Fundamentals of Financial Management (Concise 6th Edition)

Chapter 13 Capital Structure and Leverage 413

13-3 DETERMINING THE OPTIMAL CAPITAL STRUCTURE

As we saw in Figure 13-6, Bigbee’s expected EPS is maximized at a debt ratio of
50%. Does that mean that Bigbee’s optimal capital structure calls for 50% debt?
The answer is a resounding “No!” The optimal capital structure is the one that maxi-
mizes the price of the! rm’s stock, and this generally calls for a debt ratio that is lower than
the one that maximizes expected EPS.
We know that stock prices are positively related to expected earnings but
negatively related to higher risk. Therefore, to the extent that higher debt levels
raise expected EPS, leverage works to increase the stock price. However, higher
debt levels also increase the! rm’s risk, which raises the cost of equity and works

3.50

3.00

2.50

2.00

Expected

EPS

($)

Peak EPS = $3.36

0 10 20 30 40 50 60

Debt Ratio (%)

2.00

1.23

Risk

(CV )

0 10 20 30 40 50 60

Debt Ratio (%)

Additional Risk to

Stockholders from

Use of Financial

Leverage:

Financial Risk

Basic Business Risk

EPS

Relationships among Expected EPS, Risk, and Financial Leverage

F I G U R E 1 3! 6

Debt Ratio

Expected

EPS

Standard Deviation

of EPS

Coefficient

of Variation

0%a $2.40a $2.96a 1.23a

10 2.56 3.29 1.29

20 2.75 3.70 1.35

30 2.97 4.23 1.43

40 3.20 4.94 1.54

50 a 3.36a 5.93a 1.76a

60 3.30 7.41 2.25

a Values for debt ratios " 0% and 50% are taken from Table 13-2. Values at other debt

ratios are calculated similarly.