An analyst adjusts the reported carrying value of a firm’s L-T fixed rate debt to reflect an increase in interest rates during the yr The Most Likely effect on the adjusted debt to equity and int coverage ratios is: A. Debt to Equity increase, Int Coverage increase B. Debt to Eq increase, Int Coverage no effect C. Debt to Eq Decrease, Int Coverage Decrease D. Debt to Eq Decrease, Int Coverage No Effect Answer is D. What I am puzzled is why the interest coverage has no effect. Yes, I do know that when an analyst does adjustments (analysts are flexible for any type of adjustment) – that if you change the carry value of a debt to reflect an increase in interest rates, the carry value will be lower… which MEANS interest expense( even if interest expense is calculated using market rate at issuance) CAN be lower because your carry value that you just ADJUSTED to be lower is multiplied by the RATE at issuance… which means interest expense can be lower so interest coverage will indefinetly be higher… ERG… somebody… please explain. This is derived from Stalla Study Guide Page 79… Question 12
Interest is fixed on the long term debt(as mentioned above) and this is what you got to pay, therefore there is no change in the interest coverage. Any changes in effective interest rates willl have an effect in the carrying value of the debt, not the interest expense. Cheers Sumo
Sumo - but the one thing is what is the real cash flow (i.e. coupon you pay) and on the other hand there is interest expense that is recognized in P&L. So I would suppose that discounting future cash flow of that liability with higher interst rate I would recognize lower debt and at the sama time the interest expense would be lower… How do you assume the int. coverage is unchanged?
Sumo - but the one thing is what is the real cash flow (i.e. coupon you pay) and on the other hand there is interest expense that is recognized in P&L. So I would suppose that discounting future cash flow of that liability with higher interst rate I would recognize lower debt and at the sama time the interest expense would be lower… How do you assume the int. coverage stays unchanged?
Financial liabilites are carried at amortized cost unless it is held for trading or are derivatives. These are amortized at the effective interest rate. Interest expense is fixed(carrying value of a firm’s L-T fixed rate debt: mentioned in the question) and therefore increase/decrease in interest rates is not relevant here. Therefore the equation: Amortized amount the begining of the period+ Interest Expense- Coupon pay= Amortized amount at the end of the period. The decrease/increase in interest rates which impacts on coupon pay will have an offsetting effect on the carrying value of the liability at the end of the period. Cheers Sumo