Chapter 6 – Interest Rates and Bond Valuation

In this chapter, we start using the analysis tools that we developed in chapters 2 through 5 for real corporate finance problems. As you can imagine, the cost of borrowing money if you are a corporate manager is an important factor in determining whether a project will be profitable or not.

Selling bonds to the public is one way that corporations borrow money. Instead of borrowing from a bank, they sell bonds, which are really just corporate IOUs, to many individuals, banks, pension plans, etc. That way, they are not limited to what one bank can give them, and they give up less control over their enterprise — banks often set conditions that the firm may not like. It is often said that if you borrow too much from a bank, the bank owns your business.

If you have not had any experience with bonds, they can seem confusing. There are numerous new definitions and concepts in this chapter, so get out that pack of index cards! Once you learn the definitions, bonds will suddenly be simple and the calculations, given what you have learned in previous chapters, will be easy.

Since these bonds are negotiable — meaning that you can buy and sell them on the open market — buyers and sellers need to be able to figure out what they are worth. After studying this chapter, you will be able to do so as well.

LEARNING OBJECTIVES

When you finish your study of this chapter, you should know:

1. UNDERSTAND what a bond is, be able to DEFINE the types of bonds, and UNDERSTAND and be able to DEFINE the important features of bonds.
2. UNDERSTAND and be able to EXPLAIN the relationship between the current yield, coupon rate and yield to maturity of a bond.
3. UNDERSTAND and be able to EXPLAIN why bond values fluctuate.
4. UNDERSTAND and be able to EXPLAIN bond ratings and their meanings.
5. UNDERSTAND and be able to EXPLAIN the impact that inflation has on interest rates.
6. Be able to DEFINE and EXPLAIN the term structure of interest rates and the factors that influence the structure.
7. Be able to CALCULATE the market value of a bond, given information about its term, coupon and other features and the market yield at that time.

The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!

Key terminology:

Don’t forget! Homework is due by 6:30 PM on class day by e-mail to homework@nyfinancial.com! Don’t suffer a zero by being late.