More Advanced Accounting: Market Value of Debt

Welcome to our second lesson in this module on More Advanced Accounting concepts. We are
going to be discussing the market value of debt here, going over this, and then, explaining at
the end why it matters. This is one of those concepts where you sort of need to see the
demonstration in Excel before we can get into the significance of it. So, we'll start out with the
basic concept. I will go through the Excel setup and calculations, and then at the end, we'll go
through why this matters. Even though it doesn't directly impact the financial statements, it will
end up mattering in some contexts. And that's what we'll get to at the end of this lesson and
into the next lesson.

The idea here is that equity has both a book value – what appears in the balance sheet, so
common shareholders' equity – and then a market value, in other words, the common shares
outstanding times the share price. And you saw this in Module 2. Here, for example, we said
that in some of these interview questions scenarios, the company's common shareholders'
equity was $1,000. And then if we go up to the top, we can take the share price and multiply by
the shares outstanding.

[01:02]

And in this case, it's actually still the same $1,000, but that's highly unusual. Normally, it's very
different. So, for example, if the share price were $10, then the market value of equity would
be $10,000 instead. So, there is a very big difference between the market value of equity and
the book value of equity in most cases, and you can calculate it with the share price times
shares outstanding for market value, or by looking at the balance sheet and getting the
common shareholders' equity number for the book value.

The same principle applies to debt, but the differences here tend to be a lot smaller. The
reason why there's a difference with debt is that the market value or the price of debt is
based on the present value of its expected future cash flows to the investors in the debt. So,
you have to look at its future interest payments and the eventual principal repayment upon
maturity, as well as any earlier principal repayments in the holding period. What this means
is that if anything that affects the present value changes, such as the discount rate or the
expected future cash flows, then the market value of debt will change.

[02:05]

So, looking at our scenario over here, we're going to take the future interest payments and the
future principal repayments, and then we're also going to look at the prevailing yields on similar

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debt in the market, in other words, the discount rate, as well as the company's repayment
probability, to calculate this.

The most common scenario here is that the discount rate, the prevailing yields on other,
similar debt issuances, changes or the company's credit quality changes and maybe now,
there's only a 95% probability that it will repay debt rather than 100% probability. And if
you're dealing with a distressed company, maybe this drops to a 50% probability or 30%
probability or something else much lower.

Let's go into the Excel setup and calculations now. You can calculate the market value of debt in
two ways. You can either do it manually with the NPV function in Excel or with the PRICE
function, which we covered in the Excel course. To do any of this, you're going to need a
discount rate, which is what the prevailing yields on similar debt in the market is for. And then a
repayment probability, which is what the redemption line item here is for.

[03:07]

Let's go in and do the manual setup first, and then I'll show you how to calculate this using the
PRICE function instead. For the manual setup, we need the present value of these two items.
So, for the future interest payments, let's link to what we have down here for the interest
expense, copy of this across. And then for the future principal repayments, we'll link to our
number right here, and then we will copy this across.

For now, I'm going to change this back to Year 5 for the full debt repayment, just so we have
the full series of cash flows. We can sum up our cash flows like this. One other thing we have to
do here, the future interest payments are fine, but the future principal repayments, if you think
about it, we need to factor in the company's credit quality because if the company goes
bankrupt or it somehow can't repay its debt because it runs out of cash or it can issue new debt
or something like that, then there's a chance that we may not get our full principal back at the
end.

[04:02]

So, I'm going to say that the redemption value or the repayment probability is 100 for now. I'll
say that the prevailing yields on similar debt in the market are 5%, which exactly matches this
bond's coupon rate, which is also its yield right now, 5%. And then we can multiply by this
redemption value or repayment probability. This is not a percentage. This is just a flat 100
number because that's how Excel wants the input in the PRICE function. So, to make it into a
percentage, we can take this anchor it and divide by 100. And now we have that. To test it, let's

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try changing this to 90, and we can see that our future principal payments or payments there
go down to $90.

Now, to calculate this manually, we'll use the NPV function. For the rate, we want the prevailing
yields on similar debt, in other words, the discount rate. And then we'll take all of our interest
payments right here, and then we'll do the same thing for the principal repayments. Remember
that the NPV function does not calculate the net present value, it calculates the present value,
which is very confusing, but Microsoft is never going to fix it. So, get used to that.

[05:07]

We'll take the 5% here and then we'll get the future principal repayments down here, and
then we'll add these up. And so, the market value of debt, according to our calculations right
now is $100. That matches exactly the $100 face value right here, because there is a 100%
repayment probability. Also, the interest, the coupon rate on the debt that we are paying to
investors, the 5%, is the same as the rate on similar debt issuance in the market of 5%.

Now, to do this with a PRICE function, you can see some of my notes over here. We have to
enter the settlement date, the maturity date, the coupon rate, prevailing yields on similar
bonds, the amount received back at the end out of 100, and then 1, 2, or 4 for annual,
semiannual, or quarterly interest payments. Let's start entering, I'll say equals price. The
settlement date will just be the December 31st, 2020 that have been put at the top.

