FINA1310 CORPORATE FINANCE

Faculty of Economics and Finance

University of Hong Kong

Prof. Shiyang Huang

Lecture 4: Interest Rates and Bond Valuation

 Summary of Chapter 6
• Annuity:
• Finite series of equal payments that occur at regular
intervals, the first payment occurs at the end of the period
1
1− (1 + r)t − 1
(1 + r)t FV = C
PV = C r
r

• Annuity due:
• The first payment occurs at the beginning of the period
1 (1 + r)t − 1
1−
(1 + r)t FV = C ∗ (1 + 𝑟)
PV = C ∗ (1 + 𝑟) r
r

• Perpetuity:
PV = C / r
Course Overview
• Introduction

• Part I: Valuation
• Time Value of Money, Discounted Cash Flow
Valuation, Bond and Stock Valuation.

• Part II: Risk and Return

• Historical Risk and Return Relationships, CAPM.

• Part III: Capital Budgeting

• Real Investment Decisions, Cost of Capital.

• Part IV: Financing Decisions

• Raising Capital, Tradeoff between Equity and Debt.
Loan Types
• Pure Discount Loan

• Interest Only Loan

• Amortized Loan
Pure Discount Loan
• A lump-sum payment at some point in the future, no
intermediate payment

No payment in middle years, i.e. no

intermediate payment

• Example: US Treasury Bill

• If a Treasury-bill promises to repay $10,000 in 12

months and the market interest rate is 7 percent, how
much will the bill sell for in the market?
10000
= 9345.79
1.07
Interest-Only Loan
• Interest payment each period and (original) principal
payment at some point in the future

• Example: Consider a 5-year, interest-only loan with a 7%

interest rate. The principal amount is $10,000. Interest
is paid annually. What is the stream of cash flows?
Interest-Only Loan
• Consider a 5-year, interest-only loan with a 7% interest
rate. The principal amount is $10,000. Interest is paid
annually. What would the stream of cash flows be?

Years 1 – 4: Interest payments of .07(10,000) = 700

Year 5: Interest + principal = 10,700

• This cash flow stream is similar to the cash flows on

bonds, and we will talk about them in greater detail later.
Amortized Loans
• Borrower repays parts of the loan amount over time;
Principal amount reduced (“amortized”) along the way.

1) Amortized Loan with Fixed Principal Payments

2) Amortized Loan with Fixed Equal Payments

1) 2)
Amortized Loans with Fixed Principal Payments
Example: Consider a $50,000, 10 year loan at 8% interest. The loan
agreement requires the firm to pay $5,000 in principal each year plus
interest for that year. What is the schedule for total payment amount
every year?
Loan Amortization Schedule
Beginning Interest Principal Total Ending
Year Balance Payment Payment Payment Balance
1 50,000 4,000 5,000 9,000 45,000
2 45,000 3,600 5,000 8,600 40,000
3 40,000 3,200 5,000 8,200 35,000
4 35,000 2,800 5,000 7,800 30,000
5 30,000 2,400 5,000 7,400 25,000
6 25,000 2,000 5,000 7,000 20,000
7 20,000 1,600 5,000 6,600 15,000
8 15,000 1,200 5,000 6,200 10,000
9 10,000 800 5,000 5,800 5,000
10 5,000 400 5,000 5,400 0
22,000
Amortized Loans with Fixed Equal Payments
• Each payment covers the interest expense plus reduces
principal
• Consider the same 10 year loan with annual payments.
The interest rate is 8%, and the principal amount is
$50,000.
• What is the annual payment? This is an ordinary annuity.
 1   1 
1 − (1 + r) t  1 − (1 + 0.08)10 
PV = C   = C  = 50,000  C = 7,451.474
 r   0.08 
   
Amortized Loans with Fixed Equal Payments
Example: Consider the same 10 year loan with annual payments. The
interest rate is 8%, and the principal amount is $50,000.
What is the annual payment? This is an ordinary annuity.
-- Using Annuity Present Value Formula, C=7,451.47

