Principles of Managerial Finance

Time to Maturity and Bond Values

Whenever the required return is different from the coupon interest rate, the

amount of time to maturity affects bond value. An additional factor is whether

required returns are constant or changing over the life of the bond.

Constant Required Returns When the required return is different from the

coupon interest rate and is assumed to be constant until maturity,the value of the

bond will approach its par value as the passage of time moves the bond’s value

closer to maturity. (Of course, when the required return equalsthe coupon inter-

est rate, the bond’s value will remain at par until it matures.)

EXAMPLE Figure 6.6 depicts the behavior of the bond values calculated earlier and pre-

sented in Table 6.6 for Mills Company’s 10% coupon interest rate bond paying

annual interest and having 10 years to maturity. Each of the three required

returns—12%, 10%, and 8%—is assumed to remain constant over the 10 years

to the bond’s maturity. The bond’s value at both 12% and 8% approaches and

ultimately equals the bond’s $1,000 par value at its maturity, as the discount (at

12%) or premium (at 8%) declines with the passage of time.

Changing Required Returns The chance that interest rates will change and

thereby change the required return and bond value is called interest rate risk.

(This was described as a shareholder-specific risk in Chapter 5, Table 5.1.) Bond-

holders are typically more concerned with rising interest rates because a rise in

interest rates, and therefore in the required return, causes a decrease in bond

value. The shorter the amount of time until a bond’s maturity, the less responsive

288 PART 2 Important Financial Concepts

109876543210

1,200

1,100

1,000

901

952

800

887

1,052

1,115

1,134

Time to Maturity (years)

Market Value of Bond,

B

(^0)
($) Premium Bond, Required Return, kd = 8%
Par-Value Bond, Required Return, kd = 10%
Discount Bond, Required Return, kd = 12%
M
FIGURE 6.6
Time to Maturity
and Bond Values
Relationship among time to
maturity, required returns,
and bond values (Mills
Company’s 10% coupon inter-
est rate, 10-year maturity,
$1,000 par, January 1, 2004,
issue paying annual interest)
interest rate risk
The chance that interest rates
will change and thereby change
the required return and bond
value. Rising rates, which result
in decreasing bond values, are of
greatest concern.