Please see edition 13 of the book
An example: Annual coupon paying bond
Basic bond valuation Complex Systems has an outstanding issue of $1,000-parvalue bonds with a 12% coupon
interest rate. The issue pays interest annually and has 16 years remaining to its maturity date. If bonds of similar risk
are currently earning a 10% rate of return, how much should the Complex Systems bond sell for today?
The required rate of return or RRR = 10% (annually)
Annual coupon rate = 12%
Annual coupon payment = 12% of $1000 = .05*$1000 = $120
Number of coupons or n = 16
Bond price = PV of the coupons + PV of the par value
We can use the following formula we saw in chapter 5 to calculate the PV of the of the coupons. The stream of
coupons is a like an ordinary annuity. The following formula gives the PV of an ordinary annuity.
Where CF is the periodic coupon payment, r is the RRR or required rate of return, and n is the
number of coupons.
𝐶𝑜𝑢𝑝𝑜𝑛 1
𝑃𝑉𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛𝑠 = ( ) ∗ [1 − (1+𝑅𝑅𝑅)𝑛]
𝑅𝑅𝑅
$120 1
𝑃𝑉𝑛 = ( ) ∗ [1 − (1+.10)16] = $ 938.845
.10
Bond price = PV of the coupons + PV of the par value
𝑃𝑎𝑟
Bond price = $ 938.845 + 𝑛 (1+𝑅𝑅𝑅)
1000
Bond price = =$ 938.845 + = $1156.474
(1+.10)16
24. Bond valuation—Semi-annual interest Find the value of a bond maturing in 6 years, with a $1,000 par value and
a coupon interest rate of 10% (5% paid semi-annually) if the required return on similar-risk bonds is 14% annual
interest (7% paid semi-annually).
The required rate of return or RRR = 14% (annually)
The semimanual RRR = 14%/2 = 7%
Annual coupon rate = 10%
So, the semimanual coupon rate = 10%/2 = 5%
Semimanual coupon payment = 5% of $1000 = .05*$1000 = $50
Number of coupons or n= 6×2 = 12
Bond price = PV of the coupons + PV of the par value
The required rate of return or RRR = 14% (annually)
The semimanual RRR = 14%/2 = 7%
Annual coupon rate = 10%
So, the semimanual coupon rate = 10%/2 = 5%
Semimanual coupon payment = 5% of $1000 = .05*$1000 = $50
Number of coupons or n= 6×2 = 12
Bond price = PV of the coupons + PV of the par value
We can use the following formula we saw in chapter 5 to calculate the PV of the of the coupons. The stream of
coupons is a like an ordinary annuity. The following formula gives the PV of an ordinary annuity.
Where CF is the periodic coupon payment, r is the RRR or required rate of return, and n is the
number of coupons.
𝐶𝑜𝑢𝑝𝑜𝑛 1
𝑃𝑉𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛𝑠 = ( 𝑅𝑅𝑅
) ∗ [1 − (1+𝑅𝑅𝑅)𝑛 ]
$50 1
𝑃𝑉𝑛 = ( .07 ) ∗ [1 − (1+.07)12 ] =$397.15
Bond price = PV of the coupons + PV of the par value
𝑃𝑎𝑟
Bond price = $397.15+ (1+𝑅𝑅𝑅)𝑛
1000
Bond price = =$397.15+
(1+.07)12
Bond price = $50 × (7.943) + 444.01195
Bond price = $397.15 + $444
Bond price = $841.15
26. Bond valuation—Quarterly interest Calculate the value of a $5,000-par-value bond paying quarterly interest at
an annual coupon interest rate of 10% and having 10 years until maturity if the required return on similar-risk bonds
is currently a 12% annual rate paid quarterly.
The required rate of return or RRR = 12% (annually)
The quarterly RRR = 12%/4 = 3%
Annual coupon rate = 10%
So, the quarterly coupon rate = 10%/4 = 2.5%
Quarterly coupon payment = 2.5% of $5000 = .025*$5000 = $125
Number of coupons or n= 10×4 = 40
We can use the following formula we saw in chapter 5 to calculate the PV of the of the coupons. The stream of
coupons is a like an ordinary annuity. The following formula gives the PV of an ordinary annuity.
