Tutorial:

Chapter 7. Interest Rates and Bond Valuation

2FA3 - Introduction to Finance

DeGroote School of Business

1/24
7.2 More on Bond Features: Debt vs Equity

Debt Equitiy
The company has an obligation to
Equity holders have fractional
pay interest and principal amounts
ownership of the company
to the Debt holders (bondholders)
Bondholders do not have voting Equity holders get to vote on
rights corporate decisions
Dividend payments made to the
Interest payments made to the
equity holders are NOT tax
bondholders are tax deductible
deductible
The company has legal obligation to
The company does not have an
pay the interest and principal
obligation to pay out dividends
amount promised
The company goes to bankrupt
All-equity firms (no debt) cannot go
when it misses the payment
bankrupt
promised to the bondholders

2/24
7.2 More on Bond Features: Bond Indenture

The Bond Indenture refers to the legal contract made between the issuing
corporation and the bondholders which includes:
▶ The basic terms of the bonds: Maturity date, Coupon rate, Coupon
frequency, Face value, etc.
▶ The total amount of bond issued
▶ Assets used as security (next slide)
▶ Sinking fund provisions (next slide)
▶ Call provisions (next slide)
▶ Protective covenants – a clause to limit corporate activities to ensure that
the corporation does not go bankrupt

3/24
7.2 More on Bond Features: Bond Classifications
▶ Registered (specifies the owner of the bond issued) vs. Bearer (whoever
holding onto the physical bond indenture has the ownership; almost
extinct now)
▶ Based on security to be used in case of bankruptcy
▶ Collateral: secured by financial assets
▶ Mortgage: secured by real estate assets
▶ Debentures: unsecured with original maturity of 10 years or
more
▶ Noted: unsecured with original maturity of less than 10 years
▶ Senior (first to claim remaining assets upon bankruptcy) vs. Junior (only
gets to claim after all senior debts have been paid off)
▶ Sinking fund provision – separate fund reserved to repurchase issued
bonds earlier according to the fixed schedule
▶ Call provision – the corporation has an option to repurchase (or “call”)
part or all bonds at specified price prior to maturity
▶ Put provision – the bondholders has an option to enforce the corporation
to repurchase part or all bonds at specified price prior to maturity
4/24
7.2 More on Bond Features: Coupon Rates

Coupon rates reflect the risk characteristics of the bond upon issuance.
Remember that the biggest risk bondholders possess is the default risk of the
firm that they will not be able to pay back the promised amounts. Therefore,
they will demand higher coupon rate when there is a greater risk of not getting
all their money back.

Which bonds will have the higher coupon rates, all else being equal?
▶ Secured debt vs. A debenture
▶ Senior debt vs. Junior debt
▶ With Sinking Fund provision vs. Without Sinking Fund provision
▶ With a Call provision vs. Without a Call provision
▶ With a Put provision vs. Without a Put provision

5/24
7.4 Different Types of Bonds
1. Zero-coupon (stripped) bonds
▶ No periodic coupon payments; only a principal payment at the
maturity
▶ Cannot sell for more than par value – always at discount or par
2. Floating rate bonds
▶ Coupon rates are not fixed; they change (“float”) depending
on the specified index value (e.g., Consumer Price Index
(CPI)) on the indenture
▶ Coupon rates often have a “collar” (upper and lower bound)
to not exceed or go below pre-specified thresholds
3. Convertible bonds
▶ Allows the bondholders to convert the bond to an equity
(share)
▶ Tricky to say whether it should be considered as a debt or an
equity – depends on the point of view
4. Plus many other types of bonds: read the textbook yourself thoroughly
for other types of bonds as well
6/24
Ch. 7 Tutorial Question 1

The bonds of ABC, Inc. carry a 10% annual coupon, have a $1,000 face value,
and mature in four years. Bonds of equivalent risk yield 7%. What is the
market value of these bonds?

7/24
Ch. 7 Tutorial Question 1

The bonds of ABC, Inc. carry a 10% annual coupon, have a $1,000 face value,
and mature in four years. Bonds of equivalent risk yield 7%. What is the
market value of these bonds?

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question, C = $1, 000 × 10% = $100
and proper discount rate (yield or YTM) is 7%. Thus,
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.07)4 $1, 000
= $100 × +
0.07 (1 + 0.07)4
= $1, 101.62

7/24
Ch. 7 Tutorial Question 2

If a bond with a 7% coupon that pays interest semi-annually with a face value
of $1,000 is priced at par, it will have a market price of and interest
payments in the amount of each.

