1

Present Value of Future Cash Flows

Link Risk & Return
Expected Return
on Assets
Valuation
2
) r + (1
CF
+ . . . +
) r + (1
CF
+
) r + (1
CF
=
P
n
n
2
2
1
1
0
P
0
= Price of asset at time 0 (today)
CF
t
= Cash flow expected at time t
r = Discount rate (reflecting assets risk)
n = Number of discounting periods (usually years)
This model can express the price of any asset at
t = 0 mathematically.
Marginal benefit of owning
the asset: right to receive the
cash flows
Marginal cost: opportunity
cost of owning the asset
3


A bond is a long term security that obligates the
issuer to make specified interest and principal
payments to the holder on specified dates.

Bonds are sometimes called fixed income securities.

4
The face value of a bond, which the borrower repays
at maturity.
Par value
The date when a bonds life ends and the borrower
must make the final interest payment and repay the
principal/par value.
Maturity Date
A fixed amount of interest that a bond promises to pay
investors each period.
Coupon payments
The rate derived by dividing the bonds annual coupon
payment by its par value.
Coupon interest rate
5
WARNING

The coupon rate IS NOT the discount rate used in the
Present Value calculations.

The coupon rate merely tells us what cash flow the bond
will produce.

Since the coupon rate is listed as a %, this misconception
is quite common.

6
Based on
issuer
Government
bonds
Municipal
bonds
Corporate
bonds
Foreign bonds
Based on
coupon
rate
Fixed rate
Floating rate
Zero coupon
Based on
protection
Secured
Unsecured
Based on
other
features
Convertible
Exchangeable
Etc.
7
Issued by Federal governments
Have no default risk but still have interest rate risk
Used to fund budget deficits
If 1 year < maturity < 10 years: Treasury Notes
Maturity > 10 years: Treasury Bonds
Treasury Bonds
Issued by corporations
Have default risk and interest rate risk
Different corporate bonds have different levels of
default risk
Corporate Bonds
8
Issued by local and state government
Have default risk and interest risk.
In general, interest on municipal bonds tax-free
Municipal Bonds
Issued by either foreign governments or foreign
corporations.
Have default risk and interest rate risk.
Can issued in either in a currency or in investors home
currency
Can be exposed to currency risk
Foreign Bonds
9
Coupon payments are fixed at stated rate
Fixed Rate Bonds
coupon tied to prime rate, LIBOR, Treasury rate or other interest
rate
Floating rate = benchmark rate + spread
Floating rate can also be tied to the inflation rate: TIPS, for example
Floating Rate Bonds
Zero-coupon bonds pay no interest
Also known as Discount bonds or pure discount bonds
Sell below par value
Treasury Bills (Tbills)
Treasury STRIPs
Zero Coupon Bonds
10
Unsecured bonds (debentures) are backed only by general faith
and credit of issuer
Secured bonds are backed by specific assets (collateral)
Mortgage bonds, collateral trust bonds, equipment trust
certificates
Secured vs. Unsecured Bonds
A provision in a bond contract that gives the issuer the right to
redeem the bonds under specified terms prior to normal
maturity dates
Call provision
A provision in a bond contract that requires the issuers to retire
a portion of the bond issue each year.
Sinking Funds
11
Convertible bonds, in addition to paying coupon, offers the right to convert the bond
into common stock of the issuer of the bond
Exchangeable bonds are convertible in shares of a company other than the issuers
Convertible and Exchangeable Bonds
Callable bonds: bond issuer has the right to repurchase the bonds at a specified price
(call price).
Firms could retire and reissue debt if interest rates fall.
Putable bonds: the investors have the right to sell the bonds to the issuer at the put
price.
Callable and Putable Bonds
Sinking fund provisions: the issuer is required to gradually repurchase outstanding
bonds.
Protective covenants: requirements the bond issuer must meet
Positive and negative covenants

Protection from Default Risk
12
A bond that pay interest only if it is earned
Income bond
A bond that has interest payments based on
an inflation index so as to protect hodlers from
inflation
Indexed/purchasing power bond
13



Assuming annual interest:









) r + (1
M
+
) r + (1
C
+ . . . +
) r + (1
C
+
) r + (1
C
=
P
n n 2 1
0
( ) ) r + (1
M
+
r
r
C
=
n n
(

+

1
1
1
Bond Price = PV of coupons + PV of principal
14


Example

What is the price of a 5.5 % annual coupon bond, with a
$1,000 face value, which matures in 3 years? Assume a
required return of 3.5%.

03 . 056 , 1 $
) 035 . 1 (
055 , 1
) 035 . 1 (
55
) 035 . 1 (
55
3 2 1
=
+ + =
PV
PV
15


Example (continued)

What is the price of the bond if the required rate of return is 5.5%?
000 , 1 $
) 055 . 1 (
055 , 1
) 055 . 1 (
55
) 055 . 1 (
55
3 2 1
=
+ + =
PV
PV
Example (continued)

What is the price of the bond if the required rate of return is 15 %?
09 . 783 $
) 15 . 1 (
055 , 1
) 15 . 1 (
55
) 15 . 1 (
55
3 2 1
=
+ + =
PV
PV
16
6% coupon rate
for both
17
Bond prices move inversely to yields (interest rates)
r > Coupon Interest
Rate
P
0
< par value DISCOUNT
r < Coupon Interest
Rate
P
0
> par value PREMIUM
r = Coupon Interest
Rate
P
0 =
par value PAR VALUE
What happens to bond values if the required return is not equal to
the coupon rate?
The bond's price will differ from its par value.
18
880
900
920
940
960
980
1,000
1,020
1,040
1,060
1,080
0 5 10 15 20 25 30
B
o
n
d

P
r
i
c
e
Time to Maturity
Price path for Premium
Bond
Price path for Discount
Bond
Today
Maturity
19
Bond prices converge to par value (plus final coupon) with
passage of time
SEMIANNUAL COMPOUNDING

Example (continued)

Determine the price of a 5.5 % annual coupon bond, with a
$1,000 face value, which matures in 3 years?

