Part 3

Valuation of Securities

Chapters in This Part

Chapter 6 Interest Rates and Bond Valuation
Chapter 7 Stock Valuation

Integrative Case 3: Encore International

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Chapter 6
Interest Rates and Bond Valuation

 Instructor’s Resources
Chapter Overview
This chapter introduces interest-rate and bond-market fundamentals, beginning with the distinction between
nominal and real interest rates and the role of expected inflation in linking the two. Risk premia are added to
highlight components of the nominal return on a risky security, namely the (i) real risk-free rate, (ii) expected
inflation rate, and (iii) risk premium on the security. Next, the discussion turns to the relationship between the
nominal interest rate on a bond and its term to maturity—formally referred to as the term structure of interest
rates and represented pictorially by the yield curve. The exposition notes the general upward slope of the yield
curve—that is, that long-term interest rates tend to exceed short-term rates—and offers three explanations: (a)
expectations about future short-term rates, (ii) general investor preference for short-term, liquid debt, and (iii)
segmentation of short- and long-term debt markets. The focus then moves to bond-market institutions with a
catalogue of the major types of issues along with their legal issues, risk characteristics, and indenture provisions.
The role of rating agencies is also emphasized. The chapter concludes by presenting the basic model for bond
valuation as a special case of the general model for valuing assets (i.e., value is simply the present value of
expected cash flows from the asset). Examples are provided of the impact of variation in coupon/principal
payments, timing of coupon/principal payments, and required rates of return on the market price of a bond. The
final topic is yield to maturity—explained as nothing more than the interest rate equating the present value of a
bond’s remaining coupons and principal payments with its market price.

 Suggested Answers to Opener-in-Review

Assume the bonds Aston Martin issued in 2017 pay interest semiannually.
a. How much cash would a bondholder receive every 6 months if the bonds have a coupon rate of 5.75%?
The bonds pay 5.75% ÷ 2 or 0.02875 semiannually. Although not stated explicitly in the problem, par value
of the typical corporate bond is $1,000, implying a semiannual interest payment is $28.75.

b. When Austin Martin issued the bonds, maturity was 20 years, and the required return was 6% per year.
What was the market price? Did the bond sell at par, at a premium, or at a discount? Why?
Market price of the bond (given 40 semiannual coupon payments of $28.75, a $1,000 principal payment at
the end of the 40th period, and a semiannual discount rate of 6% ÷ 2 = 0.03) is $971.11. The solution may be
obtained in Excel using the present-value command with this syntax:
=pv(market interest rate, # of periods, coupon payments, par value,0) or =pv(0.03,40,28.75,1000,0)
The bond sells at a discount because the current market rate (6%) exceeds the coupon rate (5.75%). When
the market rate rises above the coupon rate, bond price falls until yield-to-maturity equals the market rate.

c. Given your answer to part b, what was the current yield of Aston Martin bonds when they were first issued?
Suppose the bonds are now worth $1,075 each. What is the current yield on the bonds now?
Current yield = Bond’s annual interest payment ÷ Current price

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As established in part b, bond price at issuance was $971.11, and annual interest is $57.50, so current yield
at issue was $57.50 ÷ $971.11 = 5.92%. If the bond now sells for $1,075, current yield is
$57.50 ÷ $1,075 = 5.35%.

d. The chapter opener also mentions Aston Martin bonds issued in 2011 with a 10.25% coupon rate. Assume
these bonds paid interest annually, carried a par value of $1,000, and matured in eight years. One year
after issue, price was 39% below par value. What was yield to maturity (YTM)?
YTM is the discount rated that equates present value of the seven remaining annual coupon payments of
$102.50 and principal payment of $1,000 with the current market price of $610. In Excel, YTM may be
obtained with the RATE function and this syntax:
=rate(# of periods, coupon payments,-market price,principal,0) = rate(7,102.50,-610,1000,0) = 21.53%
Note: Market price must be entered as a negative number.

 Answers to Review Questions

6-1 The real rate of interest measures the return on an investment, not in dollars, but in terms of how much the
investment increases one’s purchasing power. The nominal rate of interest is the actual rate of interest
charged by suppliers and paid by demanders of funds; it differs (approximately) from the real rate of
interest by expected inflation. Specifically, let r* be the real rate of interest, r the nominal interest rate, and
i the expected rate of inflation. Then,
(1 + r) = (1 + r*) × (1 + i) → r = r* + i + (r* × i)
r* ≈ r – i (or r ≈ r* + i) when the inflation rate and real rate are relatively low because (r* × i) is a
very small number.
In words, demanders and suppliers of loanable funds care about the real interest rate –the cost of
borrowing or return to saving expressed in terms of command of goods and services—but rates are
negotiated and paid in nominal terms. To ensure the nominal interest rate delivers the desired real rate,
demanders and suppliers add a premium equal to expected inflation.

6-2 The term structure of interest rates is the relationship between nominal rate of return and time to maturity
for bonds with similar risk. The yield curve is a pictorial representation of this relationship.

6-3. Under the expectations theory of the term structure, the slope of the yield curve for bonds with similar risk
should reflect expectations about future short-term interest rates on those securities.
a. Downward sloping: Investors expect short-term interest rates to fall.
b. Upward sloping: Investors expect short-term interest rates to rise.
c. Flat: Investors expect future short-term interest rates to roughly equal current short-term rates.

6-4. a. Under the expectations theory of the term structure of interest rates, the shape of the yield curve solely
reflects investor expectations about future short-term interest rates. So, an upward sloping curve
means investors expect short-term rates to rise.
b. The liquidity-preference theory assumes investors prefer short- to long-term debt instruments because
short-term debt is more liquid and less risky (i.e., suffer lower capital losses when interest rates rise).
The general preference for short maturities means investors will demand a premium to hold longer-
term debt instruments. This risk premium will produce an upward sloping yield curve even if investors
expect no changes in interest rates.