8/24
Ch. 7 Tutorial Question 2

If a bond with a 7% coupon that pays interest semi-annually with a face value
of $1,000 is priced at par, it will have a market price of and interest
payments in the amount of each.

By definition, ‘priced at par’ means that the market price of the bond is equal
to the face value of $1,000. Sine the coupon is paid semi-annually, each
interest payment will be equal to $1, 000 × 7%2
=$35.

8/24
Ch. 7 Tutorial Question 3

What is the market value of a bond that will pay a total of 40 semi-annual
coupons of $50 each over the remainder of its life? Assume the bond has a
$1,000 face value and an 8% yield to maturity.

9/24
Ch. 7 Tutorial Question 3

What is the market value of a bond that will pay a total of 40 semi-annual
coupons of $50 each over the remainder of its life? Assume the bond has a
$1,000 face value and an 8% yield to maturity.

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question, C = $50 and proper
discount rate (yield or YTM) is 8%. Since the coupons are paid semi-annually,
the discounting also occurs semi-annually. In other words, the annual yield
needs to be converted to semi-annual rates to be used for discounting.
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.08/2)40 $1, 000
= $50 × +
0.08/2 (1 + 0.08/2)40
= $1, 197.93

9/24
Ch. 7 Tutorial Question 4

ABC issued 15-year bonds seven years ago with an annual coupon of 3.5%. The
current yield is now 4.5%. What will be the market value of the bonds today?

10/24
Ch. 7 Tutorial Question 4

ABC issued 15-year bonds seven years ago with an annual coupon of 3.5%. The
current yield is now 4.5%. What will be the market value of the bonds today?

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question, C = $1, 000 × 3.5% = $35
and proper discount rate (yield or YTM) is 4.5%. Since the bond was issued
seven years ago and it had original time to maturity of 15 years, there are
15 − 7 = 8 years remaining for the bond.
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.045)8 $1, 000
= $35 × +
0.045 (1 + 0.045)8
= $934.04

10/24
Ch. 7 Tutorial Question 5
XYZ issued 10-year bonds three years ago with a semi-annual coupon of 5%.
The current yield is now 4.5%. What will be the market value of the bonds
today?

11/24
Ch. 7 Tutorial Question 5
XYZ issued 10-year bonds three years ago with a semi-annual coupon of 5%.
The current yield is now 4.5%. What will be the market value of the bonds
today?

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question, C = $1, 000 × 5%/2 = $25
and proper discount rate (yield or YTM) is 4.5%. Since the coupons are paid
semi-annually, the discounting also occurs semi-annually. In other words, the
annual yield needs to be converted to semi-annual rates to be used for
discounting. Since the bond was issued three years ago and it had original time
to maturity of 10 years, there are 10 − 3 = 7 years remaining for the bond.
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.045/2)7×2 $1, 000
= $25 × +
0.045/2 (1 + 0.045/2)7×2
= $1, 029.74

11/24
Ch. 7 Tutorial Question 6

Disney Enterprises wants to issue eighty 20-year, $1,000 zero-coupon bonds. If

each bond is to yield 8%, how much will Disney Enterprises receive (ignoring
issuance costs) when the bonds are first sold?

12/24
Ch. 7 Tutorial Question 6

Disney Enterprises wants to issue eighty 20-year, $1,000 zero-coupon bonds. If

each bond is to yield 8%, how much will Disney Enterprises receive (ignoring
issuance costs) when the bonds are first sold?

The market value of the zero-coupon bond is simply the PV of face value
(lump-sum). Since N = 80 such bonds are assumed to be issued, the total
market value is
F
PV = N ×
(1 + r )t
$1, 000
= 80 ×
(1 + 0.08)20
= $17, 163.86

12/24
Ch. 7 Tutorial Question 7
Moose Inc. issued an 8-year semi-annual bond three years ago that pays
interest of 3.5% per year. If the face value is $1,000 and the current yield is
4%, what is the market price of the bond?

13/24
Ch. 7 Tutorial Question 7
Moose Inc. issued an 8-year semi-annual bond three years ago that pays
interest of 3.5% per year. If the face value is $1,000 and the current yield is
4%, what is the market price of the bond?

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question,
C = $1, 000 × 3.5%/2 = $17.5 and proper discount rate (yield or YTM) is 4%.
Since the coupons are paid semi-annually, the discounting also occurs
semi-annually. In other words, the annual yield needs to be converted to
semi-annual rates to be used for discounting. Since the bond was issued three
years ago and it had original time to maturity of 8 years, there are 8 − 3 = 5
years remaining for the bond.
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.04/2)5×2 $1, 000
= $17.5 × +
0.04/2 (1 + 0.04/2)5×2
= $977.54

13/24
Ch. 7 Question 1

1. Is the yield to maturity on a bond the same thing as the required return? Is
YTM the same thing as the coupon rate? Suppose today a 10% coupon bond
sells at par. Two years from now, the required return on the same bond is 8%.
What is the coupon rate on the bond then? The YTM?

