Introduction to Corporate Finance

PArT 2: VALUATION, rISk AND reTUrN

Because this bond offers investors a return exactly equal to the required rate in the market, the bond

sells at par value.^5

Again, we emphasise the fundamental lesson: the price of a bond equals the present value of its future

cash flows. We now turn to a more in-depth development of the concepts underlying bond valuation,

starting with a discussion of interest rate risk.

5 Notice, too, that the effective annual yield on this bond is slightly higher than the 6% coupon rate. If the semiannual yield is 3%, the effective

annual yield equals 6.09% (1.03^2 – 1).

Monthly gross income (annual income $87,500 ÷ 12) $7,292

Estimated monthly property taxes and insurance $300

Approximate average monthly interest rate on mortgage loan (annual rate 7.00% ÷ 12) 0.58333%

Planned term of mortgage 360 months

Deposit 20% of purchase price

Funds available for making deposit $50,000

Using your estimates, we can calculate how expensive a home you can currently afford. Remember, the

amount that you borrow must equal the present value of the loan payments that you will make over the next

30 years (360 months), and the value of the home that you buy must equal the sum of your deposit and your

mortgage.

=× =

=−

=−=

Maximumallowablemonthlyhousingexpense0.28 $7,292 $2,042

Maximummonthlyloanpayment housingexpense

taxesandinsurance

$2,042 $300 $1,742

=

=÷ ×−÷

=×

=

Maximumloanamount PVof 36 0monthlypaymentsof $1,742

($1, 742 0.0058333)[1( 11 .0058333 )]

$298,630 0.87679

$261,836

360

1 Maximum purchase price based on monthly income = $261,836 + $50,000 = $311,836

2 Maximum purchase price based on deposit = $50,000 ÷ 0.20 = $250,000

The maximum purchase price is the lower of 1 and 2 above. Although your assumed income would support

a $261,836 mortgage, resulting in a maximum purchase price of about $311,836, you only have enough funds

for a deposit on a $250,000 home. Therefore, with the given values, you can afford a $250,000 home.

exceed 28% of the borrower’s monthly gross

income. You would also like to make a deposit

(down payment) equal to at least 20% of your

home’s value. To keep things simple, we will

assume that there are no closing costs, that loan

payments are made at the end of each month,

and that you have made the following estimates

of the relevant values.

[Using Eq. 3.7]