538 PART 4 Long-Term Financial Decisions
- The degree of financial leverage (DFL) is reflected in the slope of the EBIT–EPS function. The steeper the slope,
the greater the degree of financial leverage, because the change in EPS (yaxis) that results from a given change in
EBIT (xaxis) increases with increasing slope and decreases with decreasing slope.
Considering Risk in EBIT–EPS Analysis
When interpreting EBIT–EPS analysis, it is important to consider the risk of each
capital structure alternative. Graphically, the risk of each capital structure can be
viewed in light of two measures: (1) the financial breakeven point(EBIT-axis
intercept) and (2) the degree of financial leveragereflected in the slope of the cap-
ital structure line: The higher the financial breakeven point and the steeper the
slope of the capital structure line, the greater the financial risk.^23
Further assessment of risk can be performed by using ratios. As financial
leverage (measured by the debt ratio) increases, we expect a corresponding
decline in the firm’s ability to make scheduled interest payments (measured by the
times interest earned ratio).EXAMPLE Reviewing the three capital structures plotted for Cooke Company in Figure
12.6, we can see that as the debt ratio increases, so does the financial risk of each
alternative. Both the financial breakeven point and the slope of the capital struc-
ture lines increase with increasing debt ratios. If we use the $100,000 EBIT value,
for example, the times interest earned ratio (EBITinterest) for the zero-leverage
capital structure is infinity ($100,000$0); for the 30% debt case, it is 6.67
($100,000$15,000); and for the 60% debt case, it is 2.02 ($100,000
$49,500). Because lower times interest earned ratios reflect higher risk, these
ratios support the conclusion that the risk of the capital structures increases with
increasing financial leverage. The capital structure for a debt ratio of 60% is
riskier than that for a debt ratio of 30%, which in turn is riskier than the capital
structure for a debt ratio of 0%.The Basic Shortcoming of EBIT–EPS Analysis
The most important point to recognize when using EBIT–EPS analysis is that this
technique tends to concentrate on maximizing earningsrather than maximizing
owner wealth. The use of an EPS-maximizing approach generally ignores risk. If
investors did not require risk premiums (additional returns) as the firm increased
the proportion of debt in its capital structure, a strategy involving maximizing
EPS would also maximize owner wealth. But because risk premiums increase
with increases in financial leverage, the maximization of EPS does notensure
owner wealth maximization. To select the best capital structure, both return
(EPS) and risk (via the required return, ks) must be integrated into a valuation
framework consistent with the capital structure theory presented earlier.Review Question
12 – 13 Explain theEBIT–EPS approachto capital structure. Include in your
explanation a graph indicating thefinancial breakeven point;label the
axes. Is this approach consistent with maximization of the owners’wealth?