Principles of Managerial Finance

CHAPTER 12 Leverage and Capital Structure 537

Capital structure

debt ratio

EBIT

$100,000 $200,000

Earnings per share (EPS)

0%

30

60

$2.40

2.91

3.03

$4.80

6.34

9.03

10

9 8 7 6 5 4 3 2 1 0

• 1 30%

30%

60%

60%

EBIT ($000)

0%

50 100

95.50

150 200

• 2


• 3


• 4

EPS ($)

Debt

Ratio

Debt

Ratio

Debt

Ratio

= 60%

= 30%

= 0%

Financial

Breakeven

Points

FIGURE 12.6

EBIT–EPS Approach
A comparison of selected
capital structures for Cooke
Company (data from Table
12.12)

22. An algebraic technique can be used to find the indifference pointsbetween the capital structure alternatives. This
    technique involves expressing each capital structure as an equation stated in terms of earnings per share, setting the
    equations for two capital structures equal to each other, and solving for the level of EBIT that causes the equations
    to be equal. When we use the notation from footnote 21 and let nequal the number of shares of common stock out-
    standing, the general equation for the earnings per share from a financing plan is
    EPS
    Comparing Cooke Company’s 0% and 30% capital structures, we get
    



10.50EBIT15.00EBIT$225.00

$225.004.50EBIT

EBIT$50

The calculated value of the indifference point between the 0% and 30% capital structures is therefore $50,000, as

can be seen in Figure 12.6.

0.60EBIT$9.00

17.50

0.60EBIT

25.00

(10.40)(EBIT$15.00)$0

17.50

(10.40)(EBIT$0)$0

25.00

(1T)(EBITI)PD

n

tal structures for levels of EBIT between $0 and $50,000. Between $50,000 and

$95,500 of EBIT, the capital structure associated with a debt ratio of 30% is pre-

ferred. And at a level of EBIT above $95,500, the 60% debt ratio capital struc-

ture provides the highest earnings per share.^22