Market Value of Debt
The amount investors would be willing to pay to purchase a company's debt
What is The Market Value of Debt?
The Market Value of Debt is essentially the amount investors would be willing to pay to buy a company's debt. To put it simply, it's the value assigned to the debt a company owes. This is different from the book value of debt, which is the amount of debt reported on the company's balance sheets.
Now, it's important to note that a company's debt isn't just about publicly traded bonds with a fixed market value. Many companies also have non-traded debt, like bank loans, that aren't as straightforward to assess.
Since these debts are recorded in financial statements at their book value (or accounting value), analysts need to figure out their market value. The overall value of a company is significantly influenced by its market value of debt.
The market value of debt is a more accurate representation of a company's financial position as it includes cash and debt compared to the book value of debt. The market value of debt has a ton of factors deciding its value, such as company cash flows, assets under holdings, interest rates, etc.
Key Takeaways
- Market Value of Debt represents the amount investors would pay to acquire a company's debt, providing a more accurate picture of a company's financial position compared to book value.
- Market value of debt is crucial in calculating a company's enterprise value (EV), calculated as market cap + debt - cash (& equivalents).
- Analysts utilize enterprise value to identify arbitrage opportunities and conduct fundamental analysis, supporting the decision-making process.
- Market value of debt plays a role in calculating the weighted average cost of capital (WACC), an essential metric for estimating investment returns by considering both debt and equity costs.
formula for Market Value of Debt
To determine the market value of debt, one must consider the total debt reported on a company's books to be a single coupon bond, with the coupon equal to interest expense. And considering the maturity of the total debt to be the weighted average of every individual debt.
We use the equation:
Market Value of Debt = C x [ { 1 - 1/(1 + Kd)t } / Kd ] + [ FV / (1 + Kd)t ]
Where,
- C = Interest expense in USD
- Kd = Cost of debt in percentages
- T = Weighted average maturity in X number of years
- FV = Total or Net debt
From the formula, we can deduce that, all else being equal:
- Market value of debt is directly related to interest expense. Therefore, if interest expense increases, the market value of debt increases as well.
- If the book value of debt increases in value, the market value of debt will also increase.
- Weighted average maturity is an essential factor in determining the market value of debt.
We can use the market value of debt to calculate a company's enterprise value (EV), which can be further used to calculate multiple ratios, for example, EV/EBITDA. Analysts use such ratios to screen equities.
Cash and cash equivalents are subtracted from the market value of the debt to derive the EV of the corresponding firm, which refers to the net value of a company.
EV = MC + Debt - Cash (& equivalents)
- EV = Enterprise Value
- MC = Market Cap
The enterprise value of a company is compared to the calculated value of a firm to find arbitrage opportunities.
The calculated/analyzed value is the intrinsic value of a firm that analysts derive using several models, like discounted cash flow models, to arrive at a company's value. These models come under fundamental analysis techniques.
Example of Calculation Of Market Value Of Debt
Let us consider company A with a total debt of 1 Million USD with a weighted average maturity of 10 years. Given that the company's interest expense is 100,000 USD and the current cost of debt is 5%, what would its market value of debt be?
So, given that:
- FV = 1,000,000 USD
- t = 10 Years
- C = 100,000 USD
- Kd = 5% (0.05)
Substituting the above equation, we get:
Market Value of Debt = 100,000 x [ {1 - 1 / (1 + 0.05)10 } / 0.05] + [1,000,000 / (1 + 0.05)10]
= 1,386,086.74 USD
Let us further expand on the example where the individual debts are given,
Let's say:
Bank's loan = 500,000 USD for 8 Years
And other debt = 500,000 USD for 12 Years
Therefore,
Total Debt = 500,000 + 500,000 = 1,000,000 USD
The weighted average is the average weighted according to other data points, similar to taking an average but corresponding to another related quantity.
In this case,
Weighted Average Maturity (in Years) = { [500,000*8 + 500,000*12] / 1,000,000 } = 10 Years
This market value of debt(1,386,086 USD) can be used to calculate the EV of company A by adding it to cash and cash equivalents.
Market Value of Debt In WACC
Analysts and investors use the weighted average cost of capital, or WACC, to estimate potential investment returns. For example, the value of debt and equity, which businesses use to finance expansion, may be calculated using the cost of capital, which is an effective approach.
To calculate how much a corporation will cost to borrow money, the WACC, or cost of capital, considers debt and equity. However, because interest costs are tax deductible, the cost of debt is often less expensive than the cost of equity.
The interest expenditure the firm pays on its common bonds or loans borrowed from a bank is accounted for in the debt element of the WACC, which measures the cost of capital for company-issued debt.
The formula for calculating the market value of debt for WACC:
Debt = D / ( MC + D ) * Cost of debt * ( 1 – TR )
Where;
MC = Market cap of equity
D = Long-term debt
TR = Tax rate
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