Question

2. Book debt ratio vs. Market debt ratio:

Book debt ratio Market debt ratio Debt ratio, % 2 1983 1980 1977 2001 1965 1968 1971 1974 1986 1989 1992 1995 1998 2004 2007 2010 2013 2016

(i) Based on the following chart, which represents book and market aggregate debt ratios for nonfinancial US firms from 1965 to 2017, it is obvious that, in aggregate, the market debt ratio has been consistently lower than the book debt ratio. What could possibly explain such pattern? (ii) Say that the data showed a different pattern, one where, in aggregate, the market debt ratio is consistently higher than the book debt ratio. What could possibly explain such pattern?

Answer 1

(i): The pattern of market debt ratio being consistently lower than the book ratio can be explained by the fact that during the given period the market value of equity of these non-financial US firms was higher than the book value of equity. It should be noted that market debt ratio = total liabilities/(total liabilities + market value of equity). Here the trend of market debt ratio being consistently lower than book debt ratio is due to the fact that the equity of these non-financial US firms are trading at a premium i.e. above its book value. As the market value > book value it means that the market is assigning a higher value to these companies due to the potential of their asset’s earnings power.

(ii): When the data is showing a different pattern in which the market debt ratio is consistently higher than the book debt ratio it is due to the fact that market value of equity of these firms is lower than its book value. This means that these non-financial companies are not trading at a premium and the market has lost confidence in these companies and the earnings potential of their assets. Here the market is of the belief that these companies is not worth the value on its books and the assets are not able to generate future profits and cash flows.