The Importance of a Market Value Measurement of Debt in Leverage Ratios: Replication and Extensions

Abstract

A positive relationship has been shown to exist between firm capital structure (i.e., financial leverage) and systematic risk (e.g., Hamada [1972], Bowman [1979], and Hill and Stone [1980]). Empirical tests have supported this relationship (e.g., Beaver, Kettler, and Scholes [1970], Rosenberg and McKibben [1973], Thompson [1976], and Hill and Stone [1980]). However, as noted by Bowman, a disparity exists between the theoretical and empirical results; that is, theory is based on marketvalue of debt and leverage. With few exceptions, the empirical tests use book-value (accounting) measures [1980, p. 242]. Bowman [1980] examined whether the use of market improved the empirical association between systematic risk and financial leverage (debt-to-equity ratio).1 His results were surprising in that, contrary to expectations, the debt-to-equity ratio computed using book value of debt performed as well as the same ratio computed using market value of debt. An implication of this result is that it may not be necessary to incur the incremental costs of estimating market values of debt for purposes of determining associations between accounting and market of risk. The market rate of interest is an important determinant of the market value of debt. Depending on credit ratings, coupon rates, and maturity dates, small changes in the market yield can cause sizable fluctuations