412 Part 5 Capital Structure and Dividend Policy
distributions contained in Table 13-2. Although expected EPS would be much
higher if! nancial leverage were employed, the graph makes it clear that the risk
of low, or even negative, EPS would also be higher if debt were used.
Another view of the relationships among expected EPS, risk, and! nancial le-
verage is presented in Figure 13-6. The tabular data in the lower section were cal-
culated in the manner set forth in Table 13-2, and the graphs plot these data. Here
we see that expected EPS rises until the! rm is! nanced with 50% debt. Interest
charges rise, but this effect is more than offset by the declining number of shares
outstanding as debt is substituted for equity. However, EPS peaks at a debt ratio of
50%, beyond which interest rates rise so rapidly that EPS falls in spite of the falling
number of shares outstanding.
The right panel of Figure 13-6 shows that risk, as measured by the coef! cient
of variation of EPS, rises continuously and at an increasing rate as debt is substi-
tuted for equity.
These examples make it clear that using leverage has both positive and nega-
tive effects: Higher leverage increases expected EPS (in this example, until the debt
ratio equals 50%), but it also increases risk. When determining its optimal capital
structure, Bigbee needs to balance these positive and negative effects of leverage.
This issue is discussed in the following sections.0 $2.40 $3.36 EPS ($)Zero Debt Financing50% Debt FinancingProbability
DensityEPS Probability Distributions for Bigbee Electronics, With and Without Leverage
F I G U R E 1 3! 5SELF^ TEST What is business risk, and how can it be measured?
What are some determinants of business risk?
Why does business risk vary from industry to industry?
What is operating leverage?
How does operating leverage a" ect business risk?
What is! nancial risk, and how does it arise?
Explain this statement: Using leverage has both good and bad e" ects.