418 Part 5 Capital Structure and Dividend Policy
rises with! nancial leverage, hits a peak of $22.22 at a debt ratio of 40%, and then
begins to decline. Thus, Bigbee’s optimal capital structure occurs at a debt ratio of 40%,
and that debt ratio both maximizes its stock price and minimizes its WACC.^9
The EPS, cost of capital, and stock price data shown in Table 13-3 are plotted
in Figure 13-8. As the graph shows, the debt ratio that maximizes Bigbee’s ex-
pected EPS is 50%. However, the expected stock price is maximized, and the WACC(^9) We could also estimate the stock price if some earnings were retained and the expected growth rate was
positive. However, this would complicate the analysis, and it is another reason we generally analyze the optimal
capital structure decision using the WACC rather than the stock price.
E" ects of Capital Structure on EPS, Cost of Capital, and Stock Price
F I G U R E 1 3! 8
Expected
EPS ($)
Maximum EPS = $3.36
0 10 20 30 40 50 60
3.50
3.00
2.50
Debt Ratio (%)
Cost of Capital
(%)
Cost of Equity, rs
10 20 30 40 50 60
Debt Ratio (%)
20
15
10
5
Weighted Average Cost
of Capital, WACC
After-Tax Cost of
Debt, rd (1 – T)
Min. = 11.04%
Stock Price
($) Maximum = $22.22
0 10 20 30 40 50 60
Debt Ratio (%)
23
22
21
20
19
0