What is the price of the bond if the required rate of return is
3.5% AND the coupons are paid semi-annually?
49 . 056 , 1 $
) 0175 . 1 (
50 . 027 , 1
) 0175 . 1 (
50 . 27
...
) 0175 . 1 (
50 . 27
) 0175 . 1 (
50 . 27
6 5 2 1
=
+ + + + =
PV
PV
20
SEMIANNUAL COMPOUNDING (CONT.)
Example (continued)

Question: How did the calculation change, given semi-
annual coupons versus annual coupon payments?
Time Periods
Paying coupons twice a year,
instead of once doubles the total
number of cash flows to be
discounted in the PV formula.
Discount Rate
Since the time periods are now
half years, the discount rate is
also changed from the annual
rate to the half year rate.





n
r
M
C
r
C
r
C
r
C
2 3 2 1
)
2
1 (
2
....
)
2
1 (
2
)
2
1 (
2
)
2
1 (
2
Price
+
+
+ +
+
+
+
+
+
=
21
SEMIANNUAL COMPOUNDING (CONT.)





n
r
M
C
r
C
r
C
r
C
2 3 2 1
)
2
1 (
2
....
)
2
1 (
2
)
2
1 (
2
)
2
1 (
2
Price
+
+
+ +
+
+
+
+
+
=
22
( )
)
r
+ (1
M
+
r
r
C
=
n
n
2
2
2
2
1
1
1
2 (
(
(

+

Interest rate for which the present
value of the bonds coupon
payments and principal equal the
bond price.
YTM
Estimate the rate of return
investors earn if they buy at P
0

and hold it until maturity
YTM
23
n
r
M C
r
C
r
C
PV
) 1 (
) (
....
) 1 ( ) 1 (
2 1
+
+
+ +
+
+
+
=
YIELD TO MATURITY (YTM) (CONT.)
Calculating Yield to Maturity (YTM=r)

If you are given the price of a bond (PV) and the coupon rate,
the yield to maturity can be found by solving for r.
24
YIELD TO MATURITY (YTM) (CONT.)
Example
What is the YTM of a 5.5 % annual coupon bond, with a
$1,000 face value, which matures in 3 years? The market price
of the bond is $1,056.03.


03 . 056 , 1 $
) 1 (
055 , 1
) 1 (
55
) 1 (
55
3 2 1
=
+
+
+
+
+
=
PV
r r r
PV
25

WARNING

Calculating YTM by hand can be very tedious.

It is highly recommended that you learn to use the IRR
or YTM or i functions on a financial calculator.


26




The amount obtained by dividing the bonds
coupon by its current market price (which
does not always equal its par value).
Current
Yield
27

Interest rate risk: the risk of a decline in bonds value
(bond price) due to an increase in interest rate.

Interest rate risk is higher on bonds with long maturities
than on those maturing in near future.

28
C
Discount Rate
B
o
n
d

V
a
l
u
e

Par
Short Maturity Bond
Long Maturity Bond
29
For a given change in yields, longer maturity bonds have
larger price changes. Bond price volatility is positively related
to maturity
Discount Rate
B
o
n
d

V
a
l
u
e

High Coupon Bond
Low Coupon Bond
30
For a given change in yields, higher coupon issues show
smaller price fluctuation . Bond price volatility is inversely
related to coupon.
Reinvestment rate risk: the risk of decline in income from
a bond portfolio due to the decrease in interest rate.

Reinvestment rate risk is higher on bonds with short
maturities than those with longer maturities.


31

Interest rate risk
Interest rate risk relates to
the value of the bond
portfolio.
Investors hold long-term
bonds will face significant
interest rate risk, but will
not face much
reinvestment rate risk.
Reinvestment
risk
Reinvestment rate risk
relates to the income of the
bond portfolio.
Otherwise, investors hold
short-term bonds will face
significant reinvestment
rate risk, but will not face
much interest rate risk.
32
Approximately, the difference between an
investments stated or nominal return and the
inflation rate.
Real return
The stated return offered by an investment
unadjusted for the effects of inflation.
Nominal return
33
34
35
Bond ratings: grades assigned to bond issues based on
degree of default risk

Investment-
grade bonds
Moodys Aaa to Baa3 ratings
S&P and Fitch AAA to BBB-
ratings


Junk bonds

Moodys Ba1 to Caa1 or lower
S&P and Fitch BB to CCC+ or
lower
36
37
TUTORIAL QUESTIONS

CHAPTER 5 TEXTBOOK:

QUESTIONS FOR REVIEW CHAPTER 1, 2, 3, 4, 5

PRATICE PROBLEMS 7, 17, 20, 21, 22, 23 AND 25



38