N 09

Chapter 9
Debt Valuation
and Interest
Slide Contents
• Principles Applied in This Chapter

• Learning Objectives
1. Overview of Corporate Debt
2. Valuing Corporate Debt
3. Bond Valuation: Four Key Relationships
4. Types of Bonds
5. Determinants of Interest Rates
• Key Terms
Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-2

Learning Objectives
1. Identify the key features of bonds and

describe the difference between private and
public debt markets.
2. Calculate the value of a bond and relate it
to the yield to maturity on the bond.
3. Describe the four key bond valuation
relationships.

Learning Objectives (cont.)
4. Identify the major types of corporate

bonds.
5. Explain the effects of inflation on interest
rates and describe the term structure of
interest rates.

Principles Applied in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 3: Cash Flows Are the Source of

Value

9.1 OVERVIEW OF
CORPORATE DEBT

Corporate Borrowings
• There are two main sources of borrowing for

a corporation:
1. Loan from a financial institution (known as

private debt since it involves only two parties)
2. Bonds (known as public debt since they can be

traded in the public financial markets)

Borrowing Money in the Private
Financial Market
Financial Institutions provide loans to

finance firm’s day-to-day operations
(working capital loans) or it might be used
for the purchase of equipment or property
(transaction loans). Loans may or may not
be secured by a collateral.

Borrowing Money in the Private
Financial Market (cont.)
• Advantages of Private Debt Placement

– Speed
– Reduced costs
– Financing flexibility
• Disadvantages of Private Debt Placement
– Interest costs
– Restrictive covenants
– The possibility of future SEC registration

Floating-Rate Loans
In the private financial market, loans are

typically floating rate loans i.e. the interest
rate is adjusted based on a specific
benchmark rate. The most popular benchmark
rate is the London Interbank Offered Rate
(LIBOR), rate at which banks offer to lend in
the London wholesale or interbank market

Floating-Rate Loans (cont.)
For example, a corporation may get a 1-year

loan with a rate of 300 basis points (or 3%)
over LIBOR with a ceiling of 11% and a floor
of 4%.

Table 9-1 Types of Bank Debt

CHECKPOINT 9.1:
CHECK YOURSELF
Calculating the Rate of Interest on a
Floating-Rate Loan
Consider the same loan period as above but change
the spread over LIBOR from .25% to .75%. Is the
ceiling rate or floor rate violated during the loan
period?

Step 1: Picture the Problem
• The graph on the next slide shows the

LIBOR index (series 1), LIBOR plus the
spread of 75 basis points (series 2), the
ceiling rate (series 3), and the floor rate
(series 4).

Step 1: Picture the Problem (cont.)

Step 2: Decide on a Solution
Strategy
• We have to determine the floating rate for

every week and see if it exceeds the ceiling
or falls below the floor.
• Floating rate on Loan

= LIBOR for the previous week + spread of .75%

Strategy
The floating rate on loan cannot exceed the

ceiling rate of 2.5% or drop below the floor
rate of 1.75%.
– If the floating rate falls below the floor,
the rate will be reset at the floor rate.
– If the floating rate exceeds the ceiling, the
rate will be reset at the ceiling rate.

Step 3: Solve
LIBOR LIBOR + Loan
Spread Rate
(.75%)
2/29/2008 1.98%
3/7/2008 1.66% 2.73% 2.50%
3/14/2008 1.52% 2.44% 2.41%
3/21/2008 1.35% 2.27% 2.27%
3/28/2008 1.60% 2.10% 2.10%
Ceiling
4/4/2008 1.63% 2.35% 2.35% Violated
4/11/2008 1.67% 2.38% 2.38%

4/18/2008 1.88% 2.42% 2.42%
4/25/2008 1.93% 2.63% 2.50%
5/2/2008 2.68% 2.50%

Step 3: Solve (cont.)
The table shows the ceiling is violated during

the first week and last two weeks of the loan
period. The floor rate is never violated.

Step 4: Analyze
• The ceiling is the maximum rate charged on

the loan while floor is the minimum rate
charged on the loan. If the ceiling or floor
rates are violated, the loan rate is reset to
the ceiling rate or the floor rate.
• If there were no ceiling, the loan rate would

have been 2.73% during the first week of
the loan, and 2.63% and 2.68% during the
last two weeks of the loan.

