Question

Market Verses Book Values. State whether each of the following events would increase or decrease the ratio of market value to book value. 1. Big Autos increases its depreciation provision 2.Since Big Stores purchased its assets, inflation has risen sharply. I know it's suppose to be a increase and decrease result but I don't understand why? I'm stuck with the idea that if there is an increase in depreciation allocation, that lowers fixed assets Book Value, and it would lower market value, how does that add up to overall result in a increase of the ratio, if so how? For inflation, doesn't increase in prices lower Book Values, and Market is higher, but as far as how the ratio to Market to Book value is effected. I'm not sure how is there an illustration or an example you can provide me ? Do I approach the problem knowing that Market Value is always higher than Book Value, I'm not sure because I think the opposite might be the case.

Answer 1

1. In the first case the book value of the assets decreases because of the additional depreciation. However the market value remains the same. So when we divide the same market value with a lower book value the overall ratio increases. For example suppose the market value was $200 while the book value was $100. The market value to book value ratio will be 200/100 which is equal to 2. However due to higher depreciation suppose the book value reduces to 75. The market to book ratio will be 200/75 which is 2.67.

2. In the second series due to higher inflation the market value of the assets will increase. However the book value is at historical cost and so there will be no change in the book value. Hence the market value to book value ratio increases.