Hey Everyone.
I can’t seem to wrap my head around this concept:
“An increase in interest rates results in a decline in the market value of the debt and lower debt used for analysis” (analytical purposes, not accounting).
Anyone chime in on why this is?
As the discount rate increases the net present value decreases. This would reduce the market value of the debt. That sentence is basically saying that you could buy the debt back at the now lower market price so you may want to factor that lower price into the analysis. From a practical perspective, business valuation professionals will sometimes use the market value of debt, not the book value of debt, to arrive at a valuation of the equity in their analysis.
Excellent, thanks Chad. Good explanation.
When a business is valued the market value for assets, liabilities, and equity is checked. Increasing the interest rates decreases the value of debt as they will be discounted at a larger denominator. It is significantly different than the accounting perspective, though under some standards reporting at fair value is allowed.
I get the effect of interest rates on liabilities. Just a quick question. For valuation purposes if you were to consider market values at a time when rates were higher than when debt issued would’nt you be unserestimating liabilities and vice versa. At maturity the cas outflow would be par.Basically, what would be my motivation to consider a lower value of debt and ratios. TIA.
No - the value of debt actually changes with interest rates. Think about it in terms of replacement value. If rates increase, bond prices decrease. So, you can *actually pay less* to buy enough bonds to cover your existing debt liabilities. Even if the payout at maturity is constant, the present value of the debt can change.
Thanks Ohai. I understand that debt value changes with changes with interest rates. Was’nt looking at it from a PV perspective.