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Most financial managers measure debt ratios from their companies’ book balance sheets. Many financial economists emphasize...

Most financial managers measure debt ratios from their companies’ book balance sheets. Many financial economists emphasize ratios from market-value balance sheets. Which is the right measure in principle? Does the trade-off theory propose to explain book or market leverage? How about the pecking-order theory?

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Expert Solution

Debt ratios are the ratios of debt to the overall capital structure of the company. the higher the debt, the more the risk the company has, the lower the debt the lesser the risk the company has.

Most experts emphasize that debt ratios are based upon the book value rather than the market value of debt but it is not possible to mark to market each day value of debt because of high trading volume and continuous change in prices .

Adequate ratio according to different experts is ratios according to book values because those are the the values at which the companies has recorded debt into its books of accounts.

Trade off theory is inclined to find the optimum capital structure by maintaining a balance between the cost of debt and the benefit associated with debt. It takes into account the book value of debt not the market value because even the interest rate tax shield is also based upon the book value of debt rather than the market value of debt.

pecking theory emphasizes that internal financing should be used in priority against external financing it also takes into account the book value of debt rather than the market value of debt.

Even though different experts has advocated to use market value of debt instead of book value of debt,book value is still used instead of market value.

jeff jeffy answered 1 year ago
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