528 PART 4 Long-Term Financial Decisions
TABLE 12.11 Level of Debt, Interest Rate, and
Dollar Amount of Annual Interest
Associated with Cooke Company’s
Alternative Capital StructuresInterest rate Interest ($000)
Capital structure Debt ($000) on alldebt [(1)(2)]
debt ratio (1) (2) (3)0% $ 0 0.0% $ 0.00
10 50 9.0 4.50
20 100 9.5 9.50
30 150 10.0 15.00
40 200 11.0 22.00
50 250 13.5 33.75
60 300 16.5 49.50- For explanatory convenience, the coefficient of variation of EPS, which measures total (nondiversifiable and
diversifiable) risk, is used throughout this chapter as a proxy for beta, which measures the relevant nondiversifi-
able risk.
shown in the table is the number of shares of common stock outstanding under
each alternative.
Associated with each of the debt levels in column 3 of Table 12.10 would be
an interest rate that would be expected to increase with increases in financial
leverage. The level of debt, the associated interest rate (assumed to apply to all
debt), and the dollar amount of annual interest associated with each of the alter-
native capital structures are summarized in Table 12.11. Because both the level of
debt and the interest rate increase with increasing financial leverage (debt ratios),
the annual interest increases as well.
Table 12.12 uses the levels of EBIT and associated probabilities developed in
Table 12.9, the number of shares of common stock found in column 5 of Table
12.10, and the annual interest values calculated in column 3 of Table 12.11 to cal-
culate the earnings per share (EPS) for debt ratios of 0, 30, and 60%. A 40% tax
rate is assumed. Also shown are the resulting expected EPS, the standard deviation
of EPS, and the coefficient of variation of EPS associated with each debt ratio.^17
Table 12.13 summarizes the pertinent data for the seven alternative capital
structures. The values shown for 0, 30, and 60% debt ratios were developed in
Table 12.12, whereas calculations of similar values for the other debt ratios (10,
20, 40, and 50%) are not shown. Because the coefficient of variation measures
the risk relative to the expected EPS, it is the preferred risk measure for use in
comparing capital structures. As the firm’s financial leverage increases, so does its
coefficient of variation of EPS. As expected, an increasing level of risk is associ-
ated with increased levels of financial leverage.
The relative risks of the two extremes of the capital structures evaluated in
Table 12.12 (debt ratios0% and 60%) can be illustrated by showing the prob-