shows the projected price of the bonds, in the unlikely event that interest rates remain
constant from 2001 to 2025. Looking at the actual and projected price history of these
bonds, we see (1) the inverse relationship between interest rates and bond values and
(2) the fact that bond values approach their par values as their maturity date ap-
proaches.
Why do most bond trades occur in the over-the-counter market?
If a bond issue is to be sold at par, how will its coupon rate be determined?
Summary
This chapter described the different types of bonds governments and corporations is-
sue, explained how bond prices are established, and discussed how investors estimate
the rates of return they can expect to earn. We also discussed the various types of risks
that investors face when they buy bonds.
It is important to remember that when an investor purchases a company’s bonds,
that investor is providing the company with capital. Therefore, when a firm issues
bonds, the return that investors receive represents the cost of debt financing for the issuing
company.This point is emphasized in Chapter 6, where the ideas developed in this
chapter are used to help determine a company’s overall cost of capital, which is a basic
component in the capital budgeting process.
The key concepts covered are summarized below.
A bondis a long-term promissory note issued by a business or governmental unit.
The issuer receives money in exchange for promising to make interest payments
and to repay the principal on a specified future date.
Some recent innovations in long-term financing include zero coupon bonds,
which pay no annual interest but that are issued at a discount; floating rate debt,
whose interest payments fluctuate with changes in the general level of interest
rates; and junk bonds,which are high-risk, high-yield instruments issued by firms
that use a great deal of financial leverage.
A call provisiongives the issuing corporation the right to redeem the bonds prior
to maturity under specified terms, usually at a price greater than the maturity value
(the difference is a call premium). A firm will typically call a bond if interest rates
fall substantially below the coupon rate.
A redeemable bondgives the investor the right to sell the bond back to the issu-
ing company at a previously specified price. This is a useful feature (for investors)
if interest rates rise or if the company engages in unanticipated risky activities.
A sinking fundis a provision that requires the corporation to retire a portion of
the bond issue each year. The purpose of the sinking fund is to provide for the or-
derly retirement of the issue. A sinking fund typically requires no call premium.
The value of a bondis found as the present value of an annuity(the interest pay-
ments) plus the present value of a lump sum (the principal). The bond is evaluated
at the appropriate periodic interest rate over the number of periods for which
interest payments are made.
The equation used to find the value of an annual coupon bond is:
An adjustment to the formula must be made if the bond pays interest semi-
annually:divide INT and rdby 2, and multiply N by 2.
VB a
N
t 1
INT
(1rd)t
M
(1rd)N
.
Summary 181
Bonds and Their Valuation 177
