3. Suppose that a firm has both fixed-rate and floating-rate debt outs

QUESTION

3. Suppose that a firm has both fixed-rate and floating-rate debt outstanding. What effect will an unexpected decline in interest rates have on the firms times-interest-earned ratio (EBIT/interest paid)? What about the ratio of the market value of debt to that of equity? Would you judge that levera¦
Decline in interest rates will have different effect on fixed and floating debt. It will increase the market value of fixed-rate debt and decrease the interest payments of floating-rate one. The result is a rise in EBIT/interest paid because EBIT does not depend on interest and we pay lower interest because of having some liabilities in a form of floating-rate debt. Market value of debt to that of equity does not necessarily rise because stock prices go up too as a result of unexpected¦

line in interest rates. In fact market debt/equity ratio is more likely to fall, because stocks are usually more sensitive to interest rates moves than bonds (they have longer duration). It is hard to tell what happens with the leverage, if we measure it in book values it stays the same and in market values it is probably lower.

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