Borrowing Money in the Public
Financial Market
Corporations engage the services of an
investment banker while raising long-term
funds in the public financial market. The
investment banker performs three basic functions:
– Underwriting: assuming risk of selling a
security issued. The client is given the money
before the securities are sold to the public.
– Distributing
– Advising

Corporate Bonds
• Corporate bond is a debt security issued

by corporation that has promised future
payments and a maturity date.
• If the firm fails to pay the promised future

payments of interest and principal, the bond
trustee can classify the firm as insolvent and
force the firm into bankruptcy.

Basic Bond Features
• The basic features of a bond include the

following:
– Bond indenture
– Claims on assets and income
– Par or face value
– Coupon interest rate
– Maturity and repayment of principal
– Call provision and conversion features

Bond Ratings and Default Risk
Bond ratings indicate the default risk i.e. the

probability that the firm will make the bond’s
promised payments. Rating agencies use
borrower’s financial statements, financing
mix, profitability, variability of past profits,
and make judgments about the quality of the
firm’s management in order to determine
ratings.

Table 9.3 Interpreting Bond Ratings

9.2 VALUING CORPORATE
DEBT

Valuing Corporate Debt
The value of corporate debt is equal to the

present value of the contractually promised
principal and interest payments (the cash
flows) discounted back to the present using
the market’s required yield to maturity on
similar risk.

Table 9.2 Bond Terminology

Valuing Bonds by Discounting Future
Cash Flows
Step 1: Determine bondholder cash flows,

which are the the amount and timing of the
bond’s promised interest and principal
payments to the bondholders.
•Annual Interest = Par value × coupon rate
•Example 9.1: The annual interest for a 10-year bond
with coupon interest rate of 7% and a par value of
$1,000 is equal to $70, (.07 × $1,000 = $70). This
bond will pay $70 every year and $1,000 at the end
of 10-years.

Valuing Bonds by Discounting
Future Cash Flows (cont.)
Step 2: Estimate the appropriate discount rate
on a bond of similar risk. Discount rate is the
return the bond will yield if it is held to
maturity and all bond payments are made.

Valuing Bonds by Discounting
Future Cash Flows (cont.)
Step 3: Calculate the present value of the
bond’s interest and principal payments from
Step 1 using the discount rate in step 2.

Calculating a Bond’s Yield to
Maturity (YTM)
We can think of YTM as the discount rate that

makes the present value of the bond’s
promised interest and principal equal to the
bond’s observed market price.

CHECKPOINT 9.2:
CHECK YOURSELF
Calculating the Yield to Maturity on a
Corporate Bond
Calculate the YTM on the Ford bond where the
bond price rises to $900 (holding all other things
equal).

YTM=?
Years 0 1 2 3… 11
Cash flow -$900 $65 $65 $65 $1,065
• Purchase price = $900

• Interest payments = $65 per year for years 1-11
• Final payment = $1,000 in year 11 of principal.

Strategy
We can use equation 9-2a to find YTM. YTM is

the rate that makes the present value of all
future expected cash flows equal to the
current market price. We can also solve for
YTM using a calculator and a spreadsheet.

Step 3: Solve
Using a Mathematical Equation
•It is cumbersome to solve for YTM by hand

using the equation. It is more practical to use
the financial calculator or the spread sheet.

Using a Financial
Calculator Using an Excel
Spreadsheet
N = 11
I/Y = 7.89 = RATE(nper,
PV = -900 pmt,pv,fv)
PMT = 65
= RATE (11,65,-
FV = 1,000
900,1000)
= 7.89%

Step 4: Analyze
The yield to maturity on the bond is 7.89%.

The yield is higher than the coupon rate of
interest of 6.5%. Since the coupon rate is
lower than the yield to maturity, the bond is
trading at a price below $1,000. We call this a
discount bond.

Using Market-Yield-to-Maturity Data
Market-yield-to-maturity data is regularly

reported by a number of investor services and
is quoted in terms of credit spreads or
spreads to Treasury bonds. Table 9-4
contains some examples of spreads.

Table 9-4 Corporate Bond Spread
Tables

Using Market Yield to Maturity Data
(cont.)
• The spread values reported in table 9-4

represent basis points over a US Treasury
security of the same maturity as the
corporate bond.
• For example, a 30-year Ba1/BB+ corporate
bond has a spread of 275 basis points over a
similar 30-year US Treasury bond.
• Thus this corporate bond should earn 2.75%
over the 4.56% earned on treasury yield or
7.31%.