Loan Amortization Schedule

Year Beginning Total Interest Paid Principal Ending
Balance Payment Paid Balance
1 50,000.00 7,451.47 4,000.00 3,451.47 46,548.53
2 46,548.53 7,451.47 3,723.88 3,727.59 42,820.93
3 42,820.93 7,451.47 3,425.67 4,025.80 38,795.13
4 38,795.13 7,451.47 3,103.61 4,347.86 34,447.27
5 34,447.27 7,451.47 2,755.78 4,695.69 29,751.58
6 29,751.58 7,451.47 2,380.13 5,071.35 24,680.23
7 24,680.23 7,451.47 1,974.42 5,477.06 19,203.17
8 19,203.17 7,451.47 1,536.25 5,915.22 13,287.95
9 13,287.95 7,451.47 1,063.04 6,388.44 6,899.51
10 6,899.51 7,451.47 551.96 6,899.51 0.00
Totals 74,514.74 24,514.74 50,000.00
Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
What is bond?

Face value
+ Coupon

Coupon Coupon Coupon Coupon

US Bond Market Overview
• US Bond Market Size US $38.4 Trillion
• US Stock Market Size US ~$23 Trillion

Data Source: SIFMA

Bond Basics
• Bond – Security that obligates the issuer to make specified payments to
the bond holders

• Par Value (Face Value) – Principal amount of a bond that is repaid at the
end of the term (at maturity) (Often default 1000)

• Maturity – Specified date on which the principal amount of a bond is

repaid

• Coupon Payment – Stated interest payments made to the bond holder

• Coupon Rate – Annual interest payment, as a percentage of principal:

Zero coupon, fixed rate and floating rate bonds.

• Yield or Yield-to-Maturity – The rate required in the market on a bond

Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
Coupon Bond Valuation
𝑪 𝑪 𝑪 + 𝑷𝒂𝒓
𝑷𝑽 = + 𝟐 + ⋯+ 𝟏+ 𝒓 𝑻
𝟏+𝒓 𝟏+𝒓

• Straightforward application of PV of multiple cash flows

• C is the coupon payment and Par is the face value

• Bond Value = PV of Coupons + PV of Par

= PV (Annuity) + PV (Par)

• For now, we consider valuation of riskless bonds (bonds

that will be fully repaid)

• Spreadsheet function: present value (pv): PV(rate, nper,

pmt, fv)
Coupon Rate vs. Interest Rate
“Coupon Rate” is not the same concept as “Interest Rate”

• Coupon Rate = Annual Coupon / Principal

• Specified in Bond Contract

• Interest Rate = Discount Rate, Opportunity Cost of Capital,

Required Rate of Return …
• A Market-Determined Rate Representing Time Value of Money

• Both are stated as %, but don’t confuse them!

• WARNING
• The coupon rate IS NOT the interest rate used in the Present
Value calculations.
The Bond Pricing Equation
𝑪 𝑪 𝑪 + 𝑷𝒂𝒓
𝑷𝑽 = + 𝟐 + ⋯+ 𝟏+𝒓 𝑻
𝟏+𝒓 𝟏+𝒓

• Bond Value = PV of Coupons + PV of Par

= PV (Annuity) + PV (Par)

 1 
1 - (1 + r) t  FV
Bond Value = C  +
 r  (1 + r) t

 
Par Bond
• What is the price of a 6.5% annual coupon bond, with a
$1,000 face value, which matures in 3 years?

• Assume required rate of return is 6.5%

• PV(rate, nper, pmt, fv)
• rate=6.5%; nper=3; pmt=65;fv=1000;

1
1− 1000
0.065)3
(1+
Bond Value = 65 + =1000
0.065 (1+0.065)3

• Price = Par Value → “Par Bond”

Par Bond
Premium Bond
• What is the price of a 6.5% annual coupon bond, with a
$1,000 face value, which matures in 3 years?

• Assume required rate of return is 3.9%

65 1 1000
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = × 1− + = $1072.29
0.039 1.0393 1.0393

• PV(rate, nper, pmt, fv)

• Rate=3.9%; nper=3; pmt=65;fv=1000;

• Price > Par Value → “Premium Bond”

Premium Bond
 Discount Bond
• What is the price of a 6.5% annual coupon bond, with a
$1,000 face value, which matures in 3 years?

