Market Value of Bond

A firm is financed with common stock and long term fixed rate debt; Bob, a CFA charterholder should adjust which of the following items for a change in market interest rates?

a.) interest expense

b.) CFF

c.) debt/equity ratio

The answer says that the debt to equity ratio should be changed. It further states that interest rates will change the market value of bond (but because we calculate book value based on the market rate at the beginning of the period, it doesn’t effect book value) but why does a change in market value (as opposed to book value) effect debt?

Also, if you have variable rate debt, why would the market value of the debt only change slightly?

Thanks!

Because the debt/equity ratio uses the market value of both terms. So if interest rate goes up, then the market value of debt goes down, and your debt/equity ratio goes down as well.

If you have a variable rate debt, then the amount of fixed interest that you pay semi-annualy dynamically changes with respect to interest rate changes, so instead of changing price in the value of the debt, you are changing the cash flows instead to match the current interest rate. The less the current yield, the more sensitive the price of the bond to interest rate changes. Similar to a fixed bond.