Question

how does interest rate impact the valuation of debt vs equity securities. Is there an effect on one vs the other? Please explain.

Answer 1

If we are trying to value the debt and equity on the basis of future cash flows then higher interest rates would normally mean that the present value would be low. In the case of debts if there is higher interest rate applicable especially bonds then the present value of the bond would be low. The relationship between the interest rate the value of bond is inverse, if interest rates are higher the value would be low and if the interest rates are low then the value would be high. Similar to the debt if the interest rates are higher then the required rate on the equity would be high and the expected future cash flows would be discounted at a higher rate and the value of the equity would be low. So higher interest rates mean that the present value of the cash flows would be low but having said that high interest rates have different impact on the desirability of debt and equity. Interest rates are higher normally in terms of when the economy is booming and at that time debt instruments are less desirable and equity investment is more desirable.