Managerial Finance

Session 4b

Nicole Hruban
 Bond Valuation

Meyer Inc. outstanding bonds have a $1,000 par value,

and they mature in 15 years. Their bond equivalent yield
is 8%, they pay interest quarterly, and they sell at a price
of $850. What is the bond's nominal (annual) coupon
interest rate?
 Bond Valuation

Meyer Inc. outstanding bonds have a $1,000 par value,

and they mature in 15 years. Their bond equivalent yield
is 8%, they pay interest quarterly, and they sell at a price
of $850. What is the bond's nominal (annual) coupon
interest rate?
STEP 1): Find required return r from BEY

m 2
 r  b
 1    1  
 m  2

𝑟 4 0.08 2 𝑟
1 + = 1+ ⇒ = 0.0198
4 2 4
 Bond Valuation
Meyer Inc. outstanding bonds have a $1,000 par value, and they mature in 15 years.
Their bond equivalent yield is 8%, they pay interest quarterly, and they sell at a price of
$850. What is the bond's nominal (annual) coupon interest rate?
STEP 2): Solve Bond Equation for I (i.e. Coupon)
𝑟
𝐼 (1+𝑘)𝑁∗𝑘 −1 1
𝐵𝑜 = ∗ 𝑟 𝑟 +M* 𝑟
𝑘 ∗(1+ )𝑁∗𝑘 (1+𝑘)𝑁∗𝑘
𝑘 𝑘

(1+0.0198)15∗4 −1 1
𝐵𝑜 = 𝐼/0.0198 ∗ + 1,000 *
0.0198 ∗(1+0.0198)15∗4 (1+0.0198)15∗4
O P
Payment Calculation
PMT(P3,P4,P5,P6,P7)
3 Interest 0.0198 The annual Coupon Rate is:
4 Periods 60 $62.02
5 PV -850
6 FV 1000
7 End/Beg 0
Payment $15.51
YEARLY $62.02
 Bond Valuation
A 20-year, $1,000 par value bond has an
5% annual coupon. The bond currently
sells for $875.

A) What is the bond equivalent yield?

B) If the yield to maturity remains at its

current rate, what will the price be 5 years
from now?
 Bond Valuation
A 20-year, $1,000 par value bond has an 5% annual coupon. The
bond currently sells for $875.

A) What is the bond equivalent yield?

STEP 1): Find required return r
(1+𝑟)20 1
$875= 50 * + 1,000 ∗
𝑟 ∗ 1+𝑟 20 (1+𝑟)20

E F
Yield Calculation
@ yield (F3, F4, F5, F6, F7, F8, F9)
3 Settlement (Date of Trade) 1/1/2000
4 Maturity (Date of Maturity) 1/1/2020 r = 6.1 %
5 Coupon Interest 0.050
6 Price (per $100 of FV) 87.50
7 Redemption / Face Value (per $100 of FV) 100.00
8 Frequency (# paymnts per year) 1.00
Basis (type of day count) 0.00
Yield 0.060985

Alternatively you can solve with the goal seek

 Bond Valuation
A 20-year, $1,000 par value bond has an 5% annual coupon. The
bond currently sells for $875.

A) What is the bond equivalent yield?

STEP 2): Use formula to Calculate BEY
m 2
 r  b
1    1  
 m  2

1= 𝑏 2
1 + 0.061 1 + / ^(1/2)
2

1/2 = 𝑏 1/2 𝑏
1.061 1 + ⇒ 1.061 −1=
2 2

2 ∗ ( 1.061 1/2 − 1) = 𝑏 ⇒ 𝑏 = 6.01%

 Bond Valuation
A 20-year, $1,000 par value bond has an 5% annual coupon. The
bond currently sells for $875.

B) If the yield to maturity remains at its current rate, what will the price
be 5 years from now?