[06:03]

For the maturity date, remember we have a variable date here, so we need to use an INDEX
and MATCH function or similar approach to get this. I will type name INDEX and we'll index this
whole area up at the top. For the row number, I'll say 2, for the column number, I will save
MATCH. And then I'll put the year number right here and then I'll use this lookup array and then
I'll say 0 for the match type. So, we have all that.

For the rate, this refers to the coupon rate on the bond or the debt that we're analyzing. So,
we'll take the 5% here and then the yield, the "YLD" there refers to the discount rate. So, we
want the 5%. The redemption, we can just link to the 100 right here. And then for the
frequency, I'll just say 2 for semi-annual. It doesn't really make much of a difference in this case.
We have that. And so, the market value of debt here is also $100, according to the PRICE
function.

[06:57]

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Now, if we start changing some of these, you'll see immediately how the market value of
debt changes. For example, if I put the discount rate at 6% instead, instantly, this debt is
worth less. Why? Because we could go out to the market and we could instead invest in a
bond that is paying 6% rather than only 5%. Therefore, our bond has to be worth less.

On the other hand, if I change it to 4% now, our bond is worth more because everything else
out there in the market is less attractive. It pays less than the 5%. It pays only 4%, so the
market value of our debt has gone up.

The same applies for the credit quality. If a company's repayment probability, the redemption
value, goes down to, say, 95, the market value of the debt decreases. It goes down to $96.1
now. Yes, we'll still probably get the interest payments, but we have a lower chance of
getting the full repayment at the end. Obviously, the repayment probability cannot go above
100, but in theory, if you put this at 104, for example, yes, you would get something like this
where the market value of debt goes even higher. But in reality, normally, 100 is the
maximum value for this one.

[08:05]

Another observation here is that if their maturity or repayment is further into the future, you're
going to see more of a change in the market value here. For example, if we put the prevailing
yields at 6%, let's say, and we're in Year 5 for the debt repayment now, if we change this to Year
3, we see a much smaller difference. The market value of the debt is now $97, rather than
$100. But it doesn't go down to $95 or $96. And if we change it again to Year 1, now the market
value is only about $99, rather than $97 or 96 or $95 before.

So, you're going to see more of a difference when the maturity of the debt or the full
payment of the debt happens further into the future here. And that's related to the time
value of money. Let's just change this back to the 5% and 100 for now.

[08:53]

At this point, you might be wondering why all this matters. And the short answer is that the
market value of the debt makes no direct impact on the financial statements. Companies don't
record it anywhere. It doesn't affect what's shown on the balance sheet, and it doesn't affect
the amount the company pays interest on, the face value of the debt.

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Companies often list the market value in their filings, but they're not going to list it directly in
the statements. So, really this concept matters mostly for analysis and valuation of bonds,
which we'll cover later in this course.

In this module, though, this concept matters for one reason, which is that a company might
issue debt at a discount or premium to its face value, all because of these issues with the
coupon rate versus the yields or the company's credit quality. In other words, a company
could go out and say, we have a bond with a $100 face value, but we're going to let you buy it
for only $90 or only $95 or something like that. And so, right when the bond is issued,
investors could pay a different amount for it than what the company is actually paying
interest on. And that is the significance of this. When that happens, it is called original issue
discount or original issue premium, OID or OIP.

[10:00]

And it matters because once again, it requires some special accounting treatment. We'll need
to create a new amortization line item and possibly another new line item, depending on the
terms of the debt. And so, we'll get into that in the next lesson.

So, really, all this lesson was setup for the next one, where we go into what happens when
immediately upon issuance, the market value of the debt is very different. And so, investors can
buy it directly from the company at something different from the debts face value of $100 here.

That's it for this lesson. So, let's do a recap and summary. Just like equity can have a very
different book value and market value, debt can also have a very different book value and
market value. The market value of debt is based on the present value of its expected future
cash flows, so its future interest payments and eventual principal repayment upon maturity.

Usually, the market value of debt changes when the discount rate when prevailing yields on
similar debt issuances change, or when the company's credit quality changes. You can calculate
this in a couple of different ways in Excel. You can use the built-in PRICE function, which works
well, but you need quite a few input parameters.

[11:03]

If you have more of a 3-statement model, you could just link in the future interest payments as
we did, the future of principal repayments, and remember to multiply by the repayment
probability, or the redemption value divided by 100 here. And then you could just take the NPV
function, apply it to both these with your discount rate and get to the market value of debt like

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that. These items tend to make more of a difference with maturity further into the future and
less of a difference when maturity is closer to the present day. And as I said, at the end, this
point matters mostly because companies could issue debt at a discount or premium to the
debt's face value. And that's going to create some accounting differences that we'll cover in the
next lesson.

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