Corporate Finance
Bond Valuation
Sources of Corporate Finance
❑Balance sheet of Apple (in billion (!) dollars)
Assets Liabilities
Property / Plant 40 Long-term Debt 162
Other Fixed Assets 177 Accounts Payable 55
Other current liabilities 70
Inventory 7 Total
Accounts Receivable 51 Equity
Cash 62 Common Stock 63
Other current Assets 14 Retained Earnings 1
Total Assets 351 Total Liabilities 351
The Financing Decision
Bonds vs. Shares
❑ Face value/par value - the original issue price (the amount
borrowed).
❑ Maturity date - date on which the loan has to be repaid.
❑ Coupon rate - original interest rate on the bond.
Bond Valuation
❑ How do we determine the value (price) of a bond?
❑ Just as any financial asset, the value of a bond is
equal to the present value of all the cash flows
the investor will receive in the future.
➢ A company has previously issued a bond with a $1,000 face
value, paying a 5% coupon rate per year. The bond has four years
left to maturity. How much would you be willing to pay for this
bond if you can buy it today in the secondary market, and the
current rate of return on these type of securities is 4%?
$1000
$50 $50 $50 $50
T=0 1 2 3 4
$50 $50 $50 $1,050
❑ PV = 1 + 2 + 3 +
1+𝑟 1+𝑟 1+𝑟 (1+𝑟)4
❑ 𝑟 = 4%
$50 $50 $50 $1,050
❑PV = + + +
1+𝑟 1 1+𝑟 2 1+𝑟 3 (1+𝑟)4
❑𝑟 = 4%
$50 $50 $50 $1,050
❑PV = + + +
1.04 1 1.04 2 1.04 3 (1.04)4
❑PV = $1,036.30
PREMIUM!
Bond Valuation
❑ Formula for the Present Value of a bond:
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
➢ 𝑷𝒃 - bond price
➢ 𝑪 – coupon payment
➢ 𝒏 – number of periods to maturity
➢ 𝒓 – required rate of return
➢ 𝑭𝑽 – face value
➢ A company has previously issued a bond with a $1,000 face
value, paying a 3% coupon rate per year. The bond has four years
left to maturity. How much would you be willing to pay for this
bond if you can buy it today in the secondary market, and the
current rate of return on these type of securities is 5%?
$30 $30 $30 $1,030
❑PV = 1 + 2 + 3 +
1+𝑟 1+𝑟 1+𝑟 (1+𝑟)4
❑𝑟 = 5%
1−(1+𝑟)−𝑛 FV
❑ 𝑃𝐵 = C +
𝑟 (1+𝑟)𝑛
1−(1.05)−4 1000
❑ 𝑃𝐵 = 30 +
0.05 (1.05)4
❑ PV = $929.08
DISCOUNT!
➢ A firm issues a 10-year bond with a $1,000 face value, paying a
6% coupon rate per year. What will be the value of this bond five
years later, if the yield on these type of securities has remained at
6% by then?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
1 − (1.06)−5 1000
𝑃𝐵 = 60 +
0.06 (1.06)5
𝑃𝐵 = $1,000
PAR!
➢ ANZ has issued a 10-year bond with a $1,000 face value, that has
currently got 4 years left to maturity. The coupon rate is 4.3% per
year, while similar securities currently have a rate of return of
3.8%. Is the ANZ bond trading at a premium, discount or at par in
the secondary market?
❑ 𝑐𝑜𝑢𝑝𝑜𝑛 > 𝑟
❑ 𝑇ℎ𝑢𝑠, 𝑃 > 𝐹𝑉
❑ 𝑇𝑟𝑎𝑑𝑖𝑛𝑔 𝑎𝑡 𝑎 𝑝𝑟𝑒𝑚𝑖𝑢𝑚.
➢ ANZ has issued a 10-year bond with a $1,000 face value, that has
currently got 4 years left to maturity. The bond pays quarterly
coupons. The coupon rate is 4% per year, while similar securities
currently have a rate of return of 3%. What is the correct price for
the ANZ bond?
1−(1+𝑟)−𝑛 FV
❑ 𝑃𝐵 = C +
𝑟 (1+𝑟)𝑛
40
❑C= = 10
4
❑ The rate of return of 3% per year is similar to the
“effective interest rate” that the bondholder will receive.
