CMA Study Group

Balance sheet disadvantage

  • 1.  Balance sheet disadvantage

    Posted 07-26-2021 02:09 PM

    I need an example to understand the bold lines:

    Most liabilities are valued at the present value
     of cash flows discounted at the rate that was current when the liability was incurred, not at the present value of cash flows discounted at the current market interest rate. (I know this, this is not an issue)

    If market interest rates increase, a liability with a fixed interest rate that is below the market rate increases in its value to the company.
    If market rates decrease, a liability with a fixed interest rate that is higher than the market interest rate sustains a loss in value.


    Please explain me how? According my understanding:

    If current market interest rate is 8% and the company has issued its debt at 6% historically; firm is paying less to its debt holders and this is benefit to the company.
    If current market interest rate is 8% and the company has issued its debt at 9% historically, company is paying more than the interest rate in the market and thus is a loss to the company.

    Please let me know is my understanding right or wrong?



    ------------------------------
    Nupur Mahajan
    nupur1188@...
    Hartford CT United States
    ------------------------------


  • 2.  RE: Balance sheet disadvantage

    Posted 07-27-2021 03:15 AM
    If the Market rate is high as 8% and your company is offering a lower interest rate of 6% than nobody will buy your Company's Bonds due to less offered as an interest. So you are not paying less interest you are selling your company's bonds and thus at a loss. Eg you might have to offer a $100 bond at a lower rate $93 or $95. Hope that helps

    ------------------------------
    Parikshit Alagh
    Consultant
    KPMG
    New Delhi
    India
    ------------------------------



  • 3.  RE: Balance sheet disadvantage

    Posted 07-27-2021 01:42 PM
    Hello Nupur,

    Your understanding is correct but just a small tweak. You need to see the situation once you have issued the debt and then the market rate fluctuates ( increases or decreases). Currently you are seeing from perspective of " at the time of debt issuance only".

    if market interest rates increase, a liability with a fixed interest rate that is below the market rate increases in its value to the company.

    Example: If at the time of issuance of debt, you issue at fixed interest rate 6% and Market rate is 5% ( you are at loss now). Subsequently once you issue the debt, if the market rate becomes 8%, then Fixed interest rate is lower than market rate of 8%, thus increases in its value to the company.

    If market rates decrease, a liability with a fixed interest rate that is higher than the market interest rate sustains a loss in value.

    Example: If at the time of issuance of debt, you issue at fixed interest rate 6% and Market rate is 7%. Subsequently once you issue the debt, if the market rate becomes 5%, then Fixed interest rate is higher than market rate of 5%, thus sustains a loss in value.


    Basically interest rates would keep fluctuating even after fixed rate debt issuance. Depending on the interest rate direction ( Increase or decrease), it will increase in its value to the company or sustain a loss in value.

    Hope this helps.

    ------------------------------
    Kiran Kulkarni
    BENGALURU
    India
    ------------------------------