonds are called, bondholders suffer financial loss because they
must surrender higher-yield bonds and replace them with lower-yield
bonds
o Callable bonds sell for lower prices and higher yields than non-callable
bonds to compensate the buyer for the risk that the bonds will be called
o Bonds paying high yields are more likely to be called when interest rates
decline
• The difference in interest rates between a callable bond and a non-
callable bond is the call premium (CIP)
CIP = icallable  inon-callable > 0

Default Risk
• Default risk is the risk that a borrower may not make payments
as promised
o Lenders are paid a default risk premium for purchasing securities
with default risk
o The default risk premium (DRP) is the difference between the yield
on a security with default risk and the risk-free rate
DRP = idr  irf > 0
• The yield on U.S. Treasury bills is a proxy for the risk-free rate
since U.S. T-bills are considered to be free of default risk

Bond Ratings
• Individuals and small businesses rely on outside agencies for
information on the default potential of bonds
• The three most prominent credit rating agencies are Moody’s Investors
Service (Moody’s) and Standard and Poor’s (S&P), and Fitch
o All agencies rank bonds in order of probability of default and publish
rating as letter grades
o The highest grade bonds have the lowest default risk and are rated Aaa or
AAA
o Investment grade bonds are rated Aaa to Baa
o State and federal laws typically require commercial banks, insurance
companies, pension funds, certain other financial companies, and
government agencies to purchase only investment-grade securities

Exhibit 8.4: Corporate Bond Rating
Systems

Exhibit 8.5: Default Risk Premiums
for Selected Bond Ratings
Security Risk-Free Default Risk:
Security: Yield (%) Ratea (%) Premium (%)
Credit Rating (1) (2) (1) − (2)
Aaa/AAA 2.20 1.49 0.71
Aa/AA 2.68 1.49 1.19
A/A 3.18 1.49 1.69
Baa/BBB 4.37 1.49 2.88
a
20-year Treasury bond yield as of December 31, 2020.
Sources: U.S. Department of the Treasury (
https://www.treasury.gov/resource-center/data-chart-center/interestrates/Pages/TextView.aspx?data=yield ) and Fidelity
(https://fixedincome.fidelity.com/ftgw/fi/FILanding).

8.6 The Term Structure of Interest Rates
LEARNING OBJECTIVE
Describe the factors that determine the level and shape of the yield
curve.
• The Term Structure of Interest Rates

Term Structure of Interest Rates
• The term structure of interest rates refers to the relationship
between yield to maturity and term-to-maturity on a bond
• The graph of the term structure of interest rates is a yield curve
o The shape and position of the yield curve are not constant
o As the overall level of interest rates changes, the yield curve shifts up
and down and changes its shape and slope
• Basic shapes of yield curves:
o Ascending or normal yield curves slope upward from left to right and
imply higher interest rates are likely
o Descending or inverted yield curves slope downward from left to right
and imply lower interest rates are likely
o Flat yield curves imply interest rates are unlikely to change

Exhibit 8.6: Yield Curves for Treasury
Securities at Three Different Points in Time

Yield Curves for Treasury Securities
at Three Different Points in Time
Interest Rate (%)

Terms to Maturity December 2020 September 2019 December 2017
6 months 0.09 1.88 0.63
1 year 0.09 1.72 0.82
5 year 0.39 1.35 1.94
10 year 0.95 1.47 2.49
20 years 1.49 1.77 2.80
Exhibit 8.6 The shape, or slope, of the yield curve is not constant over time. The exhibit shows two
shapes: (1) the curves for December 2020 and January 2017 are upward sloping, which is the shape
most commonly observed, and (2) the curve for September 2019 is downward sloping for maturities
out to five years.

Factors that shape the Yield Curve (1 of 2)
• Real rate of interest
o The real rate of interest changes with the business cycle
o The highest rates occur at the end of an economic expansion
o The lowest rates occur at the end of an economic contraction
o Changes in the expected future real rate of interest can affect the
slope of the yield curve
• Expected rate of inflation
o If higher inflation is forecast, the yield curve will slope upward
because longer-term yields will contain a larger inflation premium
than shorter-term yields
o If investors believe inflation will subside, the yield curve will
slope downward
Factors that shape the Yield Curve (2 of 2)
• Interest rate risk

o The longer the maturity of a security, the greater its
interest rate risk (the risk of selling the security at a
lower price) and the higher the YTM
o The interest rate risk premium adds upward bias to the
slope of the yield curve

The Structure of Interest Rates:
Effects
• Cumulative effect of factors that shape the yield curve:
o In an economic expansion
• The real rate of interest and inflation premium increase
monotonically
• Interest rate risk increases
o In an economic contraction
• The real rate of interest and inflation premium decrease
monotonically
• Interest rate risk decreases

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Copyright © 2022 John Wiley & Sons, Inc.

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Fundamentals of Corporate Finance

Fifth Edition, International Adaptation

Copyright ©2022 John Wiley & Sons, Inc. 2

1. Describe the market for corporate bonds and three

Copyright ©2022 John Wiley & Sons, Inc. 3

4. Explain why investors in bonds are subject to interest

Copyright ©2022 John Wiley & Sons, Inc. 4

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 5

• Market for Corporate Bonds

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 6

• Value of corporate bonds in the U.S. $16.9 trillion at

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 7

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 8

• Fixed-income securities are those that pay interest in fixed

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 9

• Vanilla bonds, also called debentures, are typically unsecured

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 10

L.O. 8.1 Copyright ©2022 John Wiley & Sons, Inc. 11

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 12

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 13

• To calculate bond price, determine

PB = PVcoupon payments + PVprincipal payment

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 14

PB = PVcoupon payments + PVprincipal payment

= $72.73 + $66.11+ $60.10 + $751.30 = $950.24

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 16

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 17

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 18

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 19

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 20

• Most bonds issued in Europe pay annual coupons, but

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 21

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 22

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 23

L.O. 8.2 Copyright ©2022 John Wiley & Sons, Inc. 24

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 25

• Bond price can be gauged from an offer to sell it

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 26

• Yield to Maturity (YTM) is the rate that makes the

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 27

• In bond trading, the effective annual rate (EAR) is called the

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 28

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 29

Step 3: Calculate Effective Annual Yield (EAY)

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 30

• Realized yield is the return earned on a bond given the

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 31

• An investor buys a 3-year bond with a 6% coupon, purchased for

L.O. 8.3 Copyright ©2022 John Wiley & Sons, Inc. 32

• Interest Rate Risk

L.O. 8.4 Copyright ©2022 John Wiley & Sons, Inc. 33

• A number of relations exist between bond prices and

• It is important that investors and financial managers

L.O. 8.4 Copyright ©2022 John Wiley & Sons, Inc. 34

L.O. 8.4 Copyright ©2022 John Wiley & Sons, Inc. 35

L.O. 8.4 Copyright ©2022 John Wiley & Sons, Inc. 36

(1) (2) (3) (4) (5) (6) (7) (8)

Bond Price Loss from Gain from

5% $1,000.00 $ 926.40 $73.60 −7.36% $1,081.11 $ 81.11 8.11%