We have to convert it to a quarterly 𝑟 :
❑ 1.031/4 = 1.0074
❑ 𝑟 = 0.0074
➢ ANZ has issued a 10-year bond with a $1,000 face value, that has
currently got 4 years left to maturity. The bond pays quarterly
coupons. The coupon rate is 4% per year, while similar securities
currently have a rate of return of 3%. What is the correct price for
the ANZ bond?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
𝑛 = 4 × 4 = 16
1 − (1 + 0.0074)−16 1000
𝑃𝐵 = 10 +
0.0074 (1 + 0.0074)16
𝑃𝐵 = $1,039.10
Corporate Finance
Calculating the Yield to Maturity
➢ ANZ has issued a 10-year bond with a $1,000 face value, that has
currently got 4 years left to maturity. The bond is currently trading
for $1,018.24 in the secondary market. It pays annual coupons of
4.3% per year. What is the current yield to maturity on the ANZ
bond?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
1 − (1 + 𝑟)−4 1000
1,018.24 = 43 +
𝑟 (1 + 𝑟)4
PV -1018.24
𝑟 = ? ? ? → Financial calculator or Excel: FV 1000
Excel: “=RATE(NPER,PMT,PV,FV)” NP(ER) 4
PMT 43
“=RATE(4,43,-1018.24,1000)”
R ??
𝑟 = 3.80%
➢ Commonwealth Bank has issued a bond with a $1,000 face value,
that has currently got 8 years left to maturity. The bonds has
semi-annual coupon payments and the coupon rate is 4.3% per
year. The bond is currently trading at $1181.61. What is the yield
to maturity on this bond?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
1 − (1 + 𝑟)−16 1000
$1181.61 = 21.5 +
𝑟 (1 + 𝑟)16
PV -1181.61
𝑟 = ? ? ? → Financial calculator or Excel:
FV 1000
𝑟 = 0.0092376
Annual ytm: NP(ER) 16
(1.0092376)2 = 1.01856 PMT 21.5
≈ 1.86% R ??
Corporate Finance
Fluctuating Bond Prices
Bond price fluctuations
❑ Bonds are frequently traded in the secondary
market, and bond prices change all the time!
Bond price fluctuations
❑ Why do bond prices change over time?
❑ Let’s have a look at the formula for the price of a
bond. Which variables will change over time? And
which variables are fixed and do not change over
time?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
Bond price fluctuations
❑ 𝒓 and n change over time.
❑ Bond prices fluctuate over time due to:
➢Changes in the return that investors require for
holding the bond (𝑟 changes)
➢Changes in the time to maturity (n changes)
Bond price fluctuations
❑Changes in the return that investors require for
holding the bond (𝑟 changes)
❑ Investors’ 𝑟 is determined by two components:
Risk-free rate + Risk premium
Credit risk
❑ First, the risk premium part. The primary determinant
of the return that investors require for investing in a
bond is the amount of risk involved.
❑ If we buy a Qantas bond, what is the probability that
the company will not be able to repay its debts, and
we will not get our money back?
❑ If there is a high probability of default (investors losing
money), then investors will require a high return for
taking that risk.
➢ Consider a Qantas bond with a face value $1,000, semi-annual
coupon payments with a coupon rate of 5.2% p.a., and fifteen
years to maturity. What is the correct price for the bond if the
current yield that investors require on these bonds is 3.1%?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
Find the semi-annual 𝑟:
(1.031)1/2 = 1.01538
1 − (1.01538)−30 1000
𝑃𝐵 = 26 +
0.01538 (1.01538)30
𝑃𝐵 = $1,253.68
➢ Consider again the same Qantas bond (face value $1,000, semi-
annual coupon payments, coupon rate 5.2% p.a., 15 years to
maturity). How will the required yield by investors change, if
suddenly all international air traveling will be halted due to a
pandemic?
❑ If the company suddenly sees a significant drop in
earnings, there is a higher risk that the company will not
be able to repay their debt to the bondholders. (= higher
default risk, or credit risk).
❑ In other words, investing in a Qantas bond is now riskier,
so investors require a higher return (they require a
higher risk premium).