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 Chapter 6 Interest Rates and Bond Valuation 113

c. The market-segmentation theory assumes the market for short- and long-term debt instruments is
distinct, with demand and supply determining the interest rate in each market. Under the market-
segmentation theory, long-term interest rates exceed short-term rates when demand for long-term
instruments is stronger than for demand for short-term instruments (and/or supply of long-term debt is
relatively weaker than demand for short-term debt).

6-5 Prior discussion noted the nominal rate of interest (r) approximately equals the real rate (r*) plus expected
inflation (i)—ignoring risk. Broadening to encompass risky debt instruments:
RF = r* + i, where RF is the risk-free rate, and rj = r* + i + RPj
where RPj, is a risk premium on debt instrument j reflecting:
Default risk: The risk the issuer will not pay contractual interest or principal as scheduled.
Maturity (interest rate) risk: The risk interest rates will rise and cause price of the debt instrument to
fall; price volatility increases with instrument’s maturity.
Liquidity risk: The risk the instrument cannot be converted to cash quickly without a significant loss.
Contractual provisions: The risk provisions in the indenture will be invoked and materially affecting
the bond’s attractiveness (like the firm calling the bonds when interest rates fall).
● Tax treatment: Debt instruments are subject to differing tax treatment by federal, state, and local
governments; for example, interest state and local government debt is exempt from federal taxes. Tax
exemption reduces nominal rate of interest (because investors care about after-tax returns).

6-6 Most corporate bonds are issued in $1,000 denominations with maturities of 10 to 30 years. The stated
interest rate represents the percentage of the bond’s par value to be paid annually, though most bonds pay
interest semiannually. Most corporate bonds are also callable, meaning the issuer can—under conditions
detailed in the indenture—repurchase outstanding bonds from their current holders. Mechanisms that
protect bondholders are in the bond indenture and may include restrictive covenants, sinking fund
provisions, and collateral provisions.

6-7 A bond indenture is a complex legal document specifying rights of bondholders and duties of the issuing
firm. Indentures generally contain standard debt provisions and restrictive covenants. Standard debt
provisions specify generally acceptable record-keeping and business practices for the issuer and typically
do not burden a financially sound business. Restrictive covenants, in contrast, place specific operating and
financial constraints on the issuer. Violation of standard or restrictive provisions may give bondholders the
right to demand immediate repayment. Violations could also trigger other adverse consequences for the
issuing firm, such as a rating downgrade or renegotiation of the indenture.

6-8. Borrowing long term costs more than borrowing short term. On top of the base risk-free Treasury rate, the
cost of long-term debt reflects term-to-maturity, offering size, and default risk. Other things equal, the
interest rate on long-term debt rises when (i) term-to-maturity is longer, (ii) offering size is smaller
(flotation/administrative costs can be spread over more bonds), and (iii) default risk is higher.

6-9 A bond with a conversion feature gives holders the option of converting the bond into a certain number of
shares of stock within a certain period of time. A call feature gives the issuer the opportunity to
repurchase, or call, bonds at a stated price prior to maturity. Stock purchase warrants give bondholders the
right to purchase a certain number of shares of common stock at a specified price.

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6-10 Current yield equals a bond’s annual interest payment divided by its current market price. Bonds prices are
quoted as a percentage of par value; for example, a quote of 98.621 means the bond price is 98.621 percent
of par. Independent private agencies such as Moody’s, Fitch, and Standard & Poor’s rate bonds based on
the likelihood interest and principal payments will be made. Ratings reflect detailed financial ratio and
cash-flow analyses of the issuing firm. Prospective bond holders and issuers value ratings as third-party
certification—like a “Yelp” rating in the market for goods and services. Bond ratings affect rates of return;
other things equal, a higher rating implies lower default risk (and coupon rate).

6-11 Eurobonds are issued by international borrowers in countries with currencies other than that in which the
bond is denominated—such as a dollar denominated bond sold by an American firm in Japan. Foreign
bonds, in contrast, are issued by a foreign borrower in a host country’s capital market and denominated in
the host currency—such as a yen-denominated bond issued in Japan by a French firm.

6-12 A financial manager should understand valuation because, on her firm’s behalf, she will (i) issue bonds
and stocks and must, as a consequence, understand how investors value those securities and (ii) determine
whether investment projects generate cash flows with present value exceeding cost.

6-13. The three inputs in asset valuation are (i) Cash flows—cash received from asset ownership, (ii) Timing—
time period(s) when cash is received; and (iii) Required return—risk-adjusted interest rate used to
discount cash flows (i.e., higher risk implies a discount rate).

6-14 The valuation process applies to assets providing cash flows of any size (constant, mixed stream, and lump
sum) over any time period (intermittent, annual, semiannual, etc.).

6-15 The value of any asset is the present value of all cash flows expected from the asset; value depends on the
cash flows, their timing, and required rate of return. Formally:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛
V0 = 1 + 2 + 3 + ⋯+ 𝑛
(1+𝑟) (1+𝑟) (1+𝑟) (1+𝑟)
where:
V0 = asset value at time zero r = required return (discount rate)
CFt = cash flow expected in period t n = time period

6-16 The basic valuation equation for a bond paying annual interest is:
𝐶 𝐶 𝐶 𝐶 𝑀 𝐶 𝑀
B0 = + + +…+ + = [∑𝑛𝑡=1 𝑛] + [ 𝑛]
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑛 (1+𝑟)𝑛 (1+𝑟) (1+𝑟)
where:
V0 = Value of bond at t = 0 M = Par value (in dollars)
C = Coupon payment each period r = Required rate of return on bond
n = periods to maturity
For annual interest, n is the number of years and r the annual rate of return. For semiannual interest, n is
the number of years × 2, and r is annual required rate of return ÷ 2.

6-17 A bond sells at a discount when required return exceeds the coupon rate and at a premium when the
coupon rate exceeds required return. A bond sells at par value when required return equals the coupon rate.
Coupon is generally fixed, whereas required return fluctuates as market conditions change or as the
issuer’s credit quality changes.

