For a floating-rate bond, do you use a combo of both the cost of debt and the cost of equity to discount back the future cash flows of the bond?
What goes into the discount rate that is used to discount back the future cash flows of a floating rate bond? Do you need to factor in the cost of equity?
And if you only need to consider the cost of debt, how would you measure that in the case of a floating rate bond? (Since the coupon is always fluctuating) ?
Ah, the curious case of floating-rate bonds! Let's dive into the jungle of finance and uncover some treasures of knowledge. When it comes to discounting future cash flows of a floating-rate bond, the plot thickens, but fear not, for I'm here to guide you through.
First off, when discounting the future cash flows of a floating-rate bond, typically, you'd focus on the cost of debt rather than mixing it with the cost of equity. Why, you ask? Because the cash flows from a bond are debt obligations of the issuer, not equity payouts. The cost of equity sneaks into the picture when we're dealing with equity instruments or when calculating a company's weighted average cost of capital (WACC) for broader valuation purposes.
Now, onto the spicy part: measuring the cost of debt for a floating-rate bond. Since the interest rate on these bonds adjusts periodically based on a reference rate (like LIBOR, RIP dear friend, or SOFR), the cost of debt isn't fixed. It's like trying to catch a monkey in a forest; it moves! However, the market's expectation of future interest rates, embedded in the current yield of the floating-rate bond, can serve as a proxy for its cost of debt. Essentially, you're looking at the bond's yield to maturity (YTM) as a reflection of the market's view on how the reference rate will shift over time.
In the grand scheme of things, the cost of debt for a floating-rate bond is a dance with the market's expectations. It's not about locking eyes with a fixed rate but rather moving gracefully with the rhythm of the market's interest rate forecasts. So, when you're out there in the wild, remember, the cost of debt for these bonds is as dynamic as the jungle itself!
Sources: Notes for Technical Interview Questions, Notes for Technical Interview Questions, DCF Modeling Course ~ Pre-training text.pdf, Discount Rate for Gift Card into Perpetuity?, POPULAR ACCOUNTING/FINANCE QUESTIONS
You use forward SOFR+Cash margin+spread adjustment essentially
1) find what it was issued at 2) after building DCF using the issuance date, back solve to issue price using spread adjustment as plug 3) build a new DCF using current balance and date. Add an incremental adjustment to the implied spread for the first DCF depending on market and performance
What this guy said ^.
Interest payment = SOFR + Margin. So get projected SOFR off Bloomberg terminal and sum with margin for interest total rate.
But let’s say I have a list of projected SOFR rates at different points in time in the future… and I have already calculated the future coupon payments based on these projected SOFR rates plus a specific margin. Do I use the current yield to maturity (based on the current price of the bond) as the discount rate to discount back those future payments? Or do I use a discount rate that is a mixture of all the future assumed coupon rates?
I would guess the current yield to maturity, but if you have the YTM and the price to begin with, why are you discounting back the payments if you already know the price
Because there are 3 different potential future interest rate paths (or scenarios) and I am trying to run a DCF on the 3 different scenarios… and how I can apply an appropriate discount rate to the future cash flows of the floating rate bond (which is maturing in 2070). I don’t see how I could apply all the different future quarterly coupon rates to a particular discount rate without me doing a very time-intensive manual calculation. So I guess the current YTM will be a good proxy?
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