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.
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:
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):
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.
|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.|