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

Empirical research typically relies on book rather than market value of debt though theory is virtually always in terms of market values. This paper documents how book value measurements of debt distort debt-equity ratios and cost of capital calculations. We focus on three key issues First, mismeasurement can influence cross-sectional studies of capital structure, though the errors introduced may not be important because the cross-sectional correlation is very high each month between book and market-based measures. Second, mismeasurement can influence time-series studies of capital structure; this influence can be quite important. Third, mismeasurement can importantly influence calculations of cost of capital.