Question

17. On December 31st 2005, the book value of Luther Corp’s equity is $63.6 million and debt is $205.8 million. On December 31st 2006, book value of equity is $126.6 million and book value of debt is $290.1 million. Additionally on Dec 31st, 2006 Luther Corp had 10.2 million shares outstanding and these shares are trading at $16 per share. Further on Dec 31st, 2005 the company had 8 million shares outstanding and they were trading at $15 per share. Using this data, answer the questions below.

    1. What is Luther's market-to-book ratio on Dec 31st, 2005? What is this ratio on Dec 31st, 2006? What potentially reasons can explain the change in this ratio for Luther Corp?

    2. When using the book value of equity, what is the debt ratio for Luther on Dec 31st, 2006? Using the market value of equity, what is the debt ratio?

    3. What are the reasons to calculate debt ratios based on both book value and market value of equity when evaluating a firm’s solvency?

Answer 1

1. What is Luther's market-to-book ratio on Dec 31st, 2005? Market to Book ratio = MV of Equity/ BV of Equity = ( 8 million *   $15 per share) / ( $63.6 million) = 1.886= 1.89

2. What is this ratio on Dec 31st, 2006? Market to Book ratio = (10.2 million shares outstanding*  $16 per share)/ ( $126.6 million) = 1.289 = 1.29

3. What potentially reasons can explain the change in this ratio for Luther Corp? The reason for change in ratio is the mainly due to increase in number of outstanding shares and increase in BV per equity from 2005 to 2006 which is much more than the increase in shares.

4. When using the book value of equity, what is the debt ratio for Luther on Dec 31st, 2006? Debt ratio = (BV of Debt)/[ ( BV of debt) + BV of Equity)] =  ($290.1 million)/ (290.1 M +  $126.6 million) = 0.696= 0.70

5. Using the market value of equity, what is the debt ratio? Debt ratio = ($290.1 million)/ (290.1 M + (10.2*16)] = 0.64

6. What are the reasons to calculate debt ratios based on both book value and market value of equity when evaluating a firm’s solvency? While Debt ratios are calculated on the balance sheet equity ie Book value, the actual value of equity is the market value since the equity is traded. The two ratios can differ widely as market price can significantly differ from the price on the books and thus can lead to under or overvaluation of the ratios if only the book values are considered.