• Assume required rate of return is 15%

65 1 1000
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = × 1− 3 + 3 = $805.93
0.15 1.15 1.15

• PV(rate, nper, pmt, fv)

• Rate=15%; nper=3; pmt=65;fv=1000

• Price < Par Value → “Discount Bond”

Discount Bond
Continued….
• What is the price of the bond if the required rate of return is
3.9%(APR) and the coupons are paid semi-annually?
• Note: Bond yields are quoted like APRs; the quoted rate is equal to the
actual rate per period multiplied by the number of periods.

32.5 1 1000
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = × 1− + = $1072.94
0.0195 1.01956 1.01956

• PV(rate, nper, pmt, fv)

• Rate=1.95%; nper=6; pmt=32.5;fv=1000

• Price > Par Value → “Premium Bond”

Continued….
• Question 1: What happened when the required return is less
than the coupon rate?

• Question 2: What happened when the require return is

greater than the coupon rate?

• Question 3: How did the calculation change, given semi-

annual coupons versus annual coupon payments?
Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
 Yield to Maturity
• Yield to Maturity (YTM) or Yield: Interest rate for
which the present value of the bond’s payments equals
the price

𝑪 𝑪 𝑪 + 𝑷𝒂𝒓
𝑷𝒓𝒊𝒄𝒆 = + 𝟐 + ⋯+ 𝟏+ 𝒚 𝑻
𝟏+𝒚 𝟏+𝒚

• Yields are usually quoted as APRs

Relationship Between Price and Yield-
to-maturity (YTM)
When interest rates increase, what will happen to bond prices?

Coupon rate = 8% with annual coupons; Par value = $1,000; Maturity = 10 years

1500
1400
Selling at premium
1300
Bond
Price

1200
1100 P = $1000
1000
900
800
700 Selling at discount
600
0% 2% 4% 6% 8% 10% 12% 14%

Yield-to-maturity (YTM)
Calculating Yield
• Trial and error or Excel Solver. Similar to how we find
the interest rate for an annuity

• Example: Find the YTM for a bond with $1000 face

value, time to maturity of 20 years and a coupon rate
of 10% paid annually. The bond is currently selling at
$1196.363. What is the YTM?

• (a) Is YTM higher or lower than 10%?

• (b) What is annual coupon payment?
• (c) How many periods are there?

• Suppose I guess , and get , is too high or too low? Keep guessing… discount
rate (rate): RATE(nper, pmt, pv, fv)

→ YTM = 8%
Calculating Yield
 Current Yield and YTM
• Current Yield: Annual coupon payments divided by
current bond price
• Capital Gain/Loss: The percentage changes in bond
prices.

• Yield to Maturity (quoted as APR), Interest rate for

which the present value of the bond’s payment equals
the price
 Current Yield and YTM
Example:

• Consider a bond with $1000 face value, time to

maturity of 20 years and a coupon rate of 10% paid
annually. The bond is currently selling at $1196.363.

• Current yield =

• Assume no change in YTM, what is price in one year?

• What is the capital gain yield over one year?

 Current Yield and YTM
• Current yield =100/1196.36=8.359%

• YTM=rate(20, 100,-1196.36,1000)=8%

• Assume no change in YTM, what is price in one year?

Price(one year later)=PV(8%,19,100,1000)=1,192.07

• What is the capital gain yield over one year?

Capital gain/loss yield=1192.07/1196.36-1=-0.359%

In this example
Realized return (holding period return)=current yield + capital gain
yield

• Here (when there is no change in the future YTM), we have

Current Yield + Capital Gain Yield=8% =YTM
 Current Yield and YTM
• Assume no change in YTM, what is price in one year?
Price(one year later)=PV(8%,19,100,1000)=1,192.07
 Holding Period Return

• If the interest rate changes in the future, the holding period

realized return (holding period return) might be different from
the yield to maturity

• In this example: the 10% annual coupon bond with a par value
$1000 is selling for $1196.363. The remaining time to maturity
is 20 years.

• Suppose that the yield to maturity decreases by 1% at year 1.

• Question: what is the realized period from now to year 1?