Use r=6.1% and new N of 15 years

(1+0.061)15 1
B5= 50 * + 1,000 ∗
0.061 ∗ 1+0.061 15 (1+0.061)15
B C
Present Value Calculation
@ PV (C3, C4, C5, C6, C7)
3 Interest 0.061 The value is 5 years is
4 Periods 15 $893.85
5 Payment 50
6 Future Value 1000
7 End/Beg 0
Present Value $893.86
 Bond Valuation
Matrix Corp Class B bonds have a 10-year
maturity, $1,000 par value, and a 6% coupon
paid semiannually. These bonds are currently
traded at their par value. Matrix’s Class A
bonds have the same risk, maturity, and par
value, but the Class A bonds pay a 4 % annual
coupon. What should be the price of “A” bonds
in the market?
 Bond Valuation
Matrix Corp Class B bonds have a 10-year maturity, $1,000 par
value, and a 6% coupon paid semiannually. These bonds are
currently traded at their par value. Matrix’s Class A bonds have
the same risk, maturity, and par value, but the Class A bonds pay
a 4 % annual coupon. What should be the price of “A” bonds in
the market?
STEP 1): Calculate r for Class B Bond (NOTE: Bond sells at par)

(1+𝑟/2)10∗2 1
$1,000= 60/2 * + 1,000 ∗
𝑟/2 ∗ 1+𝑟/2 10∗2 (1+𝑟/4)10∗2
B C
Present Value Calculation
@ PV (C3, C4, C5, C6, C7)
3 Interest 0.03 Therefore: r/2 = 0.03
4 Periods 20
5 Payment 30
6 Future Value 1000
7 End/Beg 0
Present Value $1,000.00

Using Goal -Seek

 Bond Valuation
Matrix Corp Class B bonds have a 10-year maturity, $1,000 par
value, and a 6% coupon paid semiannually. These bonds are
currently traded at their par value. Matrix’s Class A bonds have
the same risk, maturity, and par value, but the Class A bonds pay
a 4 % annual coupon. What should be the price of “A” bonds in
the market?
STEP 2): Calculate BEY
m 2
 r  b
1    1  
 m  2

2 𝑏 2
1 + 0.03 = 1 +
2

b = 0.06
 Bond Valuation
Matrix Corp Class B bonds have a 10-year maturity, $1,000 par
value, and a 6% coupon paid semiannually. These bonds are
currently traded at their par value. Matrix’s Class A bonds have
the same risk, maturity, and par value, but the Class A bonds pay
a 4 % annual coupon. What should be the price of “A” bonds in
the market?
STEP 3): Calculate annual rate r for Class A Bonds
m 2
 r  b
1    1  
 m  2

1 0.06 2 0.06 2
1+𝑟 = 1 + ⇒𝑟= 1 + -1
2 2

r=0.0609
 Bond Valuation
Matrix Corp Class B bonds have a 10-year maturity, $1,000 par
value, and a 6% coupon paid semiannually. These bonds are
currently traded at their par value. Matrix’s Class A bonds have
the same risk, maturity, and par value, but the Class A bonds pay
a 4 % annual coupon. What should be the price of “A” bonds in
the market?
STEP 4): Use r=0.0609 to calculate price of Class A bond

(1+0.0609)10 1
Price= 40 * + 1,000 ∗
0.0609∗ 1+0.0609 10 (1+0.0609)10
B C
Present Value Calculation
@ PV (C3, C4, C5, C6, C7) Price: $846.83
3 Interest 0.0609
4 Periods 10
5 Payment 40
6 Future Value 1000
7 End/Beg 0
Present Value $846.83
 Bond Valuation

Mark Goldsmith's broker has shown him two

bonds. Each has a maturity of 5 years, a par
value of $1,000, and a yield to maturity of 12%.
Bond A has a coupon interest rate of 6% paid
annually. Bond B has a coupon interest rate of
14% paid annually.

a. Calculate the selling price for each of the

bonds.
 Bond Valuation

 (1  r ) N  1   1 
B0  I   N 
M  N 
 r  (1  r )   (1  r ) 
Bond A:
(1+0.12)5 −1 1
B0 = 60* + 1,000 ∗ = $783.71
0.12 ∗ 1+0.12 5 (1+0.12)5

B C
Present Value Calculation
@ PV (C3, C4, C5, C6, C7)
3 Interest 0.12
4 Periods 5
5 Payment 60
6 Future Value 1000
7 End/Beg 0
Present Value $783.71
 Bond Valuation

 (1  r ) N  1   1 
B0  I   N 
M  N 
 r  (1  r )   (1  r ) 
Bond B:
(1+0.12)5 −1 1
B0 = 140* + 1,000 ∗ = $1,072.10
0.12 ∗ 1+0.12 5 (1+0.12)5

