CHAPTER 12 Leverage and Capital Structure 539TABLE 12.14 Required Returns for Cooke
Company’s Alternative
Capital StructuresCoefficient of
variation of EPS
(from column 3 Estimated required
Capital structure of Table 12.13) return, ks
debt ratio (1) (2)0% 0.71 11.5%
10 0.74 11.7
20 0.78 12.1
30 0.83 12.5
40 0.91 14.0
50 1.07 16.5
60 1.40 19.0LG6 12.4 Choosing the Optimal Capital Structure
A wealth maximization framework for use in making capital structure decisions
should include the two key factors of return and risk. This section describes the
procedures for linking to market value the return and risk associated with alter-
native capital structures.Linkage
To determine the firm’s value under alternative capital structures, the firm must
find the level of return that must be earned to compensate owners for the risk
being incurred. Such a framework is consistent with the overall valuation frame-
work developed in Chapters 6 and 7 and applied to capital budgeting decisions in
Chapters 9 and 10.
The required return associated with a given level of financial risk can be esti-
mated in a number of ways. Theoretically, the preferred approach would be first
to estimate the beta associated with each alternative capital structure and then to
use the CAPM framework presented in Equation 5.8 to calculate the required
return,ks. A more operational approach involves linking the financial risk associ-
ated with each capital structure alternative directly to the required return. Such an
approach is similar to the CAPM-type approach demonstrated in Chapter 10 for
linking project risk and required return (RADR). Here it involves estimating the
required return associated with each level of financial risk, as measured by a sta-
tistic such as the coefficient of variation of EPS. Regardless of the approach used,
one would expect the required return to increase as the financial risk increases.EXAMPLE Cooke Company, using as risk measures the coefficients of variation of EPS asso-
ciated with each of the seven alternative capital structures, estimated the associ-
ated required returns. These are shown in Table 12.14. As expected, the estimated