Market Value of Debt Explained

Of all the tasks involved in the management of a company, one of the most important ones is ensuring capital allocation to run the business. For a public limited company, listed on the stock exchange, the issue of capital allocation and the accounting job related to it can be quite complex. Analyzing the current financial condition of the company and assessing its performance involves the calculation of many financial parameters. One of these parameters is the calculation of market value of debt of a company. It is an essential parameter in the calculation of the WACC (Weighted Average Cost of Capital).

To raise capital, a business needs loans and investments from external sources. This loan may be raised in various ways, including an IPO (initial public offering) and bank loans. All these different types of debt need to be analyzed in terms of current market value, to get a financial health report of the company and to calculate the WACC.

Definition

The weighted average cost of capital is a measure of returns that a company must generate, to be able to pay back to its creditors. It also provides an estimate of how much of new capital could a company be able to raise. A debt is an amount of money that a company must pay back, at a certain interest rate and in a specific time frame.

Since interest is a function of time and market conditions, the debt estimate should be calculated according to current market rates. The debt may involve securities like bond and stocks, as well as bank debt, whose value is dependent on market conditions. Thus market value is the valuation of debt, in terms of current market rates and interest rates.

Formula

As discussed before, company debt has many components and hence the evaluation of market valueinvolves the addition of all these different component debts. Here is the formula:

Total Market Value of Debt = [(Debt Market Value in Securities) + (Book Debt in Bank Loans)]

Using the above formula, one can calculate total market value of a company.

Calculation

It goes without saying that to be able to calculate the value, one needs to have actual financial data about the value of debt, which exists in the form of market securities like stocks and bonds with company investors. By knowing the exact number of stocks and bonds with investors and multiplying them with current stock market or bond market value, you can get an estimate of the value, in securities. This is just like calculation of market value of equity.

This information may be available in the financial reports declared by a company to investors. To make complete calculation possible, you need an estimate of the book debt that exists in the form of bank loans. This second piece of information about book debt is difficult to get hold of as it is rarely shared publicly. Then the total value of debt can be calculated by adding up all the component parts together, using the above formula.

As discussed previously, it is difficult to get an estimate of the book debt of a company, unless you have access to the detailed balance sheets of company affairs, for previous financial years. The market value of debt in terms of stocks and bonds itself is sufficient to give you an idea of the overall debt. To calculate the WACC however, knowledge of all the types of debt that a company has taken is essential.