Subject 2. Current Market Rates and Fair Value Reporting Option

The market value of debt is dependent on future interest rates. This is because the market value is the sum of the present value of all of the future cash flows.

Debt reported on the balance sheet is equal to the present value of future cash payments discounted at the market value rate on the date of issuance. Increases (decreases) in the current market value rate decrease (increase) the market value of the debt. This economic gain or loss is NOT reflected in either the income statement or balance sheet. For some analytic purposes the market value of a company's debt may be more relevant than its book value.

A bond that pays a fixed interest rate is more susceptible to changes in interest rates than a bond that pays a variable interest rate.

  • As the interest rates change, the bond that pays the variable interest rate will not really change in value, as the future cash flows will fluctuate with the change in the interest rate curve. Therefore, for adjustable-rate debt, book value approximates market value and no adjustment is required.
  • A bond that pays a fixed interest rate will change in value because the discount rate of each cash flow fluctuates as the market yield curve fluctuates. This is especially true of zero-coupon and other discount debt, due to their longer duration relative to debt of the same maturity issued at par.

It is important, if a company has issued debt that pays a fixed interest rate, to consider whether the market value of the debt is different from the value of the debt in the company's books.

Consider what would happen to the value of the company's debt if market interest rates change:

  • When interest rates increase, the market value of fixed-rate debt decreases.
  • When interest rates decrease, the market value of fixed-rate debt increases.
  • For floating-rate debt, increases or decreases in interest rates do not have an impact on market value, as future cash flows will change along with the changes in interest rates.

Consider how this will affect the financial statements of company that has issued fixed-rate debt (it will have no effect on companies that issue floating-rate debt):

  • When interest rates increase, and the market value of the debt decreases, this will decrease the company's liabilities. As the liabilities will be lower, the debt-to-equity ratio will be more favorable.
  • When interest rates decrease, and the market value of the debt increases, this will increase company's liabilities. As the liabilities will be higher, the debt-to-equity ratio will be less favorable.

The Market Value of Debt

The market value of a company's debt is either the market price, if it is traded, or the present value of the future cash flows. The discount rate that is used is a risk-free rate, plus an appropriate spread for the risk of the particular company.

Typical Exam Question

A firm has variable-rate long-term debt outstanding. All other factors being equal, what effect will a rise in interest have on the firm's debt-to-equity ratio and net income?

Interest has increased, which means income decreases. Retained earnings are therefore lower and the debt-to-equity ratio will increase.

User Contributed Comments 6

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ashpan: Need to check how to derive market value of debt from book value.
todolist: For fixed rate bonds, changes in mkt rate does not effect debt ratios on financials, however there is a difference between book value and mkt value of the debt.
for variable rate bonds, changes in interest rates effect financials, but no difference between book value and mkt value.
schelsea: For fixed rate bonds, changes in interest rate DO affect financials.
When interest rate increases, the market value of debt decreases, hence lower debt-to-equity ratio and vv.

For variable rate bonds, no impact on market value but it affects income, which affects retained earnings and equity, which in turn affects financials too.
bundy: Rate increase
Fixed Debt Liab less so D/E decreases
Variable Debt Int Exp more Income Less RE less so D/E rises
zkhan87: todolist is correct.
they will affect financial statements only if the d/e ratio uses mkt value debt, which is typically not the case...fixed rate bonds are recorded on the bs at the mkt rate at the time of issuance, subsequent changes in the mkt rate has no impact on the financial statements.
nmech1984: undy gottit.