Where CF is the periodic coupon payment, r is the RRR or required rate of return, and n is the
number of coupons.
𝐶𝑜𝑢𝑝𝑜𝑛 1
𝑃𝑉𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛𝑠 = ( 𝑅𝑅𝑅
) ∗ [1 − (1+𝑅𝑅𝑅)𝑛 ]
$125 1
𝑃𝑉𝑛 = ( .03
)∗ [1 − (1+.03)40 ] =$2,889.38
Bond price = PV of the coupons + PV of the par value
𝑃𝑎𝑟 $5000
Bond price = $2,889.38 + (1+𝑅𝑅𝑅)𝑛 = $2,889.38 + (1+.03)40
Bond price = $2,889.38 + $ 1,532.78
Bond price = $4,422.13
17. Bond value and changing required returns Midland Utilities has outstanding a bond issue that will mature to its
$1,000 par value in 12 years. The bond has a coupon interest rate of 11% and pays interest annually.
a. Find the value of the bond if the required return is (1) 11%, (2) 15%, and(3) 8%.
b. Plot your findings in part a on a set of “required return (x axis)–market value of bond (y axis)” axes.
c. Use your findings in parts a and b to discuss the relationship between the coupon interest rate on a bond and the
required return and the market value of the bond relative to its par value.
d. What two possible reasons could cause the required return to differ from the coupon interest rate?
a.
1. Bond price when RRR is equal to the Coupon rate =PV of the coupons+ PV of the par=
714.12+ $1,000÷ (1 + .11)12= $1,000.00 [the bond will be called a par bond as it will be sold/bought
at the par value]
2. Bond price when RRR is greater than the Coupon rate =PV of the coupons+ PV of the par=
= 596.31+ $1,000÷ (1 + .15)12= $783.18 [the bond will be called a discount bond as it will be
sold/bought at a price lower than the par value]
3. Bond price when RRR is less than the Coupon rate = PV of the coupons+ PV of the par
828.96 + $1,000÷ (1 + .08)12= $1,226.08 [the bond will be called a premium bond as it will be
sold/bought at a price higher than the par value]
To calculate the PV of the coupon payments we follow the same method shown in problem 24 & 26;
we use annual RRR and annual coupons in calculations (since the bond pays coupons annually).
b.
c. When the required return is less than the coupon rate, the market value is greater than the par
value and the bond sells at a premium. When the required return is greater than the coupon
rate, the market value is less than the par value; the bond therefore sells at a discount.
d. The required return on the bond is likely to differ from the coupon interest rate because either
(1) economic conditions have changed, causing a shift in the basic cost of long-term funds, or
(2) the firm’s risk has changed.
18. Bond value and time—Constant required returns Pecos Manufacturing has just
issued a 15-year, 12% coupon interest rate, $1,000-par bond that pays interest
annually. The required return is currently 14%, and the company is certain it will
remain at 14% until the bond matures in 15 years.
a. Assuming that the required return does remain at 14% until maturity, find the
value of the bond with (1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years,
(5) 3 years, and (6) 1 year to maturity.
b. Plot your findings on a set of “time to maturity (x axis)–market value of bond
(y axis)” axes constructed similarly to Figure 6.5 on page 246.
c. All else remaining the same, when the required return differs from the coupon
interest rate and is assumed to be constant to maturity, what happens to the
bond value as time moves toward maturity? Explain in light of the graph in
part b.
a.
1. Bond price = $120 × (6.142) + $1,000÷ (1 + .14)15= $877.16
2. Bond price = $120 × (5.660) + $1,000÷ (1 + .14)12= $886.79
3. Bond price = $120 × (4.946) + $1,000÷ (1 + .14)9 = $901.07
4. Bond price = $120 × (3.889) + $1,000÷ (1 + .14)6 = $922.23
5. Bond price = $120 × (2.322) + $1,000÷ (1 + .14)3 = $953.57
6. Bond price = $120 × (0.877) + $1,000÷ (1 + .14)1 = $982.46
To calculate the PV of the coupon payments we follow the same method shown in problem 24 & 26;
we use annual RRR and annual coupons in calculations (since the bond pays coupons annually).
b.
c. The bond value approaches the par value as we move closer to the maturity.