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6-18 If required return on a bond is constant until maturity and different from the coupon interest rate, bond
price will approach par value as maturity approaches (or par value plus the final interest payment).

6-19 Other things equal, the longer a bond’s maturity, the more responsive its price is to changes in market
interest rates. Risk-averse investors, therefore, prefer bonds with a short time to maturity. Long-term
bonds must offer a higher return than short-term bonds to attract risk-averse investors.

6-20 Yield-to-maturity (YTM) is the compound annual rate of return investors would earn by purchasing a bond
at the current market price (which, after issue, does not necessary equal par value) and holding to maturity.
YTM is the interest rate equating the present value of the bond’s remaining coupon and principal payments
with its market price. YTM can be found using time-value functions on a financial calculator—treating
current market price (B0) as present value (PV), dollar coupon per period (C) as remaining annuity-type
payments, principal (M) as lump-sum payment at maturity, and n as number of remaining periods, then
solving for yield (r). In Excel, YTM can be found with the RATE function:
=rate(remaining periods,coupon payments per period,-current market price,principal,0)
Note: Bond price must be entered as a negative number. Also, the command produces interest rate per
period and requires annualizing if coupon payments are more frequent than once per year.
6-21 Answers will vary because “givens” are algorithmically generated in MyFinanceLab.
6-22 Answers will vary because “givens” are algorithmically generated in MyFinanceLab.
6-23 Answers will vary because “givens” are algorithmically generated in MyFinanceLab.

 Suggested Answer to Focus on Practice Box:

“I-Bonds Adjust for Inflation”
What effect does the inflation-adjusted interest rate have on the price of an I-bond, compared with similar bonds
offering no inflation protection?

I-bonds offer inflation insurance. Specifically, the I-bond interest rate includes (i) a fixed rate that remains
constant over the life of the bond and (ii) an adjustable rate that equals the inflation rate (at a short lag). If
inflation rises, the adjustable component of the I-bond rate rises to ensure the actual real return roughly equals
the promised real return. Because I-bonds carry inflation protection, the U.S. Treasury can offer a slightly lower
interest rate (and, therefore obtain, a slightly higher price) than on comparable Treasuries without such
protection.

 Suggested Answer to Focus on Ethics Box:

Can Bond Ratings Be Trusted?
What ethical issues could arise because companies or governments issuing debt (rather than investors) pay
NRSROs to rate those instruments?

Rating agencies (National Recognized Statistical Ratings Organizations or NRSROs) want to keep issuers happy
to secure future business. Knowing this, an issuer could apply pressure to “inflate” the rating on a debt issue—
that is, award a rating indicating lower default risk than justified by the issuer’s financial information.—to keep
interest costs down.

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Why do you think NRSROs inflated ratings for new complex MBSs but not traditional corporate bonds in the
run-up to the Great Recession?
An NRSRO cannot ignore issuer financial condition and award any rating it wishes. Investors/firms value
ratings because of the rater’s reputation for sound, independent analysis. In the run-up to the Great Recession,
NRSROs were asked to rate new, complex mortgage-backed securities (MBSs). These securities had not been
“stress tested” by a credit cycle, so little hard evidence existed about how they might fare in a serious recession.
Put another way, NRSROs had more latitude to accept an issuer’s rosy claims about minimal default risk. In
contrast, NRSROs have rated traditional corporate debt for over a century—long enough to include many boom
and bust cycles. Any attempt to inflate ratings on traditional corporate bonds –instruments with historical data to
benchmark default risk—would seriously tarnishing the rater’s reputation.

 Answers to Warm-Up Exercises

E6-1 Finding the real rate of interest (LG 1)
Answer: If r* real interest rate, r the nominal interest rate (risk free), and i expected inflation, then:
r* ≈ r – i, or i ≈ r – r* when the inflation rate is relatively low.

The nominal rate = real rate + inflation rate = 7.4%

E6-2 Yield curve (LG 1)

Answer: a.

Yield
5.00%
4.00% 4.51% 4.62%
3.80%
3.00%
2.00%
1.00% 1.50% 1.80%
0.00% 0.50% 0.62% 0.75%

b. The expectations theory suggests that the yield curve reflects the investors’ expectations about
future interest rates. Based on the yield curve, a five-year treasury note will pay 3.80%, while a 10-
year treasury note will pay 4.51%. As the expectations theory requires them to be in equilibrium,
assuming the five-year treasury note is expected to pay r percent, we can say that:

(1 + 0.038)5 × (1 + r)5 = (1 + 0.0451)10

r = 0.0522 or 5.22%

c. Assuming that the expected rate is r, we can say that,

(1 + 0.0075) × (1 + r) = (1 + 0.015)2

r = 0.02255 or 2.255%

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 Chapter 6 Interest Rates and Bond Valuation 117

d. There are many factors that may affect the slope of the yield curve, other than expectations of rising
interest rates in the market. One possible explanation can be the liquidity preference theory, which
suggests that long-term interest rates tend to be higher than short-term rates of interest, as longer-
term debt has lower liquidity for the lender, leading them to expect higher returns in exchange for
lower liquidity. in contrast, the market segmentations theory suggests that a yield curve shows that
there is either limited supply for long-term loans or a greater demand for long-term loans, causing
rates for long-term debts to increase.

E6-3 Calculating inflation expectation (LG 1)

Answer: The inflation expectation for a specific maturity is approximately the difference between the nominal
yield and real interest rate at that maturity (i.e., in the Table below we use Equation 6.1a):
Maturity Yield Real Interest Rate Inflation Expectation
3 months 1.41% 0.80% 0.61%
6 months 1.71 0.80 0.91
2 years 2.68 0.80 1.88
3 years 3.01 0.80 2.21
5 years 3.70 0.80 2.90
10 years 4.51 0.80 3.71
30 years 5.25 0.80 4.45

E6-4 Real returns (LG 1)

Answer: If the return offered by the tresury bill is lower than 6.5%, the investor will get a negative
return in real terms. If an investor expects real return of 3%—given an inflation of 6.5%—
then the T-bill needs to offer r:

(1 + r) = (1 + 0.065) × (1 + 0.03) = 1.09695 or r = 0.09695 or 9.695%

E6-5 Calculating risk premium (LG 1)

Answer: Let rj be the nominal rate of interest on security j, RF the risk-free rate, and RPj the risk premium on
security j; then rj = RF + RPj. Or alternatively, RPj= rj – RF. So:

Company Nominal interest rate Risk premium

A 6% 6% − 4% = 2%
B 9 9% − 4% = 5%
C 5.20 5.20% − 4% = 1.20%

E6-6 The basic valuation model (LG 4)

Answer: Find the present value of the cash-flow stream for each asset by discounting expected cash flows with
the required return:
Scheme 1: PV = £300  0.12 = £2,500
£500 £800 £800 £250
Scheme 2: PV = (1.08)1 + (1.08)2 + (1.08)3 + (1.08)4 = £1,967.65

E6-7 Calculating present value of a bond when required return exceeds the coupon rate (LG 4)

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Answer: The value of a bond is the present value of its future cash flows, discounted at the required rate of
return. Let C represent dollar coupon payments per period, M the dollar face value or principal to be
returned on maturity, n the number of periods until maturity, and r the required rate of return.
𝐶 𝐶 𝐶 𝑀
Value of Bond (B0) = + +⋯+ +
(1+𝑟)1 (1+𝑟)2 (1+𝑟)𝑛 (1+𝑟)𝑛
Face value (or principal) of the bond is $20,000, interest is paid annually, and the coupon rate is 6%.
This information implies a $1,200 coupon payment is made annually. Plugging this value and the
other given information yields:
$1,200 $1,200 $1,200 $20,000
Value of Bond (B0) = + +⋯+ + = $18,402.92
(1.08)1 (1.08)2 (1.08)5 (1.08)5
Bond value (also market price) is below face value because the coupon rate (6%) is less than the
required rate of return. Bond value may also be obtained in Excel using the PV command and the
following syntax: =pv(rate,nper,pmt,fv,type), where the bond’s coupon plays the role of payment in
Excel syntax, and par value plays the role of future value]. Specifically:
=PV(0.08,5,-1200,-20000)
Note: Dollar coupon payment must be a negative number. Also, the final entry before the right
parenthesis indicates whether payments occur at beginning (1) or end of period (0).

E6-8 Bond valuations using required rates of return (LG5)

Answer: a. Specific student answers will vary but the following general relationships will hold:
● When required rate of return exceeds coupon rate, bond sells at a discount.
● When required rate of return equals coupon rate, bond sells at par value.
● When required rate of return is below coupon rate, bond sells at a premium.
b. Student answers will vary but should be consistent with their answers to part (a).

 Solutions to Problems
P6-1 Interest-rate fundamentals: The real rate of return (LG1; Basic)
Nominal return = risk -free rate + risk premium = 6% + 5% = 11%

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P6-2 Equilibrium rate of interest (LG 1; Intermediate)

a,b and c.

The intersection of the demand and supply curves for funds determines the equilibrium rate of
interest. Initial equilibrium is given by point O where r = 4%.
d. The change in tax law shifts the demand curve up and to the right, raising the equilibrium interest
rate to 6% (i.e., the intersection of demand and supply after change in tax law).

Point N: New Equilibrium

P6-3 Personal finance: Real and nominal rates of interest (LG 1; Intermediate)
a. Jonathan can buy £1,000 ÷ £20 = 50 yarns today.
b. Compound value = £1,000 × (1 + 0.06) = £1,060
c. Expected cost of yarn after a year = £20 × (1 + 0.03) = £20.60
d. Number of yarns Jonathan can buy after a year from proceeds =
£1,060 ÷ £20.60 =Point
51.46 yarns
O: Initial Equilibrium
e. Jonathan’s real rate of return can be calculated as:
(1 + 0.06) = (1.0.03) × (1 + r*)
r* = (1.06 ÷ 1.03) – 1 = 0.0291 or 2.91%
The real rate of return, 2.91%, indicates that the actual increase in the number of units Jonathan can
buy after a one-year period if he invests in T-bonds, will be 6%. This is due to the fact that the
portion of the return that is equal to inflation (3%) is required only to maintain the ability to buy the
same number of units after a year.

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P6-4 Yield curve (LG 1; Intermediate)

a.
Yield Curve
8.00%

6.00%

4.00%

2.00%

0.00%
6 Months 1 Year 5 Years 10 Years 20 Years

b. The yield curve shows a rising trend which indicates, as per the expectations theory, that the interest
rates will be growing upwards both in the near future as well as in the long term.

P6-5 Nominal interest rates and yield curves (LG 1; Challenge)

a. Real rate of return can be calculated using (1 + r) = (1 + r*) × (1 + i):
Nominal Rate of Real Rate of
Maturity Return at 3%
Return
Inflation
3 months 6% 2.91%
2 years 7.50% 4.37%
5 years 8% 4.85%
10 years 10% 6.80%
20 years 12% 8.74%

b. Real rate of return if nominal rates drop by 1%:

Nominal Rate Real Rate of

Maturity
of Return New Nominal Return at
Rate 3% Inflation
3 months 6% 5.00% 1.94%
2 years 7.50% 6.50% 3.40%
5 years 8% 7.00% 3.88%
10 years 10% 9.00% 5.83%
20 years 12% 11.00% 7.77%

c.

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Yield Curve
15%

10%

5%

0%
3 Months 2 Years 5 Years 10 Years 20 Years

The given yield curve suggests that the interest rates will go up in future as per the expectations theory.
d. The liquidity preference theory suggest that investors prefer to part with their liquidity for as short a
time as possible, and therefore seek additional return if they have to part with their liquidity for a
longer time. In the given yield curve, the interest for longer duration bonds is higher, in line with
this explanation.
e. The market segmentation theory suggests that the interest rate for a given maturity period depends
on the demand for borrowing and supply of investment for that period. Based on the yield curve, it
can be concluded that there is a relatively higher demand for investment than the available
investment for longer periods, driving up the interest rates for longer-maturity periods.

