Issued debt held at historical cost or marked-to-market?

CFA Level I Corporate Finance
#1

I came upon an interesting answer to a question about WACC and I wonder if the authors were wrong about something or if I’m not understanding the answer:

The answer states that “a decrease in the market value of the firm’s debt will increase thte market yield on the debt, which will increase the after tax cost of debt and the firm’s WACC.”

This raises a few questions:

  1. I thought the firms debt was issued at cost and then amortized over the years, and

  2. Even if the debt were marked-to-market, wouldn’t the coupon payment stay the same and therefore have the same cost to the firm? Also interest cost is paid before taxes so any help would be appreciated?

#2

The cost of a firm’s debt is calculated based on it’s yield not it’s coupon.

The yield is how the market percieves the company. A very strong company with stable cash flows, strong balance sheet etc, is well trusted by the market, so people are not afraid to loan such a company their money so it’s yield (or cost of debt) is lower.

A company with relatively weak cash flows is percieved by the market to be more risky, so no one will be willing to loan it any money, for the company to attract investors, it will have to lower the price of it’s bond, so it’s bond will sell at discount which implies that it’s yield (cost of debt) is higher.

Companies issue debt at cost (yield). When the cost (yield) is higher, then the company’s debt is said to be issued at discount. When cost (yield) is lower, then the company’s debt is said to be issued at premium.

#3

Robausting, adding to Bloodline’s comments:

I think the main source of confusion boils down to (A) the definition of WACC as well as (B) a mix up of Corporate Finance and Financial Reporting and Analysis concepts. I hope the following explanations help:

_ A. WACC definition _

WACC is NOT the cost at which the company managed to finance itself historically. If you look closely in the Cost of Capital reading in the Curriculum, you will find that WACC is described as the weighted average of the marginal cost of the various sources of capital (including debt).

Marginal means additional or new as opposed to historic. In other words WACC tells you how much, on average it would currently cost a company to raise new capital from its specific mix of financing sources.

_ B. Financial Reporting vs Corporate Finance _

Imagine that 1 year ago, a company issued a 2-year, 10% annual-pay coupon, $1,000 face value note at par (with issue proceeds equal to face value). Additionaly, assume that the note currently (with 1 year to go) trades at $982.14. You are right to say that:

  1. Irrespective of the note’ subsequent market value changes, the annual coupon amount would stay fixed at 10% of face value, i.e. $100 per annum. Market value changes do not impact the actual cash ouflow.

  2. The note would initially be recorded at an amount equal to the issue proceeds of $1,000 and subsequently carried at amortised cost. The rate at which interest would accrue on the note for financial reporting purposes would be based on its original (calculated at the time of issue) effective interest rate (or Yield to Maturity) which was 10% (the same as the coupon rate as the note was issued at par). Unless the note was marked-to-market, market value changes would not impact the way the note is accounted for in the balance sheet or income statement.

HOWEVER, for coporate finance purposes, you should note that the drop in market value (currently at $982.14) tells you that investors have increased their return expectations/requirements. If you compute the yield on an investment of $982.14 today which was scheduled to generate a cash flow of $1,100 1 year from now, you will find that it stands at 12% (up from 10% one year ago)

This tells you is that if the company were to issue new/additional/marginal debt today, it would face a higher financing cost than one year ago. In order to issue a $1,000 face value note at par (i.e. to receive $1,000 in issue proceeds) the company would have to promise investors a 12% coupon.

The marginal cost of additional capital has gone up = WACC has increased.

#4

Great point Wojtek, exactly what I was looking for!

#5

Quick nitpicky question - when you calc the weights for the WACC do you use book or market?

I assume that even using market, the WACC will still increase even though the proportion D/V is slightly lower - i.e. the decrease in proportion D/V is not enough to offset the increase in the rate of debt.

Is that the case?

Thanks