CHAPTER 12 Leverage and Capital Structure 535EBIT–EPS approach
An approach for selecting the
capital structure that maximizes
earnings per share (EPS) over the
expected range of earnings
before interest and taxes (EBIT).
LG5point Mrepresents the minimum weighted average cost of capital—the point of
optimal financial leverage and hence of optimal capital structure for the firm. Fig-
ure 12.5(b) plots the value of the firm that results from substitution of kain Fig-
ure 12.5(a) for various levels of financial leverage into the zero-growth valuation
model in Equation 12.11. As shown in Figure 12.5(b), at the optimal capital
structure, point M, the value of the firm is maximized at V*.
Generally, the lower the firm’s weighted average cost of capital, the greater
the difference between the return on a project and the WACC, and therefore the
greater the owners’ return. Simply stated, minimizing the weighted average cost
of capital allows management to undertake a larger number of profitable proj-
ects, thereby further increasing the value of the firm.
As a practical matter, there is no way to calculate the optimal capital struc-
ture implied by Figure 12.5. Because it is impossible either to know or to remain
at the precise optimal capital structure, firms generally try to operate in a range
that places them near what they believe to be the optimal capital structure.Review Questions
12 – 6 What is a firm’s capital structure?What ratios assess the degree of finan-
cial leverage in a firm’s capital structure?
12 – 7 In what ways are the capital structures of U.S. and non-U.S. firms differ-
ent? How are they similar?
12 – 8 What is the major benefit of debt financing? How does it affect the firm’s
cost of debt?
12 – 9 What are business riskand financial risk?How does each of them influ-
ence the firm’s capital structure decisions?
12 – 10 Briefly describe the agency problemthat exists between owners and
lenders. How do lenders cause firms to incur agency coststo resolve this
problem?
12 – 11 How does asymmetric informationaffect the firm’s capital structure deci-
sions? How do the firm’s financing actions give investors signalsthat
reflect management’s view of stock value?
12 – 12 How do the cost of debt, the cost of equity, and the weighted average cost
of capital (WACC) behave as the firm’s financial leverage increases from
zero? Where is the optimal capital structure?What is its relationship to
the firm’s value at that point?12.3 The EBIT–EPS Approach to Capital Structure
One of the key variables affecting the market value of the firm’s shares is its
return to owners, as reflected by the firm’s earnings. Therefore, earnings per
share (EPS) can be conveniently used to analyze alternative capital structures.
The EBIT–EPS approachto capital structure involves selecting the capital struc-
ture that maximizes EPS over the expected range of earnings before interest and
taxes (EBIT).