AuthorTopic: My CFA Level II Technical Questions
Cornell
@2017-12-03 14:16:31
Since I haven't formed/found a study group yet, and I have no one else to ask, I'm going to post my technical CFA Level II questions in this topic group (which I hope wont piss anyone off). If anyone knows of a better place for me to post questions like this, please let me know.

First question:

I'm reading "Analysis of Financing Liabilities" in the textbook, page 496. Their point about refinancing of debt doesn't seem logical to me. Here's what they say:

"Consider two firms reporting the same book value of debt. One firm issued the debt when interest rates were low; the other at higher current interest rates. Debt to equity ratios based on book values may be the same. However, the firm that issued the bonds at the lower interest rate has higher borrowing capacity as the economic value of its debt is lower. Theoretically, it could refinance its current debt at the same interest rate as the other firm, lowering the book value of debt."

My understanding of refinancing is that you do it to obtain a lower interest rate, not higher. Where am I off?

thanks,
David
bigman
@2017-12-04 10:16:54
well, like my old finance professor used to tell us, " In finance, the more you learn, the less you know"

your question on the textbook is a good one because it doesn't seem logical to refinance at a higher rate. Might have something to do with economic value vs. bookvalue of debt. Honestly I don't know. However, i do commend you on reading 496 pages of a finance book.
georgebush
@2019-03-05 10:57:17
The point is that since book value is calculated according to interest rates in effect at the time of debt issuance, and not adjusted when interest rates change, the economic value of debt is not reflected on a firm's balance sheet.

Suppose firm A issues a note in the principal amount of \$1,000,000, with payment of principal and interest (at 5%) due in 1 year, for an aggregate payment of \$1,050,000. At a market interest rate of 5%, the economic value (present value) of the note is \$1,000,000 at the time of issuance. If market interest rates suddenly rose to 50%, the economic value would be \$1,050,000/1.5 = \$700,000, i.e., firm A could borrow \$700,000 at 50% to pay off the first note. Compared to another firm, firm B, which borrowed \$1,000,000 in a 50% interest rate environment, firm A has capacity to borrow an additional \$300,000, even though its book value indicates it has borrowed the same \$1,000,000 as firm B.