# Why does this reflect a stronger solvency position?

On page 489 of the FSA CFAI book: -------------------------------------------------------------------------------- Consider two firms reporting the same book value of debt. One firm issued the debt when interest rates were low; the other at higher current interest rates. Debt-to-equity ratios based on b ook values may be the same. However, the firm that issued the bonds at the lower interst rate has higher borrowing capacity as the economic value of its debt is lower. Ratios calculated using the market value of debt would reflect the stronger solvency position. -------------------------------------------------------------------------------- Why does this reflect a stronger solvency position? I assume it is because the firm that issued at higher interest rates now has to pay at that higher interest rate, meaning a higher interest expense semiannually. But it seems to me like there might be something else, maybe having to do with refinancing? Am I just paranoid? Have I just been spending too much reading that my brain is eating itself?

It’s six of one, half a dozen of the other (I think that’s what my Mom would say). One firm has a higher interest expense, but the other firm could have the same interest expense by borrowing more money. Or the firm with lower interest expense could “refinance” their debt by buying it all back in the open market at prices lower than par and then reissue debt at current rates. If they had \$10M outstanding, they might only have to borrow \$9M to refinance it all thereby lowering their debt. Don’t know about the paranoid thing. Do you ever think that aliens are reading your thoughts or that you are working for SPECTER?

Bond prices have an inverse relationship to interest rates. The value of the debt issued when rates were lower than they are now is lower (rates up, bond price down). Therefore, the numerator will be smaller based on market values so D/E will be lower.

^ Nope. Check out how you account for bonds issued.

Joey, Could you elaborate on you’re comment, I’m not sure I totally understand what you’re getting at. What I am thinking is based on the last sentence: “Ratios calculated using the market value of debt would reflect the stronger solvency position.” Using whichever solvency debt ratio you prefer lower would indicate stronger solvency. With book values being the same and market values being sensitive to changes in interest rate, the market D/E would be lower for the firm that issued at lower rates based on my post above. So, while I don’t disagree with your post, I was thinking mine would more directly address why the last sentence of the paragraph is true. Does that make sense or does it still seem off?

1.The book value of debt doesn’t include interest expenses. 2. Market value of debt will take in account interest expenses. The firm with the lower interest rate will then have a lower debt-to-equity ration than the one with higher interest rate. By consequent that firm will reflect a stronger solvency position.

Derek38 Wrote: ------------------------------------------------------- > Joey, > > Could you elaborate on you’re comment, I’m not > sure I totally understand what you’re getting at. > What I am thinking is based on the last sentence: > “Ratios calculated using the market value of debt > would reflect the stronger solvency position.” > Using whichever solvency debt ratio you prefer > lower would indicate stronger solvency. With book > values being the same and market values being > sensitive to changes in interest rate, the market > D/E would be lower for the firm that issued at > lower rates based on my post above. So, while I > don’t disagree with your post, I was thinking mine > would more directly address why the last sentence > of the paragraph is true. Does that make sense or > does it still seem off? No that is right. The differenve between this and the earlier response is the “market D/E” which is still a little ambiguous (it’s the market value of debt/equity not market value of debt/market value of equity although we could talk about the latter as well).