Appendix  E  819
equity markets have missed some critical information, the resulting estimates 
of default probability do not reflect their omission. As discussed in Chapter 
7, markets reflect company fundamentals most of the time, but not always. 
When they do not, the market-based rating approaches would incorrectly es-
timate default risk as well.9
Leverage, Coverage, and Solvency
The leverage measure used in the academic literature is typically defined as 
the market value of debt (D) over the market value of debt plus equity (E):
Leverage =
+
D
D E
This ratio measures how much of the company’s enterprise value is claimed 
by debt holders and is an important concept for estimating the benefits of tax 
shields arising from debt financing. It is therefore also a crucial input in calcu-
lating the weighted average cost of capital (WACC; see Chapter 15 on capital 
structure weights).
Compared with coverage ratios such as earnings before interest, taxes, 
and amortization (EBITA) to interest, leverage ratios suffer from several 
drawbacks as a way to measure and target a company’s capital structure. 
First, companies could have very low leverage in terms of market value 
but still be at a high risk of financial distress if their short-term cash flow 
is low relative to interest payments. High-growth companies usually have 
very low levels of leverage, but this does not mean their debt is low-risk. A 
second drawback is that market value can change radically (especially for 
high-growth, high-multiple companies), making leverage a fast-moving in-
dicator. For example, during the stock market boom of the late 1990s, several 
European telecom companies had what appeared to be reasonable levels of 
debt financing in terms of leverage. Credit providers appeared willing to 
provide credit even though the underlying near-term cash flows were not 
very high relative to debt service obligations. But when the companies’ mar-
ket values plummeted in 2001, leverage for these companies shot up, and 
financial distress loomed. Thus, it is risky to base a capital structure target 
on a market-value-based measure.
This does not mean that leverage and coverage are fundamentally diver-
gent measures. Far from it: they actually measure the same thing but over 
different time horizons. For ease of explanation, consider a company that has 
9 See Crosbie and Bohn, “Modeling Default Risk,” 23.

820  Appendix  E
no growth in revenues, profit, or cash flows. For this company, it is possible to 
express the leverage and coverage as follows:10
Leverage
Interest
PV Interest
PV Interest
NOP
=
+
=
+
+
+
∞
D
D E
1
2
(
)
...
(
)
AT
PV NOPAT
PV NOPAT
Coverage
EBITA
Interest
1
2
1
1
+
+
+
=
=
−
∞
(
)
...
(
)
(
T) × NOPAT
Interest
where 
D
E
t
=
=
=
market value of debt
market value of equity
NOPAT
net operating profit after taxes in year
Interest
interest expenses in year
t
t
t =
T = tax rate
The market value of debt captures the present value of all future inter-
est payments, assuming perpetual rollover of debt financing. The enterprise 
value (E + D) is equal to the present value of future NOPAT, because deprecia-
tion equals capital expenditures for a zero-growth company. A leverage ratio 
therefore measures the company’s ability to cover its interest payments over 
a very long term. The problem is that short-term interest obligations are what 
mainly get a company into financial distress. Coverage, in contrast, focuses on 
the short-term part of the leverage definition, keeping in mind that NOPAT 
roughly equals EBITA × (1 - T). It indicates how easily a company can service 
its debt in the near term.
Both measures are meaningful, and they are complementary. For example, 
if market leverage were very high in combination with strong current interest 
coverage, this could indicate the possibility of future difficulties in sustaining 
current debt levels in, for example, a single-product company faced with rap-
idly eroding margins and cash flows because the product is approaching the 
end of its life cycle. Despite very high interest coverage today, such a company 
might not be given a high credit rating, and its capacity to borrow could be 
limited.
Solvency measures of debt over book value of total assets or equity are sel-
dom as meaningful as coverage or leverage. The key reason is that these book 
value ratios fail to capture the company’s ability to comply with debt service 
requirements in either the short term or the long term. Market-to-book ratios 
10 The simplifying no-growth assumption is for illustration purposes only. For a growing company, the 
same point holds.

Appendix  E  821
can vary significantly across sectors and over time, making solvency a poor 
proxy for long-term ability to service debt.
Solvency becomes more relevant in times of financial distress, when a com-
pany’s creditors use it as a rough measure of the available collateral. Higher 
levels of solvency usually indicate that debt holders stand better chances of 
recovering their principal and interest due—assuming that asset book val-
ues are reasonable approximations of asset liquidation values. However, in a 
going concern, solvency is much less relevant for deciding capital structure 
than coverage and leverage measures.