Principles of Managerial Finance

CHAPTER 12 Leverage and Capital Structure 531

3.50

3.00

3.18

2.50

2.00 0.50

0.75

1.00

1.25

1.50

Expected EPS ($)

0 10 20 30 40 50 60 Coefficient of Variation of EPS 0 10 20304050607080

Financial

Risk

Business

Risk

Debt Ratio (%)

(b)

Debt Ratio (%)

(a)

Maximum EPS

FIGURE 12.4

Expected EPS
and Coefficient
of Variation of EPS
Expected EPS and coefficient
of variation of EPS for alterna-
tive capital structures for
Cooke Company

expected EPS and coefficient of variation relative to the debt ratio. Plotting the

data from Table 12.13 results in Figure 12.4. The figure shows that as debt is

substituted for equity (as the debt ratio increases), the level of EPS rises and then

begins to fall (grapha). The graph demonstrates that the peak earnings per share

occurs at a debt ratio of 50%. The decline in earnings per share beyond that ratio

results from the fact that the significant increases in interest are not fully offset by

the reduction in the number of shares of common stock outstanding.

If we look at the risk behavior as measured by the coefficient of variation

(graph b), we can see that risk increases with increasing leverage. A portion of the

risk can be attributed to business risk, but the portion that changes in response to

increasing financial leverage would be attributed to financial risk.

Clearly, a risk–return tradeoff exists relative to the use of financial leverage.

How to combine these risk–return factors into a valuation framework will be

addressed later in the chapter. The key point to recognize here is that as a firm

introduces more leverage into its capital structure, it will experience increases in

both the expected level of return and the associated risk.

Agency Costs Imposed by Lenders

As noted in Chapter 1, the managers of firms typically act as agentsof the owners

(stockholders). The owners give the managers the authority to manage the firm

for the owners’ benefit. The agency problemcreated by this relationship extends

not only to the relationship between owners and managers but also to the rela-

tionship between owners and lenders.

When a lender provides funds to a firm, the interest rate charged is based on

the lender’s assessment of the firm’s risk. The lender–borrower relationship,

therefore, depends on the lender’s expectations for the firm’s subsequent behav-

ior. The borrowing rates are, in effect, locked in when the loans are negotiated.

After obtaining a loan at a certain rate, the firm could increase its risk by invest-

ing in risky projects or by incurring additional debt. Such action could weaken

the lender’s position in terms of its claim on the cash flow of the firm. From