Introduction to Corporate Finance

4: Valuing Bonds

TABLe 4.1 ZERO-COUPON BOND PRICES AND TAXABLE INCOME

Suppose a zero-coupon bond paid no interest, so investors earned their return by purchasing the bonds at a discount and
letting their price appreciate over time. This table illustrates how the price of a $1,000 par value discount bond rises as maturity
approaches, assuming that the yield to maturity remains at 5.5%. The final column shows the investor’s capital gain each year.

Years to maturity Yield to maturity Bond price Capital gain

5 0.055 $ 765.13

4 0.055 $ 807.22 $42.09

3 0.055 $ 851.61 $44.39

2 0.055 $ 898.45 $46.84

1 0.055 $ 947.87 $49.42

0 0.055 $ 1,000.00 $52.13

Convertible and exchangeable Bonds

Some bonds issued by corporations combine the features of debt and equity. Like ordinary bonds,

convertible bonds pay investors a relatively safe stream of fixed coupon payments. But convertible bonds

also give investors the option to convert their bonds into the ordinary shares of the company that issued

the bonds.^12 This means that if the share price increases, bondholders can share in that gain. The

following example illustrates this.

Exchangeable bonds work in much the same way that convertible bonds do, except that exchangeable

bonds are convertible into ordinary shares of a company other than the company that issued the bonds.

Exchangeable bonds are often used when one company owns a large block of shares in another company

that it wants to divest. Although the option to convert bonds into shares generally resides with the

investor who holds a convertible bond, exchangeable bonds’ conversion rights can vary. Sometimes the

12 Some convertibles have a mandatory conversion feature, meaning that the issuer can force investors to convert their bonds into shares.

convertible bond

A bond that gives investors

the option to convert it into

the issuer’s ordinary shares

exchangeable bonds

Bonds issued by corporations

that may be converted into

shares of a company other

than the one that issued the

bonds

example

It seems that the first convertible bonds of ‘modern’
times were issued by the Rome, Watertown and
Ogdensburg Railroad [in 1874]. Unable to finance an
ambitious project to build one of the first railway lines
in the US from its own capital, the company made
history issuing a convertible bond with a maturity of
30 years, a coupon of 7% and a value of $1,000. In
today’s money this would equate to roughly $200,000
(€176,000) per bond and a total issuance of between
$1–2 billion.
The usual reason advanced today for convertible
bonds is that there is a good chance that the
investment raising the funds will succeed once it
passes through its initial set-up period, but that
capital investors need the safety of prior claims for

return of capital afforded by debt (as opposed to

equity) in those early years in order to accept a low

rate of return.

Unfortunately for the railroad, the bond issue was

not a success because the bond was never converted

as the share failed to appreciate substantially and the

company had to refinance in 1904. It was repaid almost

50 years later – at a coupon of 5%. Fortunately for

investors in general, the capital market was forgiving,

and still encouraged the growth of convertible issues

over subsequent years.

Source: ‘Convertible bonds: key lessons from 150 years of issuance,’ Investment

and Pensions Europe. http://www.ipe.com/reports/convertible-bonds-key-lessons-from-

150-years-of-issuance/10007311.fullarticle. Accessed 15 December 2015. Used

with permission.