Question

Would the market-value debt ratio tend to be higher than the book-value debt ratio during a stock market boom or a recession? Explain.

Why would the WACC based on market values tend to be higher than the one based on book values if the stock price exceeded its book value?

Which would you expect to be more stable over time, a firm’s book-value or market-value capital structure? Explain.

Answer 1

1. Market debt Ratio is tend higher than the book value during a stock market recession.

Market debt ratio is a solvency ratio that measures the proportion of the book value of a company's debt to sum of the book of value of its debt and the market value of its equity.

Market debt ratio measures the level of debt of a company relative to the current market value.Market debt ratio on the other hand takes into account the market valuation of the company.

Formula of calculating Market Debt Ratio = Total Liabilities / Total Liabilities + Market value of equity.

Here market value of equity is depend of current price of the stock .

E.g. If Total Liabilities = 100000 and share outstanding = 10000

In Boom share price = 50 per share and in in recession share price = 20 and book value of share = 30   

Book value Debt Ratio = 100000/100000+10000 x 30 = 0.25 i.e. 25.00 %

So in Boom = Market Debt Ratio = 100000/100000+10000 x 50 = 0.1667 i.e. 16.67 %

In Recession = Market Debt Ratio = 100000/100000+10000 x 20 = 0.33 i.e. 33.00 %

So in above example we can see Market value debt ratio tend to be higher than book value debt ratio in stock market boom.

2. As due to Increase in Price of the stock = Higher the share of equity in market W.A.C.C. .

and cost of equity is non tax deductible , compare to Cost of Debt , so W.A.C.C. based on market value tend to be higher when stock price is more than Book value.

3. In my opinion , Book value capital structure is stable over time , because market value capital structure depend on variation in values of Stock and Market debt. But book value base capital structure has fixed value. So book value based capital structure will be stable over time compare to market base.