Promised versus
Expected Yield to Maturity
The yield to maturity calculation assumes that

the bond performs according to the terms of
the bond contract or indenture. Since
corporate bonds are subject to risk of default,
the promised yield to maturity may not be
equal to expected yield to maturity.

Promised versus Expected Yield to
Maturity (cont.)
• Example Consider a one-year bond that

promises a coupon rate of 8% and has a
principal (par value) of $1,000. Further
assume the bond is currently trading for
$850. What is the promised yield to
maturity?

Maturity (cont.)
Promised YTM
= {(Interest year 1 + Principal) ÷ (Bond Value)} – 1
= {($80+$1,000) ÷ ($850)} – 1
= 27.06%

Maturity (cont.)
The yield of 27.06% is based on the

assumption of no default. Assume there is a
40% probability of default on this bond and if
the bond defaults, the bondholders will receive
only 60% of the principal and interest owed.
What is the expected YTM on this bond?

Maturity (cont.)
YTMdefault
= {(Interest year 1 + Principal)} ÷ (Bond Value)}
–1
= {($80+$1000) × .60} ÷ ($850)} – 1
= -23.76%

Maturity (cont.)
= (27.06 × .60) + (-23.76 × .40)

= 6.73%
The financial press quotes promised yield and

not expected YTM.

CHECKPOINT 9.3:
CHECK YOURSELF
Valuing a Bond Issue

Calculate the present value of the AT&T
bond should the yield to maturity for
comparable risk bonds rise to 9% (holding
all other things equal).
i= 9%
Years 0 1 2 3… 20
Cash flows $85 $85 $85 $1,085
PV of all
Cash flows
=?
$85 annual
interest $85 interest
+ $1,000
Principal

Strategy
• Here we know the following:

– Annual interest payments = $85
– Principal amount or par value = $1,000
– Time = 20 years
– YTM or discount rate = 9%
• We can use the above information to
determine the value of the bond by
discounting future interest and principal
payment to the present.

Step 3: Solve
Using a Mathematical Formula
= $ 85{ 1-(1/(1.09)20] ÷ (.20)} + [

$1,000/(1.09)20
= $85 (9.128) + $178.43
= $954.36

Using a Financial Using an Excel

Calculator Spreadsheet
– N = 20 = PV (rate, nper, pmt, fv)

– 1/y = 9.0
= PV (.09,20,85,1000)
– PMT = 85
– FV = 1000
= $954.36
– PV = 954.36

Step 4: Analyze
• The value of AT&T bond falls to $954.36

when the yield to maturity rises to 9%. The
bonds are now trading at a discount as the
coupon rate on AT&T bonds is lower than
the market yield.
• An investor who buys AT&T bonds at its
current discounted price will earn a
promised yield to maturity of 9%.

Semiannual Interest Payments
Corporate bonds typically pay interest to

bondholders semiannually. We can adapt
Equation (9-2a) from annual to semiannual
payments as follows:

CHECKPOINT 9.4:
CHECK YOURSELF
Valuing a Bond Issue That Pays Semiannual
Interest
Calculate the present value of the AT&T bond
should the yield to maturity on comparable bonds
rise to 9% (holding all other things equal).

40
6-month
periods
i= 9%
Periods 0 1 2 3… 40
Cash flow
$42.5 $42.5 $42.5 $1,042.50

PV=?
$42.50
$42.5 interest
Semiannual
+ $1,000
interest
Principal

Strategy
• Here we know the following:
– Semiannual interest payments = $42.50
– Principal amount or par value = $1,000
– Time = 20 years or 40 periods
– YTM or discount rate = 9% or 4.5% for 6-months
• We can use the above information to
determine the value of the bond by
discounting future interest and principal
payment to the present.

Step 3: Solve
Using a Mathematical Formula
= $ 42.5{[1-(1/(1.045)40] ÷ (.20)} +
$1,000/(1.045)40
= $42.5 (18.40) + $171.93
= $954

Using a Financial Using an Excel

Calculator Spreadsheet
– N = 40 = PV (rate, nper, pmt, fv)

– 1/y = 4.50
= PV (.045,40,42.5,1000)
– PMT = 42.50
– FV = 1000
= $954
– PV = 954

Step 4: Analyze
Using semi-annual compounding we get a

value of $954 for AT&T bonds. This is very
close to the value of $954.26 found using
annual compounding.