➢ Consider again the same Qantas bond (face value $1,000, semi-
annual coupon payments, coupon rate 5.2% p.a., 15 years to
maturity). What will happen to the price of the bond, if suddenly
investors want a much higher yield?
❑ If investors are no longer happy with the yield of the
bond (they want a higher return now), they will sell the
bond, causing its price to decline.
➢ Consider again the same Qantas bond (face value $1,000, semi-
annual coupon payments, coupon rate 5.2% p.a., 15 years to
maturity, priced at $1,253.68 if the required yield is 3.1% p.a.)
What will be the price of the bond, if the required return by
investors increases to 6.8%?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
Convert to semi-annual 𝑟 ∶
1.0681/2 = 1.03344 → 𝑟 = 0.03344
1 − (1.03344)−30 1000
𝑃𝐵 = 26 +
0.03344 (1.03344)30
𝑃𝐵 = $860.45
The bond price and r have an inverse relation
❑ The required yield by investors on our Qantas bond
increased from 3.1% to 6.8%. They started selling the
bond, and the price of the bond dropped from $1,253.68 to
$860.45.
❑ Bond prices and r have an inverse relation.
❑ When required return of investors increases, the bond price
will decline.
❑ When the required return by investors decreases, the bond
price will increase.
Credit risk, credit spreads and credit ratings
Credit risk, credit spreads and credit ratings
❑ The low yield indicates that investors regard Amazon
bonds as very safe.
❑ The safest type of bonds are Treasury bonds. They are
regarded as risk free.
❑ The difference between the yield on a corporate bond and
the treasury yield is called the ‘credit spread’. The size of
the credit spread will depend on the likelihood of default
of the firm.
❑ The higher the credit risk, the higher credit spread.
❑ 0.4% (Amazon yield) – 0.2% (US Treasury yield) is a
spread of just 0.2%.
Credit risk, credit spreads and credit ratings
❑ Rating agencies rate the creditworthiness of
bonds and provide these ratings to investors.
Source:
[Link]
Interest rate risk
❑ One reason for changes over time in the return that
investors require for investing in a bond, is a change in the
amount of risk involved.
❑ Another reason for changes over time in the return that
investors require for investing in a bond, is due to changes
in the risk-free interest rate.
❑ The risk-free interest rate changes all the time (for example,
when the central bank changes its interest rates.)
Interest rate risk
❑ If the risk-free interest rate increases, the r on all
bonds will go up as well.
❑ If this happens, the price of some bonds is affected
more than others.
➢ All else equal, the greater the time to maturity of
a bond, the greater the interest rate risk.
➢ All else equal, the lower the coupon rate of a
bond, the greater the interest rate risk.
Bond price fluctuations
❑ 𝒓 and n change over time.
❑ Bond prices fluctuate over time due to:
➢Changes in the return that investors require for
holding the bond (𝑟 changes)
• Credit risk
• Interest rate risk
➢Changes in the time to maturity (n changes)
➢ Consider again the same Qantas bond (face value $1,000, semi-
annual coupon payments, coupon rate 5.2% p.a., 15 years to
maturity, priced at $1,253.68 if the required yield is 3.1% p.a.).
What will be the price of the bond 9 years from now, assuming the
required yield will not change?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
1 − (1.01538)−12 1000
𝑃𝐵 = 26 +
0.01538 (1.01538)12
𝑃𝐵 = $1,115.56
❑ The bond price will have decreased to $1,115.56
➢ Consider again the same Qantas bond (face value $1,000, semi-
annual coupon payments, coupon rate 5.2% p.a., 15 years to
maturity, priced at $860.45 if the required yield is 6.8% p.a.) What
will be the price of the bond 9 years from now, assuming the
required yield will not change?
1 − (1 + 𝑟)−𝑛 FV
𝑃𝐵 = C +
𝑟 (1 + 𝑟)𝑛
1 − (1.03344)−12 1000
𝑃𝐵 = 26 +
0.03344 (1.03344)12
𝑃𝐵 = $927.44
❑ The bond price will have increased from $860.45 to $927.44
Bond price fluctuations
❑ The bond price will approach the face value as it gets
closer to maturity.
([Link]/wiki/Bond_pricing)
