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How to Conduct Debt Valuation in a Proper Way

Posted by AM Corporate Services Pte. Ltd. 11. 17. 2017

dept valuation

We are currently working on a series of posts related to Business Valuation. In this particular article, we will be discussing debt valuation.

Besides equity financing, business owners may seek to use debt as another source of funds. Debt instruments may be comprised of the following features: 

  • the amount to be paid after a certain due date,
  • any interim payments,
  • scenarios when the debt can be recalled back by the issuer,
  • the convertibility of debt to equity, if the debt can be converted into equity, and other contractual terms, if any.

Some typical small businesses financing methods include bank loans, trade credits, factoring or overdraft agreements, etc. Besides approaching finance firms, other forms of debt instruments include bonds, debentures, certain preference shares and convertible bonds, to name just a few. The following will describe some of these debt instruments.

1. Irredeemable debt

As an example, we can take a look at perpetual bonds, which are fixed income securities with no maturity dates. The issuer companies pay a constant stream of interest payments regularly. The debt is not repaid over their lifetime.  

 

The valuation formula for irredeemable debt without tax is as follows:  Po= iKd

 

And for irredeemable debt with taxes:

 

Po= i(1-T)Kd

 

Legend:

P0 = ex-dividend market value of the debt or share

i = annual interest beginning in one year’s time

Kd = firm’s cost of debt

T = Tax rate

2. Redeemable debt 

Redeemable debts are paid back to the lenders after a certain period has passed. As an example, we can view plain corporate bonds in the bond market. The value of a bond is the sum of all present values of all receipts, including coupon payments and the par value amount at the maturity date. Presented in a formula, the price of a bond is as follows:


Bond Price= C(1+i)+C(1+i)2+C(1+i)3+…+C(1+i)n+M(1+i)n

 

Legend:

C = coupon payment

n = number of payments

i = interest rate, or required yield

M = value at maturity, or par value

3. Redeemable debt 

Redeemable debts are paid back to the lenders after a certain period has passed. As an example, we can view plain corporate bonds in the bond market. The value of a bond is the sum of all present values of all receipts, including coupon payments and the par value amount at the maturity date. Presented in a formula, the price of a bond is as follows:


Bond Price= C(1+i)+C(1+i)2+C(1+i)3+…+C(1+i)n+M(1+i)n

 

Legend:

C = coupon payment

n = number of payments

i = interest rate, or required yield

M = value at maturity, or par value 

4. Convertible bonds

A convertible bond gives the bondholder the option to exchange the bond for an agreed number of shares in the firm at a predetermined ratio (conversion ratio). It has elements that encompass both fixed security and equity.

When valuing a basic convertible bond, it is best to consider the following scenarios.

  1. If the share price of the issuer is lower than the conversion price of the bond then the bond is unlikely to be converted. The valuation of the bond will be calculated using the bond pricing formula as presented in items 1 or 2 (above).
  2. If the share price of the issuer is higher than the conversion price of the bond, there is a high chance that those bonds will be converted to shares. The value of the bond will be calculated using the following formula:

Po=share price x conversion ratio

In addition, it may also include call or put features and other complexities such as scenarios where the conversion proceeds are given as new shares (which causes a dilution in shares), or if the proceeds are given in both shares and cash. All these will impact the value of the security.

Conclusion

As the impact on choosing incorrect valuation methods can weigh heavy on the company, it is advisable to seek advice from experts. You should look for professional firms who will be able to help you with all business valuation related matters.


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Topics: Business Valuation