FINM7006 Chap.7 Debt Valuation and Investment Decisions
Debt Valuation and Investment Decisions
A fixed-coupon bond combines a finite coupon annuity with repayment of face value, while a project combines an initial outlay with incremental future cash flows. Both use present value, but their cash-flow definitions differ.
This chapter keeps coupon rate separate from yield, uses the premium-par-discount relationship as a direction check, and then carries the same discounting engine into NPV without mixing financing claims into operating project cash flows.
What this chapter covers
- 01
Bond coupons and face value
- 02
Coupon rate versus required yield
- 03
Premium, par and discount prices
- 04
Incremental project cash flows
- 05
Net present value decisions
- 06
Cash-flow definition before discounting
Worked example · free
Price a bond below face value
- +1Coupon: $1,000(0.06) = $60 each year.
- +1Coupon value: $60[1 - (1.08)-4]/0.08 = $198.73.
- +1Principal value: $1,000/(1.08)4 = $735.03.
- +2Price: $933.76, below face because yield exceeds coupon rate.
Key terms
- Coupon rate
- Coupon rate determines a bond's promised coupon amount as a percentage of face value.
- Face value
- Face value is the principal amount a plain bond promises to repay at maturity.
- Bond yield
- Bond yield is the market return used to discount promised coupons and principal.
- Incremental cash flow
- Incremental cash flow is a cash consequence that occurs because a project is accepted.
Debt Valuation and Investment Decisions FAQ
Why do bond prices fall when yields rise?
An existing bond's promised coupons and principal are fixed. A higher required yield discounts those payments more heavily, reducing their present value. The reverse occurs when yield falls. This inverse relationship assumes the promised cash flows remain unchanged while the market return changes.
How do coupon rate and yield play different roles?
Coupon rate creates the contractual coupon amount by multiplying face value. Yield is the discount rate that prices those coupons and principal. If coupon rate equals yield on the same periodic basis, price is at face value. A lower coupon rate produces a discount; a higher one produces a premium.
What does a zero NPV project mean?
Zero NPV means the discounted benefits exactly equal discounted costs at the required return. It does not mean the project has no cash flows or accounting profit. It means the project is expected to earn the required return without adding value above that benchmark on the supplied assumptions.
Exam move
Draw a bond timeline and split it into a coupon annuity plus a final principal payment. Predict premium, par or discount before calculating. For projects, create a separate ledger of initial outlay, incremental operating cash flows, working capital and terminal effects, including only facts the question supplies.
Practise explaining why bond price and project NPV use the same time-value engine but different cash-flow definitions. End every solution with price classification or accept-or-reject language. Start bond work by translating every quotation into the coupon period.
Calculate the contractual coupon from face value and coupon rate, then convert yield to a matching periodic rate and convert remaining maturity to the number of coupon intervals. Mark the final date because it contains both the last coupon and principal.
Before using a calculator, predict price direction: coupon rate above yield implies a premium, equal rates imply par under matching conventions, and coupon rate below yield implies a discount. Use that prediction to catch frequency errors. Reprice the same bond after a small yield increase and describe the inverse relation.
Then compare a short and long maturity or a high and low coupon to develop intuition about sensitivity without claiming an exact duration result that was not calculated. For investment decisions, write an incremental-cash-flow checklist. Include the initial outlay, changes in operating cash flows, opportunity costs, working-capital movements and terminal recovery when supplied.
Exclude sunk costs and avoid deducting financing costs in cash flow when the discount rate already incorporates financing. Place tax effects only when the question provides the information needed. Discount each project amount at a risk-consistent return and state the NPV rule as value creation, not merely a positive sign. Test the margin by changing the rate or a key forecast.
Compare mutually exclusive projects carefully: the largest positive NPV creates the most value under the supplied assumptions, while percentage return alone can mis-rank different scales. During final practice, alternate bond and project questions so that you must define the cash-flow object before applying the shared present-value machinery.
Give one mark to the timeline, one to matched periods, one to correct cash flows, one to arithmetic and one to interpretation. A finished bond response names premium, par or discount; a finished project response accepts, rejects or states the decision threshold and the assumptions on which it depends.
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