B C
Present Value Calculation
@ PV (C3, C4, C5, C6, C7)
3 Interest 0.12
4 Periods 5
5 Payment 140
6 Future Value 1000
7 End/Beg 0
Present Value $1,072.10
 Bond Valuation
b. Mark has $20,000 to invest. Judging on the basis
of the price of the bonds, how many of either one
could Mark purchase if he were to choose it over the
other? (Mark cannot really purchase a fraction of a
bond, but for purposes of this question, pretend that
he can.)
Bond A: Bond B:

Price: 783.71 Price: 1072.10

Investment amount: Investment amount:
$20,000 $20,000
Number of Bonds: Number of Bonds:
20,000/783.71 = 25.52 20,000/1072.10=18.66
 Bond Valuation

c. Calculate the yearly interest income of each

bond on the basis of its coupon rate and the
number of bonds that Mark could buy with his
$20,000.

BOND A: 25.52 * 60 = 1,531.17

BOND B: 18.66 *140 = 2,611.71

 Bond Valuation

d. Assume that Mark will reinvest the interest

payments as they are paid (at the end of each
year) and that his rate of return on the
reinvestment is only 10%. For each bond,
calculate the value of the principal payment plus
the value of Mark's reinvestment account at the
end of the 5 years.
 Bond Valuation
d. Assume that Mark will reinvest the interest payments as they are paid (at
the end of each year) and that his rate of return on the reinvestment is only
10%. For each bond, calculate the value of the principal payment plus the
value of Mark's reinvestment account at the end of the 5 years.

0 1 2 3 4 5

C C C C C+P

FV ?
i=10%
 Bond Valuation
d. Assume that Mark will reinvest the interest payments as they are paid (at
the end of each year) and that his rate of return on the reinvestment is only
10%. For each bond, calculate the value of the principal payment plus the
value of Mark's reinvestment account at the end of the 5 years.

For i=10% and C=60 For i=10% and C=140

E F E F
Future Value Calcuation Future Value Calcuation
FV(F3,F4,F5,F6,CF7) FV(F3,F4,F5,F6,CF7)
3 Interest 0.1 3 Interest 0.1
4 Periods 5 4 Periods 5
5 Payment 60 5 Payment 140
6 Present Value 0 6 Present Value 0
7 End/Beg 0 7 End/Beg 0
Future Value $366.31 Future Value $854.71

Future Value of C + Principal = Future Value of C + Principal =

366.31 + 1,000 = 1,366.31 854.71 + 1,000 = 1,854.71
 Bond Valuation

e. Why are the two values calculated in part d different? If

Mark were worried that he would earn less than the 12%
yield to maturity on the reinvested interest payments,
which of these two bonds would be a better choice?
Hint: Look at compounded average growth rate:
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 1/𝑛
CAGR (Geometric Average Return) = -1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

BOND A:
(1,366.31 / 783.71)^1/5 – 1 = 11.758%

BOND B:
(1854.71/854.71)^1/5 – 1 =11.586%
If Mark is worried about the reinvestment of his coupon payments, the better
choice would now actually be Bond A, because return is higher…
 Bond Valuation
Alternative Solution with excel function @MIRR:

We know: Internal Rate of Return of a bond is the rate that equates

the bond price to the present value of its cash flows.
 (1  r ) N  1   1 
B0  I   N 
M  N 
 r  (1  r )   (1  r ) 

IRR = Yield to Maturity,

We know: YTM in our example = 12%

However: Underlying assumption for YTM = IRR is that each coupon

payment CAN be reinvested at the IRR (or YTM).

Here: Mark can only re-invest the coupons @ 10%

 Bond Valuation
Excel function MIRR lets us calculate the realized return under the
assumption that coupon interest is reinvested at 10% rate:
BOND A BOND B
B C B C
MIRR(C1:C6,0.12,0.1) MIRR(C1:C6,0.12,0.1)
1 Initial Investment ($783.71) 1 Initial Investment ($1,072.10)
2 Coupon 1 60 2 Coupon 1 140
3 Coupon 2 60 3 Coupon 2 140
4 Coupon 3 60 4 Coupon 3 140
5 Coupon 4 60 5 Coupon 4 140
6 Coupon 5 + Principal 1060 6 Coupon 5 + Principal 1140
MIRR 11.7579% MIRR 11.5857%

MIRR gives us IRR, when there is a different rate for

cost of investment vs. return of investment