Irrespective of the business size, operations, and scope, any business entity’s capital structure is the same. There are two sources of financing available for every business. Either it is the equity financing or the debt financing.
As for equity financing, the funds come from the business owners or shareholders by the mean of shares.
Whereas, in debt financing, the external parties provide funds for a decided interest. The debt financing can be either made by direct bank loans or by issuing bonds.
The firm’s capital structure plays an important role in the overall financial health of the business and the enterprise value.
The accounting ratios are a good measure of assessing the company’s debt compared to its assets. However, most companies use the book values for financial reporting.
Using the book value of debt is not an inappropriate practice; however, debt’s market value is a better depiction as it considers all types of debt, bonds, or bank loans. We have explained the debt, the market value of debt, and the most suitable way to calculate it.
Either the book value or market value of the debt gives important insights for informed decision-making. We have also tried to cover the decision-making perspective of debt.
So let’s get into it.
Types of Debt
Like all men are created equal, all debts are not. There are many types of debts available to a business entity or individual.
Some are better than others; however, the two broader classifications are personal and corporate debt. Our point of concern is the corporate debts. Therefore, we will discuss the types of corporate debt.
Short-term debt is normally the one that is issued for a period of less than one year and mostly traded in the money market. Commercial papers are a good example of short-term debt.
Long-term debt is generally the debt that extends over a period of more than one year. It can b either 2 to 5 years or 5 to 10 years.
Long-term debt is the major concern of investors, third parties, and the business itself to measure and represent the financial position. The two most common debt instruments are:
Term loans are the debt instrument having maturity ranging between 1 to 30 years. The negotiation, interest rate, and all other provisions of term loans remain between the lender and borrower.
The most common institutions that issue term loans are banks, insurance companies, government agencies, investment companies, and pension funds.
Public debt is another source of financing for any company trading in stock markets. You must have heard about bonds; that is what we call public debt.
The company issues the bonds, and they are openly traded in the market until redemption. Every bondholder is entitled to a certain amount of interest on the bond.
Once issued, a company cannot control the bonds’ market price, and they are recorded at the book value normally.
Market Value Of Debt
Now let’s get to the point that what is the market value of debt?
In the case of bonds, it is easy to ascertain the market value, but for non-traded debts like bank loans, the book value is used.
By examining different research studies, we can say that in respect of empirical evidence, the concept of book value is more appropriate. However, the market value is a more relevant measure as it helps calculate enterprise value.
If we formally define the market value of debt, it will be as:
The market value of the debt is the market price of the entity’s debt that investors will be willing to pay for buying debt. The market value of debt is different from the book value that is reported in the financial statements.
How to Calculate The Market Value Of Debt?
Since any business entity’s debt is a combination of long-term, short-term, publicly traded, and non-traded loans, every instrument has different provisions.
What is an appropriate measure to consolidate all the debts, either bank loans or bonds, to calculate the market value of the entity’s debt?
The most common way of calculating the market value of debt is considering the whole debt of an entity as one coupon bond. Whole debt means all the cash or bank debt as well as bonds and non-tradable debt.
The book value of the total debt as mentioned in the financial statements is converted to the market value in this way. The total cost of the debt, or interest, is treated as the coupon rate for that imaginary coupon bond.
The maturity of that coupon bond is equal to the weighted average time when the debt will be matured.
Once you have all this data, it is put into the formula bond pricing of a coupon bond. Before we quote the formula, it is better to explain few common terms that will be used in the formula.
- Coupon Bond: Coupon bonds are debt instruments that are publicly traded, and they are also called bearer bonds. These bonds are traded in the market. No information of the purchaser is mentioned in face of the bond.
- Coupon Rate: The annual, semi-annual, or quarterly interest payments are made on bonds. The rate at which interest will be paid is also known as the coupon rate. It is mentioned on the face of the bond, and it is a fixed rate.
- Maturity: Maturity is the time period after which the bond will be matured and redeemed. No interest payments will be made after the maturity of the bond. At the time of maturity, the issuer of a bond will pay the face value to the bearer.
Here is the formula for the bond price that is used in assessing the market value of debt.
Bond Pricing Formula = C[(1 – (1/((1 + Kd)^t)))/Kd] + [FV/((1 + Kd)^t)]
C = Interest Expense
Kd = Current Cost Of Debt( Effective Interest Rate)
FV = Total Debt
T = weighted average maturity time
Let’s understand the concept with an example.
The book value of debt for ABC Company represents the total debt of $650000. The interest expense is around $30000, and the cost of debt is around 3.8%.
The company needs to find the market value of its debt for enterprise value.
From the information, it is also found that the weighted average maturity time of the entity’s debt is 8.9 years.
Let’s substitute the values in the formula.
Bond Pricing Formula = 30000[(1 – (1/((1 + 0.038)^8.9)))/0.039] + [650000/((1 + 0.038)^8.9)]
After substitution of all values, the market value of debt will be
Market Value Of Debt= 689,396
What Insights Does Market Value Of Debt Give?
To summarize the insights we get from the market value of debt, we can say that:
- It gives information about the comprehensive debt of the company
- The market value of debt highlights the financial distress of the company. If the market value is higher than the book value, it indicates that the market is ready to pay more for the debts due to some progressive signals or any expected earnings. If the case is vice versa, it signals financial distress.
- By this measure, the true cost of the capital can be easily determined.
- The market value of the debt provides inputs for the calculation of enterprise value.
Much emphasis is put on the market value than the book value because the measurement of market value makes the situation much clear.
The market value of debt is given much importance because many important decisions are dependent on this metric of any business entity.
- Whenever a business entity is assessing its funding capacity, looking for future finances, or funding a big project that can boost profitability, the debt’s market value is a critical measure. By the market value of debt, the entity can attract the creditors to fund because if the market value of debt is higher than book value, it is a signal that the company has bright future prospects.
- Enterprise value and market capitalizations are two terms and two very important measures of the firm’s overall financial health. Just like the concept of book value and market value, enterprise value is a more realistic and comprehensive concept. Since the debt’s market value encompasses all types of debt, it is used as input in Enterprise Value’s calculations. Whereas market capitalization only takes into account the freely floating shares and publicly traded debts.
- The weighted average cost of capital is a measure of the firm’s capital cost by taking into account all capital sources according to their weights. For WACC calculation, weights of all sources, including stocks, bonds, preferred stocks, other debts, are assigned proportionally. When the metric of the market value of debt is used instead of book value, the true cost of capital can be calculated.
The market value of debt is considered one of the critical measures for any business, either for the cost of capital purpose, fundraising, or credit worth-assessment.
We have tried to comprehensively discuss and touch on all aspects of this concept of accounting. We hope that the ambiguity about the calculation of the market value of debt would have been resolved.