Introduction to Corporate Finance

4: Valuing Bonds

LEARNING OBJECTIVES

After completing this chapter, you should be able to:

Perhaps the most fundamental question in finance

is, ‘What is it worth?’ In other words, finance is

all about valuing things. This chapter introduces

the key principle that financial analysts use to

value financial assets like bonds and shares as

well as physical assets such as machinery or entire

manufacturing plants. That principle says that the

value of any asset equals the present value of future

benefits accruing to the asset’s owner.

Our primary objective in this chapter is to

describe models used to value debt or fixed-

income securities, generically called bonds. In the

next chapter, we learn about pricing shares. Why

do corporate managers need to understand how

to price bonds and shares? First, companies must

occasionally approach bond and share markets to

raise capital for new investments. Understanding

how investors in these markets value the company’s

securities helps managers determine how to finance

new projects. Second, companies periodically

make investments by acquiring privately held

companies, just as they divest themselves of past

investments by selling divisions. In either case,

knowing how the market values an enterprise

guides a manager’s expectations regarding the

appropriate price for an acquisition or divestiture.

Third, a company’s share price provides an external,

independent performance assessment of top

management, one that a diligent board of directors

watches closely. Surely managers who will be

judged (and compensated) based on the value of

their company’s share price need to understand

the determinants of that price. Fourth, finance

theory suggests that the objective of corporate

management is to maximise the share price by

correctly weighing the marginal benefits and costs

of alternative actions. How can managers take

actions to maximise share prices if they don’t know

what causes share prices to rise or fall?

This chapter presents an introduction to bonds

and bond valuation. We begin by laying out the

principles of valuation – principles that can be

applied to a wide variety of valuation problems.

After that, we describe the essential features of

bonds, and show how to apply the principles of

valuation to calculate bond prices.

recall the fundamental concepts that

determine how to value assets

understand the vocabulary that describes

bonds and the markets in which they trade

interpret the relationship between bond

prices and interest rates

explain the meaning of the term structure

of interest rates.

LO4.1

LO4.2

LO4.3

LO4.4

4 -1 VALUATION BASICS

The owner of an asset is entitled to the benefits generated by the asset. These benefits may be tangible,

such as the interest payments on bonds (even when they are paid in chocolate), or intangible, such as

the pleasure one experiences when viewing a beautiful painting. Either way, the value of any asset equals

the present value of all its future benefits. Finance theory focuses primarily on tangible benefits, typically

the cash flows that an asset pays over time. For instance, a landlord who owns a block of apartments

receives a stream of rental payments from tenants. The landlord is also responsible for maintaining