CFA Level 1

AAA

Liabilities - Effect Of Changing Interest Rate On Debt Market Value


A company that issued debt prior to an increase (or decrease) in market rates experiences an economic gain (or loss) when the rates change. This economic gain or loss is not reflected in a company's financial statement. Market-value changes will not appear on the income statement or balance sheet. As a result, the book value of a company's debt will not be equal to its market value. From a company valuation point of view, the book value of equity (total assets - liability) will not reflect the current economic reality. Furthermore, if an analyst compared two companies - one that issues $1m in debt at 10% and another that issues the same debt amount at 8% three months later - the debt-to-equity ratio of both companies will be the same. However, the company that issued the debt at a lower rate will be in a much better financial position. Times interest earned and other ratios will enable an analyst to uncover these differences.
Capital And Operating Leases
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