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.

Practice Question 1

Currituck Company has fixed-rate long-term debt issued when the market rate was 7%. One year later, the market rate increased to 7.75%. As a result, the market value of the debt one year later would be higher than its book value. True or False?

Correct Answer: False

When market interest rates increase, the market value of debt declines, since the present value of the interest payments and principal is lower when computed at a higher interest rate.

Practice Question 2

The selling price of long-term debt is less than the debt's maturity value when the ______

A. stated interest rate is less than the effective interest rate.
B. effective interest rate is less than the stated interest rate.
C. stated interest rate is greater than the coupon interest rate.

Correct Answer: A

When the market rate (effective rate) is higher than the stated rate (coupon rate) of the bonds, buyers will not be willing to pay the face or maturity value because they can make a higher rate elsewhere in the market.

Practice Question 3

If the market rate of interest for a long-term debt issue is less than the stated rate of interest for the debt, the debt will be issued at ______.

A. less than its face value
B. more than its face value
C. its maturity value plus interest

Correct Answer: B

If the market rate of interest for a long-term debt issue is less than the stated rate of interest for the debt, the debt will be issued at a premium, an amount greater than face value.

Practice Question 4

If a firm has variable-rate debt and the interest rate rises, the market value of the firm's debt should ______.

A. increase
B. decrease
C. remain unchanged

Correct Answer: C

If a bond has a variable interest rate, the rate will change with the market rate, and its market value will stay the same.

Practice Question 5

When does the selling price of long-term debt equal its maturity value?

A. When the nominal interest rate is equal to the stated interest rate
B. When the effective interest rate is equal to the nominal interest rate
C. When the effective interest rate is equal to the market interest rate

Correct Answer: B

When the market rate (or the effective rate) of interest is equal to the stated interest rate, the bonds will sell for their face value (maturity value).

Practice Question 6

All of the following statements about the effects of changing interest rates on the market value of debt and on financial statements and ratios are true except:

A. financial ratios will not be impacted by changes in market interest rates.
B. only when interest rates drop and the value of the outstanding debt increases would the firm be required to revalue the book value of its debt.
C. if a company was to buy back its bonds at a discount to their book value, then it would have to record an extraordinary gain.

Correct Answer: B

The book value of the debt would not be impacted by what is prevailing in the markets. Thus, even as the market value of a firm's bond fluctuates by the hour, it will have no impact on the debt's book value.