Principles of Managerial Finance

540 PART 4 Long-Term Financial Decisions

TABLE 12.15 Calculation of Share Value

Estimates Associated with

Alternative Capital Structures

for Cooke Company

Estimated

Expected EPS required return, ks Estimated

(from column 1 (from column 2 share value

Capital structure of Table 12.13) of Table 12.14) [(1)(2)]

debt ratio (1) (2) (3)

0% $2.40 .115 $20.87

10 2.55 .117 21.79

20 2.72 .121 22.48

30 2.91 .125 23.28

40 3.12 .140 22.29

50 3.18 .165 19.27

60 3.03 .190 15.95

required return of owners,ks, increases with increasing risk, as measured by the

coefficient of variation of EPS.

Estimating Value

The value of the firm associated with alternative capital structures can be esti-

mated by using one of the standard valuation models. If, for simplicity, we

assume that all earnings are paid out as dividends, we can use a zero-growth val-

uation model such as that developed in Chapter 7. The model, originally stated in

Equation 7.3, is restated here with EPS substituted for dividends (because in each

year the dividends would equal EPS):

P 0  (12.12)

By substituting the expected level of EPS and the associated required return, ks,

into Equation 12.12, we can estimate the per-share value of the firm, P 0.

EXAMPLE We can now estimate the value of Cooke Company’s stock under each of the

alternative capital structures. Substituting the expected EPS (column 1 of Table

12.13) and the required returns, ks(column 2 of Table 12.14), into Equation

12.12 for each of the capital structures, we obtain the share values given in col-

umn 3 of Table 12.15. Plotting the resulting share values against the associated

debt ratios, as shown in Figure 12.7, clearly illustrates that the maximum share

value occurs at the capital structure associated with a debt ratio of 30%.

EPS



ks