Computing the Promised Yield to Maturity The promised yield to maturity can be computed by using the present value

model with semiannual compounding. The present value model gives the investor an accurate result and is the technique used by investment professionals. The present value model equationEquation 18.1 shows the promised yield valuation model:

Pm =

All variables are as described previously. This model is somewhat complex because the solution requires iteration. As noted, the present value equation is a variation of the internal rate of return (IRR) calculation where we want to find the discount rate, i, that will equate the present value of the cash flows to the market price of the bond (Pm). Using the prior example of an 8 percent, 20-year bond, priced at $900, the equation gives us a semiannual promised yield to maturity of 4.545 percent, which implies an annual promised YTM of 9.09 percent.

The values for 1/(1 + i) were taken from the present value interest factor tables in the appendix at the back of the book using interpolation.

COMPUTING BOND YIELDS You will recall from your corporate finance course that you start with one rate (e.g., 9 percent or 4.5 percent semiannual) and compute the value of the stream. In this example, the value would exceed $900, so you would select a higher rate until you had a present value for the stream of cash flows of less than $900. Given the discount rates above and below the true rate, you would do further calculations or interpolate between the two rates to arrive at the correct discount rate that would give you a value of $900. YTM for a Zero Coupon Bond In several instances, we have discussed the existence of zero coupon bonds that only have the one cash inflow at maturity. This single cash flow means that the calculation of YTM is substantially easier as shown by the following example. Assume a zero coupon bond maturing in 10 years with a maturity value of $1,000 selling for $311.80. Because you

are dealing with a zero coupon bond, there is only the one cash flow from the principal payment at maturity. Therefore, you simply need to determine what the discount rate is that will discount $1,000 to equal the current market price of $311.80 in 20 periods (10 years of semiannual payments). The equation is as follows: $311.80 = $1000/ (1+i) 20 You will see that i = 6 percent, which implies an annual rate of 12 percent. For future reference, this yield also is referred to as the 10-year spot rate, which is the discount rate for a single cash flow to be received in 10 years. Promised Yield to Call Although investors use promised YTM to value most bonds, they must estimate the return on certain callable bonds with a different measurethe promised yield to call (YTC). Whenever a bond with a call feature is selling for a price above par (that is, at a premium) equal to or greater than its call price, a bond investor should consider valuing the bond in terms of YTC rather than YTM. This is because the marketplace uses the lowest, most conservative yield measure in pricing a bond. When bonds are trading at or above a specified crossover price, which is approximately the bonds call price plus a small

premium that increases with time to call, the yield to call will provide the lowest yield measure. The crossover price is important because at this price the YTM and the YTC are equalthis is the crossover yield. When the bond rises to this price above par, the computed YTM becomes low enough that it would be profitable for the issuer to call the bond and finance the call by selling a new bond at this prevailing market interest rate. Therefore, the YTC measures the promised rate of return the investor will receive from holding this bond until it is retired at the first available call date, that is, at the end of the deferred call period. Note that if an issue has multiple call dates at different prices (the call price will decline for later call dates), it will be necessary to compute which of these scenarios provides the lowest yieldthis is referred to as computing yield to worst. Investors must consider computing the YTC for their bonds after a period when numerous high-yielding, high-coupon bonds have been issued. Following such a period, interest rates will decline, bond prices will rise, and the highcoupon bonds will subsequently have a high probability of being calledthat is, their yields will fall below the crossover yield.