P6-6 Nominal and real rates and yield curves (LG 1; Challenge)
a. The approximate real rate of interest is the nominal rate minus expected inflation:
r* ≈ r – i ≈ 5% - 1% ≈ 4%
If Tyra spends $200 at Dollar Barrel today where everything costs $1, she can purchase 200 items. If,
however, she invests the $200, at year end she will have $210. In one year, inflation will cause Dollar
Barrel prices to rise to $1.01 per item. So, Tyra will be able to purchase $210 ÷ 1.01 = 207.92 items.
By investing, her real purchasing power increases by 3.96% [(207.92 ÷ 200) – 1]. The actual increase
in Tyra’s purchasing power (3.96%) is roughly equal to the approximate real return from investing
(4%).
b. The approximate real rate of interest is the nominal rate minus expected inflation:
r* ≈ r – i ≈ 20% - 10% ≈ 10%
If Tyra spends $200 at Dollar Barrel today where everything costs $1, she can purchase 200 items. If,
however, she invests the $200, at year end she will have $240. In one year, inflation will cause Dollar
Barrel prices to rise to $1.10 per item. So, Tyra will be able to purchase $240 ÷ 1.10 = 218.18 items.
By investing, her real purchasing power increases by 9.09%. The actual increase in Tyra’s purchasing
power (9.09%) is roughly the same as the approximate real return from investing (10%). But notice
the approximation is much worse. In part (a), the error was 0.04%; here the error is 0.91%. In words,
the approximation deteriorates (i.e., error rises) as expected inflation rises.

P6-7 Term structure of interest rates (LG 1; Intermediate)

a.

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b. and c.
Five years ago, the yield curve was slightly upward sloping, suggesting (under the expectations
theory) investors expected future short-term interest rates to be only slightly higher than current
short-term rates. Two years ago, the yield curve had a sharp downward slope, suggesting investors
expected a dramatic decline in short-term interest rates (perhaps due to a coming recession). Today,
the yield curve is upward sloping, suggesting investors expect short-term rates to rise.
d. Consider two 10-year investment options five years ago: (i) a 10-year bond offering 9.5% or (ii) a 5-
year bond offering 9.3% and another 5-year bond in 5 years. Under the expectations theory of the
term structure, the options should offer the same return. Assuming the options offered the same
return and denoting expected return on a 5-year bond 5 years ago E(r):
(1.095)10 = (1.093)5 × (1+E(r))5 → (1.095)10 ÷ (1.093)5 = (1+E(r))5
5
E(r) = √1.58869 – 1 = 0.097 = 9.7%
Alternatively, return on 5-year bond in five years = [(10 × 9.5%) – (5 × 9.3%)] ÷ 5 = 9.7%.

P6-8 Term structure (LG 1; Basic)

Assuming the expected return between year two and three to be r, the expectations theory suggests:
(1 + 0.07)3 = (1 + 0.06)2 × (1 + r)
Or 1 + r = 1.073/1.062 = 1.0902 or r = 0.0902 or 9.02%

P6-9 Risk premiums (LG 1; Intermediate)

a. Nominal return = real rate + inflation rate
Real rate = 4% – 2% = 2%

b. Nominal return = real rate + inflation rate + risk premium

A: 2% + 6% + 4% = 12%
B: 2% + 5.5% + 5% = 12.5%
C: 2% + 5% + 2% = 9%
D: 2% + 4.8% + 3% = 9.8%
E: 2% + 6% + 6% = 14%

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 Chapter 6 Interest Rates and Bond Valuation 123

c. It is because the security has a different maturity. The expected inflation is an average inflation over
the period until its maturity.

P6-10 Bond interest payments before and after taxes (LG 2; Intermediate)
a. The number of bonds to be issued = $50,000,000 ÷ 1,000 = $50,000
b. The company needs to pay both coupons ($60) and par ($1,000)
Total interest expense = $1,060  $50,000 = $53,000,000
c. c. As interest payments are tax-deductible, the after-tax cost of interest payments is = $60  (1 − 0.38)
= $37.2. The total after-tax expense = $1,037.20 × 50,000 = $51,860,000.

P6-11 Bond prices and yields (LG 4; Basic)

1
1−(1+𝑟)10 1,000
a. $810.34 = 50 × ( 𝑟
) + (1+𝑟)10

𝑟 = 7.8%
b. Current yield = 50 ÷ $810.34 = 6.17%
c. The current yield only reflects the yield of the bond at the current moment, not the total return over
the duration of the bond.
1
1−(1+0.08)9 1,000
d. Price of the bond one year later = 50 × ( 0.08
) + (1+0.08)10 = $812.59.

Total return = 6.37%

P6-12 Personal finance: Valuation fundamentals (LG 4; Basic)

a. In years 1 – 4, $6,000 is paid on property taxes and maintenance, but $10,000 is saved on rent. Also,
in year 4, the condo will sell for $125,000. So, the timeline is:
Year
0 1 2 3 4

? $4,000 $4,000 $4,000 $129,000

$4,000 $4,000 $4,000 $129,000

b. Value of Condo Purchase = + + + = $121,370.10
(1.04)1 (1.04)2 (1.04)3 (1.04)4
The value of any asset is the present value of its cash flows. At a 4% discount rate, the present value
of cash flows from the condo purchase is $121.370.10, so this is the maximum price to pay.

