Summary Chapter 8: Bond Valuation and Interest Rates
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Course
Financial Management 244
Institution
Stellenbosch University (SUN)
A complete summary of Chapter 8: Bond Valuation and Interest Rates from the Corporate Finance textbook assigned to the module. This includes outlines from the slides as well.
A bond/debenture is a promise to pay a certain amount on a specific date and to pay
interest on a regular basis to the bondholder. A bond is a form of financing and a
type of loan or IOU.
This form of debt financing is usually used by governments or the corporate sector
and is mainly used to finance expansion.
1. The public first buys the bond from the borrower (issuer) and becomes the
bondholder (lender).
2. The issuer is obliged to pay interest (coupons) to the lender at fixed intervals.
3. At the end of the life of the bond (maturity), the bond issuer has to repay the
principal amount (par/nominal amount).
Characteristics of Bonds
A bond is an interest-only loan, because only interest will be paid every period and
the amount borrowed will be repaid at the end of the loan. Bonds have certain
unique characteristics that are vital in understanding this form of debt financing.
The amount borrowed and repaid at the end of the life
Nominal/Par Value
of the bond.
The fixed interest rate that the issuer pays the
Coupon Rate
bondholder every period.
The amount that the issuer pays the bond holder very
Coupon
period (nominal value x coupon rate = coupon).
The time left until the bond reaches the end of its term
Maturity
and the nominal value has to be repaid.
The interest rate earned by the bondholder if the bond
Yield-to-Maturity (YTM)
is bought and held until maturity.
The yield-to-maturity (YTM) rate also represents the bondholders’ opportunity costs:
what they could have earned if they did not buy the bond. The market interest rate is
usually used as a proxy.
Investors in the market will receive a
higher interest rate than investors
If YTM>CR
buying the bond.
The bond will be selling at a discount.
Investors in the market will receive a
lower interest rate than investors buying
If YTM<CR
the bond.
The bond will be selling at a premium.
PV = Nominal Value
The bond will be selling at nominal/par
If YTM+CR
value.
How to Value a Bond
, Financial Management 244
The value of a bond is made up of two types of cash flows:
The constant coupon payments over the lifetime of the bond (annuity).
The nominal value (a once-off payment on the maturity date).
T
Coupon Nominal
PV =∑ +
t =1 (1+YTM ) (1+YTM )T
t
Both types of cash flows are discounted to calculate the present value of the bond.
When calculating the value of a bond, there are five variables involved. With any 4 of
these variables, the fifth can be calculated. On a financial calculator:
FV: Nominal Value
PMT: Coupon
I/YR: Yield-to-Maturity
N: Time to Maturity
PV: Bond Value
Bond Value=PV of the Coupons+ PV of the Nominal Amount
1
1− t
(1+ i) N
Bond Value=C × +
i (1+ i)t
Where:
C = Annuity Payment (Coupon Amount)
N = Nominal Amount
i = Interest Rate
T = Time to Maturity
1
(1+i)t
PV of the Annuity=C ×1−
i
PV of the Nominal Vale ¿
Semi-Annual Payments
Semi-annual payments refer to those payments made twice per year, or every six
months. In this case, three things need to happen:
1. The maturity has to double (Maturity x 2)
2. The coupon rate has to be halved (Coupon Rate/2)
3. The YTM has to be halved (YTM/2), OR the P/YR must be changed to 2 on
the calculator.
Types of Bonds
There are a great number of various types of bonds available to investors. There are
nine types of bonds focused on in this chapter:
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