• Tips: need to calculate the price at year 1
 Holding Period Return

• Bond price at year 1: PV(7%,19,100,1000)=1,310.07

• Holding Period return=(100+1310.07)/ 1196.363-1=17.86%

Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
Will Bond Prices stay the same after issuance?
Example: Microsoft Corp. US dollar bond, issued on Sep 22, 2010,
maturity date April 2040, coupon rate 4.5%, price at offering is $98.91.

Data source: FINRA

Implication of Yield

Low demand -> Low price of the bond -> High interest rate
Interest Rate Risk
• Interest Rate Risk
• Change in price due to change in interest rate
• All other things being equal, long-term bonds have more
interest rate risk than short-term bonds
• All other things being equal, the lower the coupon rate,
the larger the interest rate risk
 Interest Rate Risk – Different Maturity
• Sensitivity of price to changes in yield measures risk
• Example: consider 10% coupon bonds for different interest rates.
Face value = $1000. Maturities = 2 years & 30 years

Which bond has

greater interest rate
risk?

Why?
 Interest Rate Risk – Different Maturity
• Longer-maturity bonds have more interest rate risk
than shorter-maturity bonds

𝑪 𝑪 𝑪+𝑷𝒂𝒓
Bond Price= 𝟏+𝒓 + + ⋯+
𝟏+𝒓 𝟐 𝟏+𝒓 𝑻

• Variation in bond price comes from T components

• Interest rate affects bond price through its effect on each
component
𝑪+𝑷𝒂𝒓
• Interest rate has larger effect on than previous periods’
𝟏+𝒓 𝑻
𝑪 𝑪
payment, such as 𝟏+𝒓 and 𝟏+𝒓 𝟐
 Interest Rate Risk
All else equal,
• Longer-maturity bonds have more interest rate risk
(called “price risk” sometimes) than shorter-maturity
bonds

• The larger the coupon rate, the smaller the interest

rate risk
Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
Inflation
What is inflation?
• Change in real purchasing power of $1 over time
• Different from time value of money (how?)
• For some countries, inflation is extremely problematic
• How to quantify the effects of inflation?

Wealth 𝑊𝑡 ֞ Price Index 𝐼𝑡

Wealth 𝑊𝑡+1 ֞ 𝑃𝑟𝑖𝑐𝑒 Index 𝐼𝑡+1

𝐼𝑡+1
Increase in Cost of Living: − 1 ≡ ℎ (inflation rate)
𝐼𝑡
Real Wealth: ෩𝑡+1 = 𝑊𝑡+1 ； 𝑊
𝑊 ෩𝑡 = 𝑊𝑡
𝐼𝑡+1 𝐼𝑡
Inflation and Interest Rates
• Nominal Interest Rate – Interest rate that has not been
adjusted for inflation (𝑅)
• Real Interest Rate – Interest rate that has been adjusted
for inflation (𝑟)

Real Wealth: ෩𝑡+1 = 𝑊𝑡+1

𝑊
𝐼𝑡+1
෩𝑡+1
𝑊 𝑊𝑡+1 1 1+𝑅
Real Return r: 1+r = ෩𝑡
= × 1+ℎ = 1+ℎ
𝑊 𝑊𝑡

Fisher Effect:
𝟏+𝑹= 𝟏+𝒓 × 𝟏+𝒉

𝑹≈𝒓+𝒉
Example of Fisher Effect
• What is the real rate on an investment that generated
10% return and the inflation rate was 4%?
• r = (1.10)/(1.04) – 1 = 5.77%
• Approximation: r = 10% -4% = 6%

• If we require a 10% real return and we expect inflation

to be 8%, what is the nominal rate?
• R = (1.10)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation are relatively high,
there is significant difference between the actual Fisher Effect
and the approximation.
 PV, Nominal Rate and Real Rate

For PV Calculations, Treat Inflation Consistently:

• Discount nominal cash flows using nominal interest rates

• Nominal cash flows: expressed in actual dollar cash flows

• Nominal interest rate: actual prevailing interest rate

• Discount real cash flows using real interest rates

• Real cash flows: expressed in constant purchasing power

• Real interest rate: interest rate adjusted for inflation
Example of PV and Inflation
• Suppose you want to withdraw money each year for the next
three years, and you want each withdrawal to have $25,000
worth of purchasing power as measured in current dollars.

