Introduction to Corporate Finance

4: Valuing Bonds

their yields. If the investors purchasing long-term bonds have a strong preference for investing in those

securities, despite their low yields, then a yield curve that slopes down does not necessarily imply that

investors expect interest rates to fall.

4-5d CONCLUSION

Valuing assets, both financial assets and real assets, is what finance is all about. In this chapter, we

have learned some simple approaches to pricing bonds, which are among the most common and most

important financial instruments in the market. A bond’s price depends on how much cash flow it promises

investors; how that cash flow is taxed; how likely it is that the issuers will fulfil their promises (default

risk); whether investors expect high or low inflation; and whether interest rates rise or fall over time.

In the next chapter, we apply many of these same ideas to the pricing of preferred and ordinary shares.

CONCEPT REVIEW QUESTIONS 4-5

15 Explain why the height of the yield curve depends on inflation.

16 Suppose the Australian government issues two five-year bonds. One is an ordinary bond that offers

a fixed nominal coupon rate of 4%. The other is an inflation-indexed bond. When the latter bond is

issued, will it have a coupon rate of 4%, more than 4%, or less than 4%?

SUMMArY

■ Valuation is a process that links an asset’s

return with its risk. To value most types of

assets, one must first estimate the asset’s

future cash flows and then discount them at

an appropriate discount rate.

■ Pricing bonds is an application of the general

valuation framework. A bond’s price equals the

present value of its future cash flows, which

consist of coupon and principal payments.

■ The yield to maturity is a measure of the

return that investors require on a bond. The

YTM is the discount rate that equates the

present value of a bond’s cash flows to its

current market price.

■ Bond rating agencies help investors evaluate

the risk of bonds. Bonds with lower ratings

must offer investors higher yields.

■ The return that is most important to investors

is the real, or inflation-adjusted, return.

The real return is roughly equal to the

nominal return minus the inflation rate.

■ Bonds are categorised based on who

issues them or on any number of features

such as convertibility, callability, maturity,

and so on.

■ Bond prices and interest rates are inversely

related. When interest rates rise (fall), bond

prices fall (rise), and the prices of long-term

bonds are more responsive in general to

changes in interest rates than are short-term

bond prices.

■ The ‘term structure of interest rates’

describes the relationship between time to

maturity and yield to maturity on bonds of

equivalent risk. A graph of the term structure

is called the yield curve. The slope of the

yield curve is highly correlated with future

economic growth.

LO4.1

LO4.2

LO4.3

LO4.4