9.3 BOND VALUATION:
FOUR KEY RELATIONSHIPS

Bond Valuation:
Four Key Relationships
• First Relationship The value of bond is

inversely related to changes in the yield to
maturity.
YTM = 12% YTM rises to

15%
Par value $1,000 $1,000
Coupon rate 12% 12%
Maturity date 5 years 5 years
Bond Value $1,000 $899.44
Bond
Value
Drops

Figure 9-1 Bond Value and the Market’s Required
Yield to Maturity (5-Year Bond, 12% Coupon
Rate)

Bond Valuation: Four Key
Relationships (cont.)
• Second Relationship: The market value of a

bond will be less than the par value
(discount bond) if the market’s required
yield to maturity is above the coupon
interest rate and will be valued above par
value (premium bond) if the market’s
required yield to maturity is below the
coupon interest rate.

• Third Relationship As the maturity date

approaches, the market value of a bond
approaches its par value. That’s because at
maturity the bond will be taken away and the
investor will receive the par value of the
bond.

Table 9-5 Bond Prices Relative to
Maturity Date

Figure 9-2 Value of a 12% Coupon
Bond during the Life of the Bond

Fourth Relationship Long term bonds have

greater interest-rate risk than short-term
bonds.
•While all bonds are affected by a change in

interest rates, the prices of longer-term bonds
fluctuate more when interest rates change
than do the prices of shorter-term bonds (see
Table 9.6)

9.4 TYPES OF BONDS

Table 9-7 Types of Corporate Bonds

9.5 DETERMINANTS OF
INTEREST RATES

Determinants of Interest Rates
As we observed earlier, bond prices vary

inversely with interest rates. Therefore in
order to understand how bond prices
fluctuate, we need to know the determinants
of interest rates.

Inflation and Real versus Nominal
Interest Rates
• Quotes of interest rates in the financial press

are commonly referred to as the nominal
(or quoted) interest rates. Real rate of
interest adjusts for the effects of inflation.
• Real Rate of Interest (approximation)

≈ Nominal interest rate – Inflation premium

Fisher Effect: The Nominal and Real
Rate of Interest
• The relationship between the nominal rate

of interest, rnominal , the anticipated rate of
inflation, rinflation , and the real rate of interest
is known as the Fisher effect.

CHECKPOINT 9.5:
CHECK YOURSELF
Solving for the Real Rate of Interest
Assume now that you expect that inflation will be
5% over the coming year and want to analyze
how much better off you will be if you place your
savings in an account that also earns just 5%.
What is the real rate of return in this
circumstance?
• Let us assume that the prices of goods and

services today is $1.00 per unit.
• With a 5% inflation, these goods and
services will cost $1.05.
• Thus, $10,500 expected in the savings
account at the end of the year will buy you
only 10,000 units (10,500/1.05) at the end
of the year.

Year 0 Year 1
Savings Account Balance $10,000.00 $10,500.00
Price Index (5% inflation) $1.00 $1.05
Purchasing Power (units) 10,000.00 10,000.00

Strategy
Step 3: Solve
We can estimate the real rate of interest by
using equation 9-4b.
rreal = {(1+.05) ÷ (1+.05)} – 1 = 0%

Step 4: Analyze
Here the nominal rate of interest is equal to

the expected rate of inflation. Therefore, the
real rate of return is equal to zero i.e. there is
no increase in purchasing power from
investing the savings at 5%.

CHECKPOINT 9.6:
CHECK YOURSELF
Solving for the Nominal Rate of Interest
If you anticipate that the rate of inflation will now
be 4% next year, holding all else the same, what
rate of return will you need to earn on your
savings in order to achieve a 2% increase in
purchasing power?

• Let us assume that the prices of goods and

services today is $1.00 per unit.
• If the expected rate of inflation is 4% and
you want to be able to purchase 2% more,
you will need to earn a nominal rate of
interest on your savings that will allow you
to buy 10,200 units at $1.04 each.

Year 0 Year 1
Savings Account Balance $10,000.00 $10,608
Price Index (5% inflation) $1.00 $1.04
Purchasing Power (units) 10,000.00 10,200.00
Real rate (% increase in 2%

purchasing power)
Interest rate of
6.08% solved
in step 3

Strategy
Step 3: Solve
We can use the Fisher model found in
equation 9-4a to determine the nominal rate
of interest.
rnom=.02 + .04 + (.02 × .04) = .0608 or 6.08%

Step 4: Analyze
In order to achieve a 2% increase in

purchasing power in the face of a 4% rate of
inflation, you must earn a 6.08% rate on your
savings.