• If the inflation rate is 4% each year, and the nominal discount

rate is 10%,

• What is the PV of the cash flows?

• Rate=(1+10%)/(1+4%)=5.77%
• nper=3; pmt=25000;fv=0
• PV(rate, nper, pmt, fv)=67,110.78
Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
Term Structure of Interest Rates
• Term Structure contains information about future interest
rates 𝑷𝒂𝒓
𝑩𝒐𝒏𝒅 𝑷𝒓𝒊𝒄𝒆 = 𝒕
𝟏 + 𝒓𝟎,𝒕
Term Structure of Interest Rates
• Consider a bond with exactly three years to maturity. Face value is £100 and
the coupon rate is 5% (coupons are paid annually). The one, two and three
year spot rates are 4%, 4.5% and 6% respectively.
• What is the price of the bond?
Term Structure of Interest Rates
• Consider a bond with exactly three years to maturity. Face value is £100 and
the coupon rate is 5% (coupons are paid annually). The one, two and three
year spot rates are 4%, 4.5% and 6% respectively.
• What is the price of the bond?
Example – Bond Pricing (Not Required)
• Consider the following bond data where coupons are annual and par value
is £100. What should be the price of Bond A?
Example – Bond Pricing (Not Required)
• Consider the following bond data where coupons are annual and par value
is £100. What should be the price of Bond A?
Example – Bond Pricing (Not Required)
Example – Bond Pricing (Not Required)
Example – Bond Pricing (Not Required)
Determinants of Term Structure
• Real Rate: Compensation that investors demand for
forgoing use of their money

• Inflation Premium: Compensation that investors

demand for loss in purchasing power

• Interest Rate Risk Premium: Compensation that

investors demand for bearing interest rate risk
Upward-Sloping Term Structure

𝑟0,𝑡
Downward-Sloping Term Structure

𝑟0,𝑡
Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Interest Rate and Inflation
• Term Structure of Interest Rates
• Bond Features

Reading : Chapter 7
Bond Classifications
• Registered vs. Bearer Forms
• A bond whose owner is registered with the bond's issuers
• A bearer bond is a bond or debt security issued by a business entity
such as a corporation, or a government. It differs from the more
common types of investment securities in that it is unregistered – no
records are kept of the owner, or the transactions involving ownership.

• Security
• Collateral – secured by financial securities
• Mortgage – secured by real property, normally land or buildings
• Debentures
• Unsecured debt (in US)
• Secured debt (in UK)
• Notes – unsecured debt with original maturity less than 10 years
 Bond Ratings – Investment Quality
• High Grade
• Moody’s Aaa and S&P AAA – capacity to pay is extremely strong
• Moody’s Aa and S&P AA – capacity to pay is very strong

• Medium Grade
• Moody’s A and S&P A – capacity to pay is strong, but more susceptible to
changes in circumstances
• Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions
will have more impact on the firm’s ability to pay

• Investment Grade
• Rating of Baa or BBB and above
 Bond Ratings – Speculative

• Low Grade
• Moody’s Ba and B
• S&P BB and B
• Considered possible that the capacity to pay will degenerate.

• Very Low Grade

• Moody’s C (and below) and S&P C (and below)

• income bonds with no interest being paid, or

• in default with principal and interest in arrears

Government Bonds
• Treasury Securities
• Federal government debt

• T-bills – pure discount bonds with original maturity of one year or less

• T-notes – coupon debt with original maturity between one and ten years

• T-bonds – coupon debt with original maturity greater than ten years

• Municipal Securities (Munis)

• Debt of state and local governments

• Varying degrees of default risk, rated similar to corporate debt

• Interest received is tax-exempt at the federal level

Zero Coupon Bonds

• Price <= par value

• Sometimes called zeroes, deep discount bonds, or original issue discount

bonds (OIDs)

• Zero-coupon bonds

• Treasury Bills are good examples of zeroes

Key Takeaways

• Market Overview
• Bond Valuation
• Yield to Maturity (YTM)
• Interest Rate Risk
• Current Yield and Holding-Period Return
• Interest Rate and Inflation
• Term Structure of Interest Rates

Next Week: Chapter 8