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124 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

P6-13 Valuation of assets (LG 4; Basic)

Asset End of Year Cash Flows Discount Rate Present Value
1 $ 3,000
A 2 $ 3,000 0.08 $7,731.29
3 $ 3,000
B 1– $ 500 0.05 $10,000.00
1 0
2 0
C 3 0 0.06 $33,626.62
4 0
5 $45,000
D 1–5 $ 1,500 0.04 $13.395.41
6 8,500
1 $ 2,000
2 3,000
E 3 5,000 0.07 $17,429.52
4 7,000
5 4,000
6 1,000

P6-14 Personal finance: Asset valuation and risk (LG 4; Intermediate)

a. The value of an asset is the present value of its cash flows. So:
Year CF PV (r = 4%) PV (r = 6%) PV (r = 10%)

1 $4,000 $3,846.1 $3,773.5 $3,636.3

5 8 6
2 4,000 3,698.22 3,559.99 3,305.79
3 5,000 4,444.98 4,198.10 3,756.57
4 5,000 4,274.02 3,960.47 3,415.07
5 4,500 3,698.67 3,362.66 2,794.15
NPV = 19,962.0 18,854.8 16,907.9
5 0 4
The amount of NPV in the bottom row suggests the maximum amount that Lothar should pay in every
risk situation.
b. If for any reason Lothar cannot assess the true nature of the risk associated with this investment, he
should act conservatively and go for the lowest valuation of $16,907.94, applicable for a high-risk
scenario.

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 Chapter 6 Interest Rates and Bond Valuation 125

c. If the associated risk of an asset increases, the applicable discount rate also goes up in order to
accommodate higher-risk premiums. This increase in discount rate decreases the present value and
hence the value of the asset.

P6-15 Basic bond valuation (LG 5; Intermediate)

a. The value of the bond will be determined by two cash flows: an annuity of coupon payments; and
the one-off cash payment worth its face value at maturity.

PV = €8 × PVFA (4%, 12 years) + € 100 ÷ (1 + 0.04)12 = €8 × 9.385 + 62.45 = €137.53

b. One of the possible reasons may be that the Motorway Development Corporation (MDC) has issued
this bond with a lower credit rating but then has improved its credit rating over the period. Or there
may be a change in the demand and supply for investment in the market, resulting in this bond
being sold at a premium.
c. If the applicable discount rate goes up to 10%, the PV will change as:

PV = €8 × PVFA (10%, 12 years) + €100 ÷ (1+0.10)12 = €8 × 6.814 + 31.86 = €86.37

The bond is now valued sub-par at €86.37 (or being sold at a discount) as the applicable discount
rate is higher than the coupon rate being offered by the bond.

P6-16 Bond valuation: Annual interest (LG 5; Basic)

Years to Required Bond
Bond Maturity Return (r) Coupon (C) Par Value (M) Value
(n)
A 20 12% 0.11  $1,000 = $110 $1,000 $925.31
B 16 8% 0.08  $1,000 = $80 $1,000 $1,000.00
C 8 9% 0.09  $100 = $9 $100 $ 111.94
D 13 6% 0.06  $500 = $30 $500 $ 420.96
E 10 7% 0.07  $1,000 = $70 $1,000 $1,154.43

P6-17 Bond value and changing required returns (LG 5; Intermediate)

a. Original price
1
1− 1,000
(1 + 0.08)10
𝑃𝑟𝑖𝑐𝑒𝑥1 = 80 × ( )+ = $1,000
0.08 (1 + 0.08)10

1
1− 1,000
(1 + 0.08)10
𝑃𝑟𝑖𝑐𝑒𝑌1 = 40 × ( )+ = $731.5967
0.08 (1 + 0.08)10

New price
1
1− 1,000
(1 + 0.10)10
𝑃𝑟𝑖𝑐𝑒𝑥2 = 80 × ( )+ = $877.1087
0.10 (1 + 0.10)10

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126 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

1
1− 1,000
(1 + 0.10)10
𝑃𝑟𝑖𝑐𝑒𝑌2 = 40 × ( )+ = $631.3260
0.10 (1 + 0.10)10

The percentage change in Bond X = -12.29%

The percentage change in Bond Y = -13.71%

b. New price
1
1− 1,000
(1 + 0.06)10
𝑃𝑟𝑖𝑐𝑒𝑥2 = 80 × ( )+ = $1,147.2017
0.06 (1 + 0.06)10

1
1− 1,000
(1 + 0.06)10
𝑃𝑟𝑖𝑐𝑒𝑌2 = 40 × ( )+ = $852.7983
0.06 (1 + 0.06)10

The percentage change in Bond X = -14.27%

The percentage change in Bond Y = -16.57%
c. Bond Y is riskier than bond X. It is because bond Y has fewer coupons, it has more interest rate risk.

P6-18 Bond value and time: Constant required returns (LG 5; Intermediate)
a. Using the PV function in Excel with the syntax:
=pv(required return, years to maturity, coupon, par value)
Required Years to ParValue Bond
Return (r) Maturity (n) Coupon (C) (M) Value
14% 1 0.12  $1,000 = $120 $1,000 $982.46
14% 3 $120 $1,000 $953.57
14% 6 $120 $1,000 $922.23
14% 9 $120 $1,000 $901.07
14% 12 $120 $1,000 $886.79
14% 15 $120 $1,000 $877.16
b.

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 Chapter 6 Interest Rates and Bond Valuation 127

c. As can be seen in part (b), other things equal, when required return differs from the coupon rate and
remains constant to maturity, bond value will approach par value as time to maturity declines.

P6-19 Personal finance: Bond value and time—Changing required returns (LG 5; Challenge)
a. and b.
Years to Required Par Bond
Bond Maturity Return (r) Coupon (C) Value (M) Value
(n)
5 8% 0.11  $1,000 = $110 $1,000 $1,119.78
A 5 11% $110 $1,000 $1,000.00
5 14% $110 $1,000 $897.01
15 8% $110 $1,000 $1,256.78
B 15 11% $110 $1,000 $1,000.00
15 14% $110 $1,000 $815.73
c.
Value
Required Return Bond A Bond B
8% $1,119.78 $1,256.75
11% 1,000.00 1,000.00
14% 897.01 815.73

The longer the time to maturity, the more responsive bond price is to changes in required return.
d. Lynn could minimize interest-rate risk by choosing Bond A with the shorter maturity. The price of
bond A will move less with any given change in required return than the price of bond B.

