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are able to observe regularities in capital structure practice, some of which are consistent with the
theories.
This concludes the chapter‟s examination of risk and return, cost of capital, and capital structure.
The final two sections of the chapter discuss and illustrate how to value bonds and stocks, the debt and
equity financial instruments issued by companies when raising capital for internal investment.
Bond Valuation
The value of any financial instrument, also called the market price, is the present value of the cash
flows from the instrument, discounted at the appropriate required return for the instrument. Recall that
bonds make contractual payments to investors called debt service, consisting of periodic interest
payments and repayment of the bond‟s face or par value when the bond matures. Bond valuation,
therefore, requires knowledge of the interest and principal payments from the bond, the timing of
these payments, and the required return of the bond. Since bonds are contractual, the amount and
timing of the payments to investors are known, so once the required return of the bond is determined,
the value of the bond can be calculated.
To illustrate the mechanics of bond valuation, let‟s create a hypothetical bond issued in the United
States by the Breckenridge Company. The bond has a $100 face value, matures on October 15, 2023,
and pays an annual coupon interest rate of 6.75%. Bonds issued in the United States typically pay
interest twice a year—that is, semiannually—so investors who hold this bond receive coupon interest
payments every year equal to 6.75% of the face value of the bond, but they actually receive one-half
of this amount twice a year. With the $100 face value of the bond, this means bondholders receive
coupon interest payments of $3.375 every six months for each bond they own, calculated as follows:
The maturity date of the bond is October 15, 2023, so these coupon interest payments are made
every six months to the bondholders, every October 15 and April 15. On the maturity date, the
bondholders will receive their last coupon interest payment of $3.375 for each bond they own, plus the
$100 face value of the bond, and at this date the bond matures and is retired.
Assume it is December 17, 2008, and you would like to know the value or price of the bond on this
day. (The date a bond is bought or sold is called the settlement date for the bond.) The last piece of
information necessary to determine the bond‟s value is the market interest rate for this bond, also
called the yield to maturity, as this is the required return for the bond. Assume the market interest rate
for the Breckenridge Company bond on December 17, 2008, is 6.10%, which is used to determine the
bond‟s value or price on the settlement date.
To summarize, the relevant information for the Breckenridge Company bond is: