Principles of Managerial Finance

CHAPTER 12 Leverage and Capital Structure 527

TABLE 12.10 Capital Structures Associated with

Alternative Debt Ratios for Cooke

Company

Capital structure ($000) Shares of common

Debt Equity stock outstanding (000)

Debt ratio Total assetsa [(1)(2)] [(2)(3)] [(4)$20]b

(1) (2) (3) (4) (5)

0% $500 $ 0 $500 25.00

10 500 50 450 22.50

20 500 100 400 20.00

30 500 150 350 17.50

40 500 200 300 15.00

50 500 250 250 12.50

60 500 300 200 10.00

aBecause the firm, for convenience, is assumed to have no current liabilities, its total assets equal its

total capital of $500,000.

bThe $20 value represents the book value per share of common stock equity noted earlier.

16. This assumption is needed so that we can assess alternative capital structures without having to consider the
    returns associated with the investment of additional funds raised. Attention here is given only to the mixof capital,
    not to its investment.

Hint As you learned in
Chapter 2, the debt ratio is
equal to the amount of total
debt divided by the total
assets. The higher this ratio,
the more financial leverage
a firm is using.

cial risk depends on the capital structure decision made by the management, and

that decision is affected by the business risk the firm faces.

The total riskof a firm—business and financial risk combined—determines

its probability of bankruptcy. Financial risk, its relationship to business risk, and

their combined impact can be demonstrated by continuing the Cooke Company

example.

EXAMPLE Cooke Company’s current capital structure is as follows:

Let us assume that the firm is considering seven alternative capital structures. If we

measure these structures using the debt ratio, they are associated with ratios of 0,

10, 20, 30, 40, 50, and 60%. Assuming that (1) the firm has no current liabilities,

(2) its capital structure currently contains all equity as shown, and (3) the total

amount of capital remains constant^16 at $500,000, the mix of debt and equity

associated with the seven debt ratios would be as shown in Table 12.10. Also

Current capital structure

Long-term debt $ 0

Common stock equity (25,000 shares at $20)  (^5)  (^0)  (^0) , (^0)  (^0)  (^0) 
Total capital (assets) $

5

0

0

,

0

0

0