–Refer to the solution posted on the Avenue

14/24
Ch. 7 Question 2

2. Suppose you buy a 7% coupon, 20-year bond today when it’s first issued. If
interest rates suddenly rise to 15%, what happens to the value of your bond?
Why?

–Refer to the solution posted on the Avenue

15/24
Ch. 7 Question 3

3. Malahat Inc. has 7.5% coupon bonds on the market that have ten years left
to maturity. The bonds make annual payments. If the YTM on these bonds is
8.75%, what is the current bond price?

16/24
Ch. 7 Question 3

3. Malahat Inc. has 7.5% coupon bonds on the market that have ten years left
to maturity. The bonds make annual payments. If the YTM on these bonds is
8.75%, what is the current bond price?

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question, C = $1, 000 × 7.5% = $75
and proper discount rate (yield or YTM) is 8.75%.
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.0875)10 $1, 000
= $75 × +
0.0875 (1 + 0.0875)10
= $918.89

16/24
Ch. 7 Question 6
6. Langford Co. issued 14-year bonds a year ago at a coupon rate of 6.9%.
The bonds make semiannual payments. If the YTM on these bonds is 5.2%,
what is the current bond price?

17/24
Ch. 7 Question 6
6. Langford Co. issued 14-year bonds a year ago at a coupon rate of 6.9%.
The bonds make semiannual payments. If the YTM on these bonds is 5.2%,
what is the current bond price?

The market value of the bond is the sum of the PV of coupons (annuity) and
the PV of face value (lump-sum). In this question,
C = $1, 000 × 6.9%/2 = $34.5 and proper discount rate (yield or YTM) is
5.2%. Since the coupons are paid semi-annually, the discounting also occurs
semi-annually. In other words, the annual yield needs to be converted to
semi-annual rates to be used for discounting. Since the bond was issued a year
ago and it had original time to maturity of 14 years, there are 14 − 1 = 13
years remaining for the bond.
1
1− (1+r )t F
PV = C × +
r (1 + r )t
1
1− (1+0.052/2)13×2 $1, 000
= $34.5 × +
0.052/2 (1 + 0.052/2)13×2
= $1, 159.19

17/24
Ch. 7 Question 8

8. Happy Valley Corporation has bonds on the market with 14.5 years to
maturity, a YTM of 6.1%, and a current price of $1,038. The bonds make
semiannual payments. What must the coupon rate be on these bonds?

18/24
Ch. 7 Question 8

8. Happy Valley Corporation has bonds on the market with 14.5 years to
maturity, a YTM of 6.1%, and a current price of $1,038. The bonds make
semiannual payments. What must the coupon rate be on these bonds?

Recall the bond pricing formula

1
1− (1+r )t F
PV = C × + .
r (1 + r )t
Re-arranging the above and solving for C , we obtain
 
F r
C = PV − × 1
(1 + r )t 1 − (1+r )t
 
$1, 000 0.061/2
= PV − × 1
(1 + 0.061/2)14.5×2 1 − (1+0.061/2) 14.5×2

= $32.49

Hence, the annual coupon rate is ($32.49 × 2)/$1, 000 = 6.50%.

18/24
Ch. 7 Question 11

11. An investment offers a 14% total return over the coming year. Bill
Morneau thinks the total return on this investment will be only 9%. What does
Morneau believe the inflation rate will be over the next year?

19/24
Ch. 7 Question 11

11. An investment offers a 14% total return over the coming year. Bill
Morneau thinks the total return on this investment will be only 9%. What does
Morneau believe the inflation rate will be over the next year?

Recall the Fisher equation

(1 + R) = (1 + r )(1 + h)

Re-arranging the above and solving for h, we obtain

1+R
h= −1
1+r
1 + 0.14
= − 1 = 4.59%.
1 + 0.09

19/24
Ch. 7 Question 12

12. Say you own an asset that had a total return last year of 10.7%. If the
inflation rate last year was 3.7%, what was your real return?

20/24
Ch. 7 Question 12

12. Say you own an asset that had a total return last year of 10.7%. If the
inflation rate last year was 3.7%, what was your real return?