Interest-Rate Determinants –
Breaking It Down
The nominal return or interest rate on a note

or bond can be thought of including five basic
components:

Interest Rate Determinants (cont.)
• The inflation premium
• Default–risk premium
• Maturity-risk premium
• Liquidity-risk premium

The Maturity-Risk Premium and the
Term Structure of Interest Rates
• The relationship between interest rates and

time to maturity with risk held constant is
known as the term structure of interest
rates or the yield curve.
• Figure 9-3 illustrates a hypothetical term

structure of U.S. Treasury Bonds.

Figure 9-3 The Term Structure of
Interest Rates or Yield Curve

The Shape of the Yield Curve
By reviewing equation 9-5, we can gain

insight into the shape of the yield curve for US
Treasuries. Since there is no default risk or
liquidity risk and the real-risk free rate of
interest is unlikely to change, the shape of the
yield curve is driven by inflation premium and
maturity risk premium.

The Shape of the Yield Curve (cont.)
During periods when inflation is expected to

subside, the inflation premium should
decrease over longer maturities, resulting in a
downward sloping Treasury yield curve as
shown in Figure 9.5. The reverse is also true
as shown in Figure 9.4

Figure 9.4
Treasury
Yield Curve
during
Period of
Increasing
Inflation

Figure 9.5
Treasury
Yield Curve
during
Period of
Decreasing
Inflation

Shifts in the Yield Curve
• The yield curve changes over time as

expectations regarding each of the four
factors that underlie interest rates change.
• Figure 9-6 shows the yield curve one day
before 911 attack and again two weeks
later. Investors shifted their funds to the
safety of Treasuries, pushing up the prices
and bringing down the yields.

Figure 9-6 Changes in the Term Structure
of Interest Rates around September 11,
2001

Shifts in the Yield Curve (cont.)
• The yield curve is generally upward

sloping but it can assume different shapes
i.e. downward sloping or flat.
• Figure 9-7 illustrates different shapes of

yield curves at different dates, observed
within a span of only 13 months.

Figure 9.7 Historical Term Structure of
Interest Rates for Government Securities

Key Terms
• Amortizing bond
• Basis point
• Bond rating
• Bond indenture
• Call provision
• Collateral
• Conversion feature

Key Terms (cont.)
• Convertible bond
• Corporate bond
• Coupon interest rate
• Credit spread
• Current yield
• Debenture
• Default-risk premium

Key Terms (cont.)
• Discount bond
• Eurobonds
• Fisher effect
• Floating rate
• Floating rate bonds
• Inflation premium
• Interest rate risk

Key Terms (cont.)
• Junk (high-yield) bond

• LIBOR
• Liquidity-risk premium
• Maturity-risk premium
• Mortgage bond
• Nominal (or quoted) interest rate
• Non-amortizing bond

Key Terms (cont.)
• Par or face value of a bond

• Private market transaction
• Premium bond
• Real rate of interest
• Recovery rate
• Secured bond
• Spread to Treasury bonds

Key Terms (cont.)
• Subordinated debentures
• Syndicate
• Term structure of interest rates
• Transaction loan
• Unsubordinated debentures
• Yield curve
• Yield to maturity
• Zero coupon bond

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Chapter 9

• Principles Applied in This Chapter

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-2

1. Identify the key features of bonds and

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-3

4. Identify the major types of corporate

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-4

• Principle 1: Money Has a Time Value.

• Principle 2: There is a Risk-Return Tradeoff.

• Principle 3: Cash Flows Are the Source of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-5

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-6

• There are two main sources of borrowing for

1. Loan from a financial institution (known as

2. Bonds (known as public debt since they can be

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-7

Financial Institutions provide loans to

Copyright ©2014 Pearson Education, Inc. All rights reserved. 9-8

• Advantages of Private Debt Placement

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In the private financial market, loans are

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For example, a corporation may get a 1-year

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• The graph on the next slide shows the

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• We have to determine the floating rate for

• Floating rate on Loan

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The floating rate on loan cannot exceed the

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4/11/2008 1.67% 2.38% 2.38%

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The table shows the ceiling is violated during

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• The ceiling is the maximum rate charged on

• If there were no ceiling, the loan rate would

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• Corporate bond is a debt security issued

• If the firm fails to pay the promised future

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• The basic features of a bond include the

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Bond ratings indicate the default risk i.e. the

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The value of corporate debt is equal to the

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Step 1: Determine bondholder cash flows,

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We can think of YTM as the discount rate that

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• Purchase price = $900

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