Question 2: Debt-to-Equity Market Value, is the Long-term Debt over the Market Value of the company. This is another measure of a company's financial structure, as defined by the amount of longterm 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 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 volaitlity 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 Long-term Creditors Short-term Creditors Subordinated Loans Insurance Funds Market Cap Company A $500 million $300 million $200 million $0 $2 billion Company B $500 million $200 million $300 million $0 $2 billion Company C $200 million $300 million $500 million $0 $2 billion All three companies have identical Debt-to-Equity MV Ratios. All three companies experience identical shocks to their revenues. Part (b): Now, consider current environment of rapidly rising interest rates. Does this environment change your analysis in (a) above? Explain.