Recall the Fisher equation

(1 + R) = (1 + r )(1 + h)

Re-arranging the above and solving for r , we obtain

1+R
h= −1
1+h
1 + 0.107
= − 1 = 6.75%.
1 + 0.037

20/24
Ch. 7 Question 14

14. At the time of the last referendum, Quebec provincial bonds carried a
higher yield than comparable Ontario bonds because of investors’ uncertainty
about the political future of Quebec. Suppose you were an investment manager
who thought the market was overpaying these fears. In particular, suppose you
thought that yields on Quebec bonds would fall by 50 basis points. Which
bonds would you buy or sell? Explain your choices.

21/24
Ch. 7 Question 14

14. At the time of the last referendum, Quebec provincial bonds carried a
higher yield than comparable Ontario bonds because of investors’ uncertainty
about the political future of Quebec. Suppose you were an investment manager
who thought the market was overpaying these fears. In particular, suppose you
thought that yields on Quebec bonds would fall by 50 basis points. Which
bonds would you buy or sell? Explain your choices.

As in the solution posted in the Avenue: There is a negative relationship

between bond yields and bond prices. If an investment manager thinks that
yields on Quebec provincial bonds will decrease then (s)he should buy them
because they will increase in price and any investor who buys the bonds at
today’s price will receive a capital gain. In order to fund this purchase of
Quebec bonds, he should short (sell) the Ontario bonds with the same maturity.

21/24
Ch. 7 Question 26

26. Suppose your company needs to raise $45 million and you want to issue
30-year bonds for this purpose. Assume the required return on your bond issue
will be 6%, and you’re evaluating two issue alternatives: a 6% annual coupon
bond and a zero-coupon bond. Your company’s tax rate is 35%.
a. How many of the coupon bonds would you need to issue to raise the $45
million? How many of the zeroes would you need to issue?

22/24
Ch. 7 Question 26

26. Suppose your company needs to raise $45 million and you want to issue
30-year bonds for this purpose. Assume the required return on your bond issue
will be 6%, and you’re evaluating two issue alternatives: a 6% annual coupon
bond and a zero-coupon bond. Your company’s tax rate is 35%.
a. How many of the coupon bonds would you need to issue to raise the $45
million? How many of the zeroes would you need to issue?

a. For the coupon bond, the annual coupon rate and the yield are equal to
each other, both being 6%. This implies that the market price of the coupon
bond is equal to the face value. In other words, the coupon bonds trade at par.
Therefore, since each bond has a face value of $1,000 , the company needs to
sell $45, 000, 000 ÷ $1, 000 = 45, 000 number of coupon bonds.
On the other hand, the market price of zero-coupon bond is
PV = F /(1 + r )t = $1, 000/(1 + 0.06)30 = $174.11. Therefore, to fund $45
million, the company needs to sell $45, 000, 000 ÷ $174.11 = 258, 457.30
number of zero-coupon bonds.

22/24
Ch. 7 Question 26

26. Suppose your company needs to raise $45 million and you want to issue
30-year bonds for this purpose. Assume the required return on your bond issue
will be 6%, and you’re evaluating two issue alternatives: a 6% annual coupon
bond and a zero-coupon bond. Your company’s tax rate is 35%.
b. In 30 years, what will your company’s repayment be if you issue the coupon
bonds? What if you issue the zeroes?

23/24
Ch. 7 Question 26

26. Suppose your company needs to raise $45 million and you want to issue
30-year bonds for this purpose. Assume the required return on your bond issue
will be 6%, and you’re evaluating two issue alternatives: a 6% annual coupon
bond and a zero-coupon bond. Your company’s tax rate is 35%.
b. In 30 years, what will your company’s repayment be if you issue the coupon
bonds? What if you issue the zeroes?

b. For coupon bond, you pay the regular (last) coupon amount ant the
principal at the maturity date. That is, you will pay the regular coupon of
$1, 000 × 6% = $60 and the principal amount of $1,000, hence the total of
$1,060 for each bond. So, the total payment will be
$1, 060 × 45, 000 = $47, 700, 000.
For zero-coupon bond, you only return the principal amount of $1,000 at the
maturity. Hence, the total payment will be
$1, 000 × 258, 457.30 = $258, 457, 300.

23/24
Ch. 7 Question 26

26. Suppose your company needs to raise $45 million and you want to issue
30-year bonds for this purpose. Assume the required return on your bond issue
will be 6%, and you’re evaluating two issue alternatives: a 6% annual coupon
bond and a zero-coupon bond. Your company’s tax rate is 35%.
c. Based on your answers in (a) and (b), why would you ever want to issue the
zeroes? To answer, calculate the firm’s after-tax cash flows for the first year
under the two different scenarios.

c. This question covers materials beyond the scope of this course and you will
not be responsible for it.

24/24