Definition
The market value of debt is the price or amount that an investor is willing to pay to buy a company’s debt instrument. This amount is usually different from the book value present in the company statement of financial position.
Alternatively, it is the cost of replacing the debt if the company replaces it with new debt.
| Market Value = Value Today |
| Book value = Value When Issued. |
Where the debt instruments are traded in the market, the market value of debt can be determined by multiplying the number of debt instruments by the market price per instrument.
The market value of debt = (No. of debt instruments) * (Current price per debt instrument)
The market value of debt is usually more challenging to determine when the firms have all their debt in the form of instruments that are not traded in the market.
Many organizations have non-traded debt, such as bank loans. Such debt is specified in book value terms rather than market value terms in the balance sheet.
The following formula is used to calculate the market value of non-traded debt.
C = [(1 – (1/((1 + Kd)^t)))/Kd] + [FV/((1 + Kd)^t)]
Where,
C = Interest expense ($)
Kd = Current cost of debt (%)
t = Weighted Average Maturity (in years)
FV = Total debt value at maturity
The above formula is explained in detail later in this article.
Why is the book value of debt required to be converted to market value?
Although the book value of debt is most commonly used in practical finance, the market value of debt is more precise because it involves both the cash flows and the debt of a firm.
Also, the market value of debt helps financial analysts calculate a firm’s enterprise value. The estimated market value of the debt is often used to determine a company’s weighted average cost of capital (WACC).
This helps the company evaluate future investments and projects and support various vital decisions.
For more precise results, prepare an estimate of each debt’s market value separately and add them all up. Care is to be exercised in determining debt market value, as this is not an exact methodology.
Converting book value debt into market value debt:
The easiest way to convert book-value debt into market-value debt is
- To think of the entire debt on the books as one coupon bond,
- Coupons are set equal to the interest expenses on all the debt and
- A maturity is set equal to the face-value weighted average maturity of the debt.
The market value of the debt formula
Now, let’s reproduce the above-discussed formula for performing calculations:
Let’s start by going through each of the variables of the formula.
C = [(1 – (1/((1 + Kd)^t)))/Kd] + [FV/((1 + Kd)^t)]
C = Interest expense ($)
Kd = Current cost of debt (%)
t = Weighted Average Maturity (in years)
FV = Total debt value at maturity
Let’s plug in some numbers to make sense of this formula. A company has a total debt of $1 billion on its balance sheet, with interest expenses of $60 million and a maturity of 6 years.
The company has also determined that the blended cost of new debt would be 7.5%. The market Value of Debt will be as follows:
One way to check the above result is to take the income statement interest expense, which is $60 million, and divide it by the book value of the debt, which is $1000 million. You will get the cost of debt to be 6%.
Since the current interest rate is 7.5%, which is higher than 6%, it makes sense that the debt’s market value is lower than the book value. Thus, investors will be willing to pay less for it.
Relationship of Market Value of Debt and Current Market Interest Rate
The market value of debt has an inverse relationship with the current interest rate. As the current interest rate prevalent in the market is higher than the interest rate the company is paying, the market value of its debt will be lower than what is reflected in its books.
The reverse will be true if the current interest rate is less than the company’s interest rate.
Calculation of Market Value of Debt Using Microsoft Excel
A simple Microsoft excel formula can also be used to calculate the market value of debt. I have assumed the following data to explain the formula:
Face Value $1,000
Coupon rate 10%
Time to Maturity 20 years
The current market rate of 8%
Bonds outstanding 2,000
Market value from the above data can easily be found using the PV formula in excel. Various arguments used in the PV formula are explained as under:
PV (rate, nper, pmt, fv)
- Rate is the interest rate per period, i.e., the current market rate 8%
- Nper is the total number of periods, i.e., 20 years.
- Pmt is the payment made in each period and cannot change over the lifetime of the investment, i.e., Coupon rate of 10% of the face value $1,000 = $100
- FV is the face value i.e., $1,000
By plugging in the values as mentioned above in the PV excel formula, along with the negative signs at the start, we get $1,196.36. This value is the market value per bond. Thus, the total market value of all bonds is $2,392,726 (2,000 x $1,196.36)
The market value of debt Importance
- It is more reliable to use to arrive at the real cost of capital.
- Similarly, investors and analysts use the market values of debts to evaluate future funding and financial growth projections.
- Due to its reliability when seeking financing, companies usually rely on market values of debt to make informed decisions.
- Also, the market value is more dependable when determining the net worth of a business.
Summary
Along with the current interest rate, the company’s performance, its ability to service its debt obligations, and the condition & value of these assets also have a bearing on the market value of debt.
All these factors shall be taken into consideration for the calculation of the market value of debt.
