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