P6-20 Yield to maturity (LG 6; Basic)

Bond Coupon Rate Coupon Time to YTM Price
Frequency Maturity
A 5% semi-annually 5 years 5% $1,000
B 5 annually 5 5 $1,000
C 7 semi-annually 7 7 $1,000
D 7 annually 10 7 $1,000
E 12 semi-annually 8 8 $1,233.05
F 10 annually 8 7 $900.65

P6-21 Yield to maturity (LG 6; Intermediate)

a. Yield to maturity can be calculated (using Excel) as:

Years to
Par Value Current
Bond Coupon Rate Maturit YTM
(M) Value
y (n)
A $400 9% 10 $375 9.75%
10.00
B $300 10% 18 $300
%

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128 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

C $1000 10% 14 $1200 7.88%

D $100 10% 12 $120 7.88%
E $2000 6% 4 $1800 6.99%

b. The market value of the bond gravitates towards its par value as the time remaining to maturity
decreases. However, Bond B gives an example where the bond is valued at par, then YTM will also
be equal to coupon rate.

P6-22 Yield to maturity (LG 6; Intermediate)

a. In Excel, the RATE function will generate a bond’s yield to maturity (YTM). For example, for bond
A in the table below, the proper syntax is:
=rate(periods, −payment,present value, −future value)
where periods (n) is number of periods to maturity, payment (C) is coupon payment, present value is
bond price (V0), and future value is principal or par value (M). Note: Values for coupon and principal
must be entered as negative numbers. Specifically, for bond A:
=rate(8, −90,820, −1000) which gives a rate of 12.71%
Years to Coupon Par
Maturity Payment Value Bond Price
Bond (n) Coupon Rate (C ) (M) (V 0 ) YTM
A 8 9% $90 $1,000 $820 12.71%
B 16 12% $120 $1,000 $1,000 12.00%
C 12 12% $60 $500 $560 10.22%
D 10 15% $150 $1,000 $1,120 12.81%
E 3 5% $50 $1,000 $900 8.95%
b. If YTM exceeds coupon rate, the bond sells at a discount, and if the coupon rate exceeds YTM, the
bond sells at a premium. When YTM equals the coupon rate, the bond sells at par value.

P6-23 Personal finance: Bond valuation and yield to maturity (LG 2, LG 5, and LG 6; Challenge)
a. Value of the Crabbe Waste bond may be found in Excel using the PV function and n = 5,
YTM = r = 7.5%, C = 0.06324  $1,000 = $63.24, and M = $1,000:
=pv(0.075,5, 63.24,1000) = $952.42
Value of the Malfoy bond may be found in Excel using the PV function and n = 5,
YTM = r = 7.5%, C = 0.088  $1,000 = $88.00, and M = $1,000:
=pv(0.075,5, 63.24,1000) = $1,052.60
b. The number of Crabbe Waste bonds = $20,000  $952.42 = 21, and the number of Malfoy bonds =
$20,000  $1052.60 = 19.
c. Annual interest income on Crabbe Waste bonds = 21 bonds × $63.24 per year = $1,328.04, and
annual interest income on Malfoy bonds = 19 bonds × $88 = $1,672.06.
d. By purchasing the Crabbe Waste bonds, Mark will receive $1,328.04 in interest at the end of years
1-5 and $21,000 (21 bonds × $1,000) in principal at the end of year 5. The future value of reinvested
interest may be found using the FV function in Excel with the following syntax:

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 Chapter 6 Interest Rates and Bond Valuation 129

=fv(r,n,𝐶𝐹) = rate(0.10,5,1328.04) = $8,107.82

where r is the required rate of return, n is years interest will be earned, and CF is total interest earned
at the end of each year. Adding the $21,000 in principal brings the total to $29,107.82.
By purchasing the Malfoy bonds, Mark will receive $1,672 in interest at the end of years 1-5 and
$19,000 (19 bonds × $1,000) in principal at the end of year 5. The future value of reinvested interest
may be found using the FV function in Excel with the following syntax:
=fv(r,n,𝐶𝐹) = rate(0.10,5,1672) = $10,207.73
Adding the $19,000 in principal brings the total to $29,207.73.
e. The opportunity to reinvest coupon payments at 10% is attractive because both bonds offer yield to
maturities of only 7.5%. Although both bonds offer the same YTM, Malfoy has the higher coupon
rate. So buying Malfoy bonds would generate $88 per bond each year to reinvest at 10% while
buying Crabbe Waste bonds would produce only $63.24. Malfoy is, therefore, the better investment.

6-24 Bond valuation—Semiannual interest (LG 6; Intermediate)

For this bond:
FV = £320, PMT = 32 or £16 every six months, n = 5 × 2 = 10, i = 12% ÷ 2 = 6%
Solving for PV = PV of annuity of £16 for 10 periods + PV of face value at the end of the 10th period:
PV = £16 x PVFA (6%, 10 periods) + 320 ÷ (1+0.06)10 = £16 x 7.360 + £178.686 = £296.44

Heather has paid £300 for this bond, which is slightly above the actual value of the bond.

