The market value of debt, market versus book value of debt, and returns to assets

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Finance, Real Estate, and Business Law


This paper measures the market value of long-term debt and assesses how using book values of debt as proxies for market values can have serious effects in empirical work. Market values of debt are estimated from the Lehman Brothers Fixed Income Data Base, which has become available only recently. This database contains dealer quotes for end-of-month bid prices, and generally these quotes are of acceptable quality. In a significant number of cases, we have quotes on 90% or more of a firm's outstanding debt issues. The role of debt in corporate decisions and performance is a major concern for firm management, investors, and financial scholars. Estimates of debt are used to answer important questions on the optimal capital structure for a firm, what determines the actual capital structures observed, and what the firm's overall cost of capital is, a measure that is typically backed out by using data on firm capital structure. Despite the substantial interest in such issues, empirical research usually relies on book rather than market value of debt. This reliance arises primarily because of the difficulty of obtaining quality estimates of the market value of firm debt. Because of this difficulty, there has been little work on the nature, extent, and seriousness of the errors introduced by using book rather than market value of debt. This paper begins to close the gap left by empirical studies and allows investors and corporate decision makers to make sensible assessments of the data to apply the book value of debt. Book values sometimes seriously mismeasure market values of debt; not surprisingly, this mismeasurement is associated with changes in bond-market yields. We focus on three key empirical issues to explore how the use of book values of debt affects empirical results. First, mismeasurement can influence cross-sectional studies of capital structure, though we find evidence that the errors introduced may not be important. Second, mismeasurement can influence time series studies of capital structure: this influence can be quite important. Third, calculation of a firm's overall cost of capital requires estimates of the value of debt: we find that mismeasurement can have important effects on these estimates. We show how some empirical results are sensitive to using market values of bonds, but others are not, depending on the time period and questions considered. As an example, we compare estimates of capital structure that use hook versus market values of debt over the period 1978-1991. We present two estimates of aggregate debt-to-value ratios for large firms that on average issue investment-grade debt. One estimate uses our measure of market value of debt, the other book value; both use market values of equity. We also provide summary statistics that describe the behavior of capital structure over time for 15 industries. In the early part of our study period, estimated long-term-debt-to-value ratios based on book and market values of longterm debt diverge substantially. as expected, differences in book and market capital structure are associated with changes in the level of interest rates. In studies that explain capital structure differences across firms at a point in time, use of book rather than market value of debt introduces measurement error, but the associated problems may not be severe. Across 15 industries, correlating debt-to-value ratios using book and market values for bonds is almost perfect at any point in time. However, work with data across industries and time simultaneously can contain substantial measurement error, because the time variation of the book value of debt often deviates substantially from the time variation of the market value of debt. Deviations of the two measures arise in major part because changes in yields affect the market value of debt. The risk of equity or debt depends on the mixture of the two used in financing a firm's assets. In this sense, the risk is likely to be important in understanding the combined risk the firm faces, rather than looking separatory at its debt and equity. For example, the expected rate of return and volatility of a firm's assets are more likely to be time-constant than those of either equity or debt alone, because equity and debt's expected rates of return and volatilities vary not only with those of the firm's assets, but also with changes in the firm's debt-to-value ratio. Further, the majority of studies that consider equities and bonds together use book rather than market values of bonds, another possible source of error. One illustration of these problems involves estimated costs of capital for 15 industries, found in a CAPM-based approach using estimated market-model betas. Differences in results across estimation methods can be large. In practice, bond prices are often not available. Bond betas are guessed rather than estimated, which can lead to even greater discrepancies. If the capital structure changes a lot over time, it is probably better to first estimate the firm's overall cost of capital rather than starting with separate estimates of equity and debt cost of capital.

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