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