# i rate sensitivity

quick one before going to bed A firm has a variable long term rate debt outstanding. All else equal, what effect will a rise in interest have on the firm’s D/E ration and net income ? Ha ! as i’m making that one up : as an analyst what would be ur adjustment if the LT debt was fixed rate instead of variable rate ?

That depends:)) if it is in the form of loans, at interest rates going up, so does the market value of your debt, D/E increases. If it is in the form of bonds, at I up, market value of your debt goes down, D/E decreases.

That depends:)) if it is in the form of loans, at interest rates going up, so does the market value of your debt, D/E increases. ok well I saw it as interest expense up --> income down --> retained earnings down --> D/E up what do u think of the adjustment part ?

> > If it is in the form of bonds, at I up, market > value of your debt goes down, D/E decreases. correct, and if you are like Lehman and Merrill, you book a gain and hit the income stmtm to hide shi\$\$ earnings otherwise.

none - historical market rule

That’s only if you have debt with floating rate.

> > If it is in the form of bonds, at I up, market > value of your debt goes down, D/E decreases. ho :s map, “variable long term rate debt outstanding”

saurya_s Wrote: ------------------------------------------------------- > none - historical market rule I’m giving out the answer as it is 2am and I’m sleeping on my chair … if the LT debt are variable rate, they won’t really change in value as futur CF will fluctuate with the change in the i rate curve therefore for variable (adjustable) LT debt book value almost = market value --> no adjustment If the LT debt is fixed rate -> discount rate on each CF fluctuates with the market yield curve (think of zero coupon bonds) thus for analysis we should use market value rather than BV goodnight

If your debt has fixed interest rate, no matter how high or low I goes, your IE would be the same. NI would not decrease, E would not increase, D/E would remain unchanged. If the cost of debt floats, so does the market value of your debt.

Here is a question: Using reported financial statements and assuming no other changes to the firm’s debt or equity, what is the effect on a firm’s debt-to-equity ratio if interest rates increase during the year? a.No effect since financial statements are not affected by changes in interest rates. b. Higher since bond prices decline as interest rates increase. c. Lower since bond prices increase as interest rates increase. d. No effect since any changes in the debt will be offset by changes in the equity.

^^^the book value of bonds is unaffected by market rates, so i think there won’t be any effect A) unless they have issued floating-rate debt, bonds with a put option, or anything else that might be affected by a change in interest rates

supersharpshooter Wrote: ------------------------------------------------------- > ^^^the book value of bonds is unaffected by market > rates, so i think there won’t be any effect > > A) > > unless they have issued floating-rate debt, bonds > with a put option, or anything else that might be > affected by a change in interest rates RATES UP, PUT DOWN, MARKET VAL OF DEBT DOWN, HOLDER OF PUT CAN PUT THE INSTRUMENT AGAINST COMPANY, IS THIS WHAT U MEAN ?

yeah i mean if the bonds are putable, an increase in interest rates might give some of the bondholders the incentive to exercise their put option and get their money back in which case cash and liabilities go down and the D/E ratio is altered

hum… if fixed rate debt : BV is constant and market value down (use market value for analysis) if floating: BV approximates market value… but anyway the BS and IS are not affected by unrealised gain or loss

SFAF107 in US and IAS 32 require footnote disclosure of these unrealised gain/loss that I just mentioned one more reason to pick A