P6-25 Bond valuation—Semiannual interest (LG 6; Challenge)

Semiannual
Par Annual Coupon Annual Semiannual
Years to Periods Value Coupon Payment Required Required
Bond Maturity (n ) (M) Rate (C ) Return Return (r ) Bond Value
A 12 24 $1,000 10% $50 8% 4% $1,152.47
B 20 40 $1,000 12% $60 12% 6% $1,000.00
C 5 10 $500 12% $30 14% 7% $464.88
D 10 20 $1,000 14% $70 10% 5% $1,249.24
E 4 8 $1,000 6% $30 14% 7% $761.15

P6-26 Bond valuation—quarterly interest (LG 6; Challenge)

FV = 1,000, n = 8 4 = 32, i = 10% ÷ 4 = 2.5% PMT = (1,000 12%) ÷ 4 = $30
Using the equation (from Chapter 5) for annuity, and present value of a single cash flow:

𝐶𝐹1 1
𝑃𝑉𝑜 = ( ) × [1 − ]
𝑟 (1 + 𝑟)𝑛

30 1
𝑃𝑉𝑜 = ( ) × [1 − ] + 1,000 ÷ (1 + 0.025)32
0.025 (1 + 0.025)32
𝑃𝑉𝑜 = 655.48 + 453.77 = $ 1,109.25

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130 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

P6-27 Ethics problem (LG 1; Intermediate)

This is a good question for class discussion. On the one hand, bundling ratings with other services could
reduce welfare by: (i) giving ratings agencies some market power and (ii) tempting agencies to “tweak”
ratings based on issuer willingness to buy other services. The counterargument recognizes the
information ratings agencies produce about the quality of private and public debt instruments improves
financial-market efficiency. Put another way, a better informed market means more accurate
prices/interest rates which, in turn, implies scarce loanable funds are more likely to find their way to the
highest valued uses. Bundling could also allow ratings agencies to earn higher profits, which in turn,
would spur internal research on ways to award more informative ratings at lower cost. Finally, provided
debt instruments have been “stress tested” by a credit cycle, ratings agencies have a strong incentive to
award the correct rating—one justified by the issuer’s financial condition—because of the reputational
cost for fudging to sell add-on services.

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 Chapter 6 Interest Rates and Bond Valuation 131

 Case: “Evaluating Annie’s Proposed Investment in

Atilier Industries Bonds”
Case studies are available on www.pearson.com/mylab/finance.

a. Annie should convert the bonds. The value of the stock if the bond is converted is 50 shares × $30 per share
= $1,500. If the bond is called, Annie would receive only $1,080.
b. Current value of bond under different required returns:
Sells at
Years to Coupon Par Required Discount,
Maturity Paymen Value Rate of Par, or
Case (n) Coupon Rate t (C ) (M) Return Bond Price Premium?
1 25 8% $80 $1,000 6% $1,255.67 Premium
2 25 8% $80 $1,000 8% $1,000.00 Par
3 25 8% $80 $1,000 10% $818.46 Discount

c.
Semiannual Sells at
Par Annual Coupon Annual Semiannual Discount,
Years to Periods Value Coupon Payment Required Required Par, or
Case Maturity (n ) (M) Rate (C ) Return Return (r ) Bond Value Premium?
1 25 50 $1,000 8% $40 6% 3% $1,257.30 Premium
2 25 50 $1,000 8% $40 8% 4% $1,000.00 Par
3 25 50 $1,000 8% $40 10% 5% $817.44 Discount

Under all three required returns for both annual and semiannual interest payments, the relationship between
required return (relative to coupon rate) and bond price (relative to par value) is the same. When required
return is above (below) the coupon rate, the bond sells at a discount (premium). When required return equals
the coupon rate, the bond sells at par. With semiannual payments, the premium and discount are slightly
larger because interest and principal payments compound more often.
d. If expected inflation increases by 1%, required return will increase from 8% to 9%, and bond price will drop
to $901.77 (i.e., with n = 25, r = 9%, C = $80, and M = $1,000, present value = $901.77). This amount is the
maximum Annie should pay for the bond after the increase in expected inflation.
e. If the ratings downgrade raises expected return from 8% to 8.75%, bond price will fall to $924.81 (i.e., with
n = 25, r = 9%, C = $80, and M = $1,000, present value = $924.81). This amount is the maximum Annie
should pay for the bond after the ratings downgrade.
f. In three years, the bond will be worth $1,110.61 (i.e., with n = 22, r = 7%, C = $80, and M = $1,000, present
value = price = $1,110.61)—the present value of remaining interest and principal payments. If Annie
purchased the bond at par and sells it at the new price, her capital gain would be $110.61.
g. In ten years, the bond will be worth $1,091.08 (i.e., with n = 15, r = 7%, C = $80, and M = $1,000, price =
$1,091.08)—the present value of remaining interest and principal payments. If Annie purchased the bond at
par and sells it at the new price, her capital gain would be $91.08. Notice bond price is more sensitive to
changes in interest rates for the longer time to maturity (22 years) than the shorter (15 years). Other things
equal, maturity (interest-rate) risk decreases as the bond approaches maturity.
h. Yield to maturity, given n = 25, r = 7%, C = $80, and a bond price (V0) = $983.80, is 8.154%.
Current yield = C ÷ V0 = 8.132%.

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132 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

i. Annie should probably not invest in the Atilier bond because:

● The potential for a rating downgrade means significant risk of capital loss from a rise in the default
premium.
● The threat of higher inflation means, coupled with the bond’s long time to maturity, means a significant
risk of capital loss from a higher base (risk free) interest rate.

 Spreadsheet Exercise
Answers to Chapter 6’s CSM Corporation spreadsheet problem are available on
www.pearson.com/mylab/finance.

 Group Exercise
Group exercises are available on www.pearson.com/mylab/finance.

This chapter’s exercise focuses on debt. Each group will conduct Internet research to identify debt recently
issued by its shadow firm—specifically the issue’s rating and interest rate. Then, armed with this information,
each group will compare that interest rate with the rate on Treasuries with similar maturities to infer the risk
premium on the shadow firm’s debt. An important lesson from this exercise is the lack of transparency in the
bond market, particularly compared with the stock market. Updated information is not as easily compared across
multiple websites, and details are often sketchy. (Because a recent debt issue is needed, groups may need to look
at the recent SEC filings of their shadow firm.) Students may find their shadow firms have multiple recent debt
offerings, and these offerings have different ratings because of different covenants. In the final part of the
exercise, each group will explore a potential capital investment for its fictitious firm. The interest rate used will
reflect research on the shadow firm, but other project details are entirely up to the group. Encourage creativity, as
students will live with their fictitious firm another two months.

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