When companies raise finance, they generally have two options. The first is equity, which represents funds they can get from shareholders. Usually, equity is an easier option for companies due to the availability of these funds. Companies can get equity finance from new shareholders or existing ones. However, equity finance is usually more expensive due to the associated costs.
The second option is to raise debt finance. Debt finance does not come from shareholders. Instead, companies obtain it from third parties. Debt finance is usually cheaper than equity finance. However, it may have some disadvantages as well. Usually, companies report their debt finance at book value in the balance sheet. Sometimes, however, it may also have a market value. Before discussing the market value of debt, it is crucial to understand what debt is.
What is Debt?
Debt is any assets borrowed by one party from another. In most circumstances, these assets include monetary compensation. Usually, this transaction involves two parties. The first party is the borrower, who borrows money. The borrower can be an individual, a company, an organization, an institution, etc. Similarly, the second party is the lender who provides the finance. The lender is usually a financial institution. However, it may also be other companies, individuals, etc.
For companies, debt represents a financial obligation and appears on their balance sheets. It is a type of liability and is, therefore, repayable in the future. The definition of liability includes any obligations that result in outflows of economic benefits in the future. Since debt meets this definition, it falls under the category in the balance sheet.
Debt also comes with various terms and conditions. Usually, it includes the repayment of the principal amount with regular interest payments. It also involves an interest rate which dictates the percentage of interest the borrower has to pay. However, these payments are not perpetual. Instead, debt comes with a maturity or expiration date. At this date, the interest payments end, but the borrower also has to return the principal amount.
Overall, debt includes obligations from one party to another. The parties may differ from one transaction to another. However, the general principle for debt remains the same. There are several forms of debts that companies may accumulate. The most prevalent of these are loans taken from a financial institution. However, it may also include bonds, note payables, short-term debts, etc.
What is the Market Value of Debt?
The market value of debt represents the market price investors must pay to buy a company’s debt. In practice, however, investors do not acquire a company’s debts. Usually, this amount is relevant when investors invest in a company and want to evaluate a company’s debts through market perception. Similarly, it may be applicable to acquisitions and mergers when companies go through these processes.
The market value of debt differs from the value that companies report on the balance sheet for liabilities. The value of debt on the financial statements is known as its book value. It represents the total outstanding principal amount for the debt at the time of reporting. It does not include the debt’s interest component, which companies usually expense out during a period.
Since the book value of debt only represents its accounting value, the market value of debt can be crucial. Analysts calculate this amount to provide a better picture of how a company fares when it comes to its total debt. This figure also provides a basis to calculate other metrics. For example, the enterprise value requires investors to calculate a company’s market value of debt.
Overall, the market value of debt presents the market’s perception of how much a company’s debts are worth. As this figure is not a part of the financial statements, investors have to calculate it themselves. This market value will include traded debt, consisting of bonds, and non-traded debts, including bank loans. Companies report these at book value in their financial statements. For investors, however, the market value of debt may be more relevant.
How to calculate the Market Value of Debt?
The calculation of the market value of debt is not as easy as its book value. Determining the market value of publicly traded debt is straightforward. Companies can get the market value of the bonds to calculate their market value of debt. However, companies also have non-traded debts. The market value for these is not available. Since companies accumulate debt from various sources, the calculate becomes complex.
When calculating the market value of debt, investors have to assume the company’s total debt as a single coupon bond. The coupon will be equal to the interest expenses on all debt. Similarly, they must take the weighted average maturity for all the debts for this combined amount. Once they do so, they can use the bond pricing formula below to calculate the market value of debt.
Market Value of Debt = C [(1 – (1 / ((1 + Kd)t))) / Kd] + [ FV / ((1 + Kd)t) ]
In the above formula, ‘C’ denotes the total interest expense. As mentioned, this will be the total interest expense for all the debts combined together. Usually, this figure is available in a company’s income statement or notes to the financial statements. Alternatively, investors can get it from the statement of cash flows.
‘Kd’represents the current cost of debt. The calculation for the cost of debt requires investors to use financial management models. Similarly, ‘T’ signifies the weighted average maturity for all the debts combined together. This figure is usually in years. Lastly, ‘FV’ is the total value of debt for the company. Once investors calculate these figures, they can measure a company’s market value of debt.
Example
A company, ABC Co., has total debts of $100 million on its balance sheet. The interest expense that the company incurs on this debt is $8 million. The company’s cost of debt is 4.2%. Lastly, ABC Co.’s weighted average maturity for these debts is 9.2 years. Therefore, ABC Co.’s market value of debt will be as below.
Market Value of Debt = C [(1 – (1 / ((1 + Kd)t))) / Kd] + [ FV / ((1 + Kd)t) ]
Market Value of Debt = $8 million [(1 – (1 / ((1 + 4.2%) ^ 9.2 years))) / 4.2%] + [ $100 million / ((1 + 4.2%) ^ 9.2 years)]
Market Value of Debt = $128,510,500 or $128.51 million
Why is the Market Value of Debt important?
The market value of debt is crucial to investors for several reasons. Firstly, the market value of debt is more reliable when calculating the real cost of capital. It allows companies and investors to get an accurate picture compared to the traditional cost of capital. Furthermore, it helps investors and analysts use the market value of debt to evaluate forecasts for funding and financial growth. By doing so, they can get a better picture of a company’s operations.
The market value of debt also allows companies to rely on market values when seeking finance. This way, they can make more informed decisions due to their reliability. For lenders, this value is also crucial. Since it does not represent the book value of debt, it can be more critical in determining a borrower’s actual debt value.
The market value of debt can also help analysts reach a better net worth value for companies and businesses. This amount is also crucial in various other calculations. For example, the enterprise value formula requires investors to calculate the market value of debt first. Overall, this metric paints a better picture of a company’s debt position.
Conclusion
Debt represents any obligations that companies accumulate toward third parties. Usually, it is a part of a company’s balance sheet evaluated through its book value. The market value of debt represents the amount investors will be willing to pay to acquire a company’s debt. It presents a better picture of a company’s debt position and is of significant importance.
