Session 5 - Bond Valuation and Determinants of Interest Rates, Chapter 5 All page numbers are references to Corporate Finance: A Focused Approach 7th edition by Ehrhardt and Brigham (Cengage South-Western, 2020) Chapter 5 Chapter 5 applies Time Value of Money techniques to the valuation of bonds, defines some new terms, and discusses how interest rates are determined. Chapter 6 focuses on the relation between risks and returns. While for quiz and exam purposes, you must know everything from both chapters, you should focus on computing returns as we use that later in the course. Things to Absorb From Chapter 5, know everything until section 5-14, although the likelihood of yield-to-call being on an exam is low. This chapter develops the valuation techniques of fixed income securities. Bonds are valued similar to an ordinary annuity. You already know the valuation techniques from Chapter 4. The most difficult part of this chapter is the terminology and learning the interrelationships between the various bond components. The most important relationship is that "If the market price decreases, this implies that the yield to maturity has increased," and this is often expressed as "rate up implies price down." Also, since most bonds make coupon payments twice per year, make sure you can compute the price and yield to maturity on semiannual coupon bonds. Finally, this chapter shows a conceptual way of determining the Yield/Interest Rate on Financial Securities as a function of the r* (Real risk-free rate) + IP (Inflation premium) + DRP (Default risk premium) + LP (Liquidity premium) + MRP (Maturity risk premium). Do not need to absorb - details about junk bonds or the bankruptcy code of the United States Things to Read You will need to read the chapter.  Things to Do Make 100 on the quiz.  Also, since most bonds make coupon payments twice per year, make sure you can compute the price and yield to maturity on semiannual coupon bonds. Questions and Problems that you should be able to answer - Questions 1-3 and Problems - All. Note, I have used variations of every one of the end of chapter Questions and Problems in past semesters' quizzes and exams. Problems 7 and 12-22 are questions types I have used on recent exams.  To gain Excel skills, you should use the Excel Toolkit link in Content in CourseDen. Calculator links Simple and useful instructions for most calculators Note, that your calculator is probably set to 12 payments per year and 2 decimal places.  You need to change this to 1 payment per year and at least 4 decimal places. Watch the Chapter  Introduction and Overview video. The Powerpoints for all of this chapter’s videos are located here. Read pages 195-209. Watch the Features, Terms and Basic Bond Valuation video (minicase page 238, parts a-e). After this, you should be able to answer most of the end of chapter questions and to solve problems 1 and 2. Read pages 210-214. Watch  the Advanced Bond Valuation video (minicase parts f-h).  This video discusses bonds with semi-annual payments (definitely on the exam) and Yield to Call.  After this, you should be able to solve end of chapter problems 3-14, 21 and 22. Read the rest of the chapter. Watch the Determinants of Interest Rates video (minicase parts i-m).  After this, you should be able to solve any remaining end of chapter questions and problems.  I also created a video on More on Determinants of Rates and Bankruptcy Law video (minicase parts n-q).  Bankruptcy is not usually tested,  but I enjoy the subject. The is another chapter where you should spend your time solving problems such as the quiz and End-of-Chapter problems and practicing with your spreadsheet and calculator.  The only way to learn this material is to do this material. The list of suggested questions/problems is at the top of the page.  Here are audio solutions to common bond valuation problems. You are considering buying bonds in ACBB, Inc. The bonds have a par value of $1,000 and mature in 37 years. The annual coupon rate is 10.0% and the coupon payments are annual. If you believe that the appropriate discount rate for the bonds is 13.0%, what is the value of the bonds to you? | Audio Solution XZYY, Inc. currently has an issue of bonds outstanding that will mature in 31 years. The bonds have a face value of $1,000 and a stated annual coupon rate of 20.0% with annual coupon payments. The bond is currently selling for $890. The bonds may be called in 4 years for 120.0% of the par value. What is your expected quoted annual rate of return if you buy the bonds and hold them until maturity? | Audio Solution Again, Inc. bonds have a par value of $1,000, a 33 year maturity, and an annual coupon rate of 12.0% with annual coupon payments. The bonds are currently selling for $923. The bonds may be called in 4 years for 112.0% of par. What quoted annual rate of return do you expect to earn if you buy the bonds and company calls them when possible? | Audio Solution Within Year, Inc. has bonds outstanding with a $1,000 par value and a maturity of 17 years. The bonds have an annual coupon rate of 17.0% with semi-annual coupon payments. You would expect a quoted annual return of 14.0% if you purchased these bonds. What are the bonds worth to you? | Audio Solution Yes They May, Inc. has a bond issue outstanding with a $1,000 par value and a maturity of 40 years. The bonds have an annual coupon rate of 15.0% with quarterly coupon payments. The current market price for the bonds is $1,035. The bonds may be called in 4 years for 115.0% of par. What is the quoted annual yield-to-maturity for the bonds? | Audio Solution Yes They Can, Inc. has a bond issue outstanding with a $1,000 par value and a maturity of 20 years. The annual coupon rate is 9.0% with semi-annual coupon payments. The bonds are currently selling for $859. The bonds may be called in 3 years for 109.0% of par. What is the quoted annual yield-to-call for these bonds? | Audio Solution You are considering buying bonds in AZYX, Inc. The bonds have a par value of $1,000 and mature in 13 years. The annual coupon rate is 11.0% and the coupon payments are annual. The bonds are currently selling for $1,442.63 based on a yield-to-maturity of 6.0%. What is the bond's current yield? | Audio Solution You are considering buying bonds in AZYX, Inc. The bonds have a par value of $1,000 and mature in 13 years. The annual coupon rate is 11.0% and the coupon payments are annual. The bonds are currently selling for $1,442.63 based on a yield-to-maturity of 6.0%. What is the bond's expected capital gain/loss if the bonds are held until maturity? | Audio Solution Panther Enterprises has outstanding zero coupon bonds that have a face value of $1000 and mature in exactly 18 years. The market price of the bonds is $179.86. What will be the percentage change in the market price of the bonds if the yield to maturity falls by half? | Audio Solution If you find yourself making lots of general valuation errors, rather than bonds specific errors, watch this video that discusses the most common Time Value of Money errors. The Chapter 5 Quiz should take you about 60 minutes. Be sure to bring have your financial calculator/spreadsheet available. Revised September 18, 2020