CFA Practice Question

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CFA Practice Question

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.

User Contributed Comments 4

User Comment
Emily1119 Can anyone explain the relationship between interest rate, interest payment and principle?

If interest increase, why the interest payment is lower?
jonan203 emily1119, it is due to the coupon rate in relation to par at issue.

coupon = 5%
par = $1,000
payment = $50

if market rates rise to 7%, the coupon is still 5%; however, the price of the all existing debt instruments must adjust to reflect the current market rate of 7%

Solve for X:
$50 payment (coupon times par) / $X bond price = .07
X = $714.28

coupon was 5%, rates rose to 7%, market price drops, thus bond prices and interest rates have an inverse relationship
jonan203 BTW, formula is:

coupon payment / market interest rate = market bond price
sshetty2 We use the market rate of interest to discount all future cash flows for the purpose of our present value calculation of the value of existing debt. If the market rate of interest rises, this means that the opportunity cost of capital has risen and therefore we are now discounting future cash flows by a larger number. Market rates go up -- Debt value goes down
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