Fair Value vs Book Value of Debt
Hi all,
Just a quick and simple question that has been boggling my mind recently. Most of the time when valuing a company using DCF or multiples I'd simply adjust the EV for book value of debt to arrive at the equity value just by assuming the book value would be a fair reflection of the fair value.
Let's say however the company is doing bad, and yields for similar debt instruments have gone up significantly and therefore I wanted to use the fair value measure of the debt.
In that case however, the fair value of my debt will be lower than the book value right. I am discounting with higher rates - lower value of cash flows as of today. Well a lower fair value of debt, which is a liability item, would not that simply make my equity value higher if I am subtracting it from the EV in order to arrive to equity value indirectly? All of a sudden the company is doing bad, fair value of the debt is lower but the equity value is higher.
Any thoughts?
No. You don't create equity value by debt trading off, debt still has to be paid at par before value can flow to equity. Just think about what you're saying: The equity of a company has become more valuable because the debt requires a greater yield due to the company's credit worthiness (market movements / RV aside) declining? No, just no.
And conversely, you'd never dream of using market values if debt was trading at a premium to par, would you?
I look at it two ways -- and it really depends what the purpose of the analysis is:
1) The company can create equity value by repurchasing the debt at market prices below par. The is part of the logic behind DVAs on bank balance sheets. Of course, to create that equity value you are trading liquidity, so for many distressed firms it's a purely theoretical (read: useless) calculation.
2) If I'm establishing EV from a restructuring analysis perspective I am looking at EV at each piece through the cap stack -- in other words, what is my EV assuming the secureds/unsecureds/equity is the fulcrum? So if the secureds are the fulcrum, I'm zeroing out everything below it, and if the unsecureds are the fulcrum, I'm zeroing out the equity.
Could you elaborate point 2? Because if I understood correctly even at that sitauation I'd take book value rather than fair value, because lower fair value would imply higher value allocated to those which are below in the cap structure.
When calculating your EV/ Net debt for equity value bridge/ weighted cost of debt, would you generally use their carrying value( as reported on the BS), or the principal.. I would think the total principal would be the more proper amount for bullet repayment items like bonds, but that total principal amount would differ from the carrying amount on BS, do to repurchases/ net financing costs?? Curious to hear your thoughts
Saw this on here and thought you would be the best equipped to answer.. When calculating EV, would you use the total principal of debt, or the carrying value( net of issuance costs).. Likewise when calculating your average interest rate for cost of debt, would you divide total interest expense for the year by the total carrying value of debt or the principal, given the amortization of issuance cost is deemed part of interest expense?? Also, would you use principal or carrying value of debt when unlevering and relevering betas?
True, and that was the confusion. So estimating a fair value of debt does not make sense if you wanted to calculate the equity value indirectly from EV.
My first instinct is to say that if the market value of a company's debt decreases because it's performing poorly, then market cap also has to decrease. But honestly this seems right to me, because your EV is going unchanged and you're decreasing something you're subtracting out from the EV value. Is there something else that would affect the EV if yield spread goes up?
Nevermind, oreos clarified it above.
No reason to adjust debt to market unless it's an asset, which won't have an impact on Debt-Equity ratios. Lots of other FS will be impacted if debt investments are marked up or down, but not the capital structure.
Yield doesn't matter because the company has already raised the capital. Yield is a reflection of the market so it is important from that perspective but, as far as pricing goes, the company is paying par value and that is how the interest and principal will be accounted for.
Different story if the transaction you're working on is a bond issue or has a debt component, because now the coupon rate will have to be in line with market expectations but, if you're only dealing with the capital structure, you don't need to worry about it before you get to that step.
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