Debt$-$to$-$Equity Market Value ratio is the ratio of Long$-$term Debt over the Market Value of the company.

This is another measure of a company's financial structure resilience to shocks, as defined by the amount of long$-$term debt ratio to the value which the market attributes to the equity capital of the company.

The calculation is as follows:

Debt$-$to$-$Equity Market Value Ratio $=$

$($Long$-$term Creditors $+$ Short$-$term Creditors $+$ Subordinated Loans $+$ Insurance Funds$)/$ Market

Capitalization

Observe that, as we discussed in our class notes:

Equity fair value critically depends on expected level of earnings, equity book value and earnings volatility.

The above holds because the firms always have an option to default on equity holders and liquidate assets.

Meanwhile, research shows that debt value increases when earnings become more volatile in the proximity of default.

The rationale for this is that increased earnings volatility allows firms to use 'good' periods of earnings to refinance debt at lower interest rates, raising price of debt.

Considering the concept of Debt$-$to$-$

Equity MV Ratio above, suppose we

have three companies:

All have total capital at $$1$ billion

Company A

Company B

Company C

Long$-$term Senior Creditors

$$500$ million

$$500$ million

$$200$ million

All three companies have identical Debt$-$to$-$Equity MV Ratios.

All three companies experience identical shocks to their revenues putting pressure on companies to liquidate.

Part $($a$)$:

Based solely on the above differences in companies debt structure, which company would you expect to have the highest probability $/$ likelihood of liquidation?

Which company has the lowest probability of liquidation?

Explain your reasoning.

liquidation.

Part $($b$)$:

Now, consider current environment of high and stable interest rates.

Does this environment change your analysis in $($a$)$ above?

Explain your reasoning.$|$