For most companies, part of the cost of doing business includes carrying debt on the books. Borrowing money is a way for these companies to have the capital they need for funding new startups or expanding existing operations. But this debt is viewed differently on in-house balance sheets and open-market valuations. A company's market value of debt is calculated differently than the actual debt that its balance sheet may reflect.
Market Value of Debt
A company's debts can be loosely grouped into two categories: traded debt and nontraded debt. Nontraded debt, for example, may be a bank debt such as a loan, and traded debt may be represented by bonds. The portion of debt that's traded in the bond market has a specific market value, which can be described in market value terms and reported on a company's balance sheet. But a company's nontraded debt, described in book value terms, must be calculated.
Market Value Vs. Book Value
A company's market value of debt represents the price of its debt that market investors would be willing to purchase. This amount is different than the actual book value of its debt that is shown on the balance sheet. And the reason for the difference is that all of a company's debt is not publicly traded, such as bonds, so it's difficult to place a specific market value on a nontraded debt, such as a bank loan.
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Market Value Calculation of Debt
When estimating the market value of debt, financial analysts frame the amount of a company's total debt as representing a single coupon bond. This coupon equals the total debt's interest and the maturity equals the total debt's weighted average maturity. The representative coupon bond then becomes valued as the company's total current debt cost.
Market Value Calculation Formula
For calculating the market value of debt using the bond pricing method, the formula is:
C[(1 – (1/((1 + Kd)^t)))/Kd] + [FV/((1 + Kd)^t)]
In this equation,
- C = the interest expense in dollars
- Kd = the current cost of debt as a percentage
- t = the weighted average maturity in years
- FV = the total debt
Market Value Calculation Example
Using actual figures for a real-world example, assume:
- C (interest expense) = $25,000
- Kd (current cost of debt, expressed as a percentage) = 3.8 percent
- t (weighted average maturity) = 8.94 years
- FV (total debt) = $540,000
By plugging these numbers into the above equation from an example given by the Corporate Finance Institute, the company's calculated market value of debt is $573,441.15:
25,000[(1 – (1/((1 + .038)^8.94)))/.038] + [540,000/((1 + .038)^8.94)] = $573,427.15
Why Calculate Market Value Debt?
Calculating the market value of a firm's debt helps determine its cost of capital. The calculation is useful for estimating future projections for financing its growth and funding its ongoing operations. By crunching these numbers, the company hopefully won't come up short of financial expectations, and its budgeting will more closely align with actual market constraints instead of leaning too heavily on the strictly-by-the-books numbers. Calculating the market value of a company's debts helps the company make informed financial decisions instead of relying on sentiment.