Question

A firm has current assets that could be sold for their book value of $32 million. The book value of its fixed assets is $70 million, but they could be sold for $100 million today. The firm has total debt with a book value of $50 million, but interest rate declines have caused the market value of the debt to increase to $60 million. What is the ratio of the market value of equity to its book value?

Answer 1

Answer:

Market value of equity / book value of equity   72/52 = 1.38

The company is a little overvalued.

It means that the assets they have because the rate is declining, have a higher yield than the market, that's why their market value increase, therefore the investor will pay more to acquire the company or shares of the company because their profits will be above the common of the industry.

Explanation:

concept                book value       market value          diference

current assets     32 millons          32 millons                        0

long term assets 70 millons         100 millons     +30,000,000

liabilities               50 millons         60 millons        -10,000,000

TOTALS           70+32  - 50= 52    32+100-60=72     +20,000,000

Market value of equity / book value of equity   72/52 = 1.38

This ratio tries to determinate if a company is being undervalued or overvalued.

It is usually good to help a third party at the task of  determinate whether or not a company's market value is suffering from speculation (when extremely overvalued)

When the ratio is below 1 It will mean that it is undervalued. The manager may interpret this that third parties see the company cheap while trading.

When it is above 1, it is overvalued, this means an investor will pay more for a portion of the company than it really has.  This can lead to thinking that forecast profit is rising and because of that the investors are paying a premium. But if it gets really high, then it is saying that the company is subject to speculation and the price bubble may explode anytime.