Book Value Adjustment for Bonds
(CFA Video) Book Value Adjustment for Bonds Exercise
Question:
ABC Inc. issued 1000 bonds with par value each equals $1000. The coupon rate was 5% and the market rate was 5%. The bonds still have 2 years to maturity. Today, the yield spread of the bond to treasury yield increases from 2% to 3%. How should an analyst adjust the book value and shareholders’ equity to reflect this change? (assume the treasury yield is 3%)
Answer:
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Book Value is calculated using the market rate at issuance. It has nothing to do with the current market rate.
If the coupon rate equals the market rate at issuance, then the book value is just at its par value.
So
the book value does not change overtime
But
as an analyst, we want to see how the current market rate affects the financial
ability of the company
Rate increases, bond value will decrease. The company will be able to repurchase some of the outstanding bonds
Find
the Fair Value of the bonds
N=2,
I/Y=3+3=6%, FV=1M, PMT=50K
PV=982k
So the liability has to be reduced by 18k and the share holders’ equity increased by 18k
Very Good Description about the Changing rates on the balance sheet and Financial statements
thanks and regards
Yes this is a good explanation.
The equity section increased by 18K is quite misleading. The rate increased can only benefit the company IF the company can reinvest the borrwoed money to higher rate instructment. If the company do nothing, the equity should not be affected at all.
I understand the equity increasing by 18k. But I don’t understand why equity should also increase. I mean, what account in shareholder’s equity will increase and why?