corporate issuers , CFA LEVEL1

Q1 — Bond prices move, so why is the value of debt treated as constant?

Two different “values” are being mixed up here.

Ye

Q1 — Bond prices move, so why is the value of debt treated as constant?

Two different “values” are being mixed up here.

Yes, a bond’s market price moves inversely with its yield. But in the capital structure framework, debt is treated as fixed for two reasons:

• The debtholder’s claim is contractual and capped. Coupons and principal don’t change with firm performance, so when operating value rises or falls, almost all of that change flows to equity — the residual claimant. That’s why in V = D + E, D stays broadly constant and E absorbs the swings.
• In MM we hold interest rates and business risk constant and vary only the debt-equity mix. Yield-driven price movement is deliberately assumed away, because it isn’t what’s being studied.

Separately, on the balance sheet debt is carried at amortised cost, so the reported figure doesn’t move with market yields at all.

Debt value does start moving with firm performance in distress, once default risk is real, the bond price falls and creditors begin bearing business risk. That’s precisely where MM’s assumptions break and costs of financial distress enter.

Q2 — Dividends are paid after interest, so why do creditors object?

Interest is only the current period’s claim. A creditor’s real protection is the cash and assets that remain inside the firm to service future coupons and repay principal.

A dividend is cash leaving permanently. After it’s paid:

• The asset cushion behind the debt is smaller — higher probability of default, lower recovery if it happens.
• Effective leverage rises, since the equity base shrinks while debt is unchanged.
• Creditors don’t share in any upside, so nothing compensates them for the added risk. The bond price falls, and wealth transfers from bondholders to shareholders.

Also, “profit after interest” isn’t cash. A firm can report profit and fund dividends from reserves or fresh borrowing — the extreme case being a debt-funded special dividend, which is a pure wealth transfer.

This is exactly why indentures carry restricted-payments covenants capping dividends and buybacks.

Q1 — Bond prices move, so why is the value of debt treated as constant?

Two different “values” are being mixed up here.

Ye

Q1 — Bond prices move, so why is the value of debt treated as constant?

Two different “values” are being mixed up here.

Yes, a bond’s market price moves inversely with its yield. But in the capital structure framework, debt is treated as fixed for two reasons:

• The debtholder’s claim is contractual and capped. Coupons and principal don’t change with firm performance, so when operating value rises or falls, almost all of that change flows to equity — the residual claimant. That’s why in V = D + E, D stays broadly constant and E absorbs the swings.
• In MM we hold interest rates and business risk constant and vary only the debt-equity mix. Yield-driven price movement is deliberately assumed away, because it isn’t what’s being studied.

Separately, on the balance sheet debt is carried at amortised cost, so the reported figure doesn’t move with market yields at all.

Debt value does start moving with firm performance in distress — once default risk is real, the bond price falls and creditors begin bearing business risk. That’s precisely where MM’s assumptions break and costs of financial distress enter.

Q2 — Dividends are paid after interest, so why do creditors object?

Interest is only the current period’s claim. A creditor’s real protection is the cash and assets that remain inside the firm to service future coupons and repay principal.

A dividend is cash leaving permanently. After it’s paid:

• The asset cushion behind the debt is smaller — higher probability of default, lower recovery if it happens.
• Effective leverage rises, since the equity base shrinks while debt is unchanged.
• Creditors don’t share in any upside, so nothing compensates them for the added risk. The bond price falls, and wealth transfers from bondholders to shareholders.

Also, “profit after interest” isn’t cash. A firm can report profit and fund dividends from reserves or fresh borrowing — the extreme case being a debt-funded special dividend, which is a pure wealth transfer.

This is exactly why indentures carry restricted-payments covenants capping dividends and buybacks.