Lecture Fundamentals of corporate finance: Lecture 6 - Ross, Westerfield, Jordan

Chapter 6 - Interest rates and bond valuation. The goal in this chapter is to introduce you to bonds. After studying this chapter you will be able to understand: Important bond features and types of bonds, cond values and yields and why they fluctuate, bond ratings and what they mean, the impact of inflation on interest rates, the term structure of interest rates and the determinants of bond yields.

Lecture 6 Interest Rates and Bond Valuation © 2003 The McGraw­Hill Companies, Inc. All rights reserved 7.2 Lecture Outline • Bonds and Bond Valuation • Bond Markets • Inflation and Interest Rates – Fisher Effect • DeterminantsofBondYields McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 7.3 Bond Definitions • • • Bond Par value (face value) Coupon rate Coupon payment Maturity date Yield or Yield to maturity McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 7.4 Present Value of Cash Flows as Rates Change • Bond Value = PV of coupons + PV of par • Bond Value = PV annuity + PV of lump sum • Remember, as interest rates increase the PV’s  decrease • So, as interest rates increase, bond prices  decrease and vice versa McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 7.5 Valuing a Discount Bond with Annual Coupons • Consider a bond with a coupon rate of 10% and  coupons paid annually. The par value is $1000  and the bond has 5 years to maturity. The yield to  maturity is 11%. What is the value of the bond? – Using the formula: • B=PVofannuity+PVoflumpsum B=100[11/(1.11)5]/.11+1000/(1.11)5 B=369.59+593.45=963.04 McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 7.6 Graphical Relationship Between Price and Yield-to-maturity 1500 1400 1300 1200 1100 1000 900 800 700 600 0% McGraw­Hill/Irwin 2% 4% 6% 8% 10% 12% 14% © 2003 The McGraw­Hill Companies, Inc. All rights reserved 7.7 Bond Prices: Relationship Between Coupon and Yield • If YTM = coupon rate, then par value = bond  price • If YTM > coupon rate, then par value > bond  price – Why? – Selling at a discount, called a discount bond • If YTM