Principles of Managerial Finance

CHAPTER 12 Leverage and Capital Structure 541

2.00

2.50

3.00

3.50

15.00

20.00

25.00

0 10 20 30 40 50 60 70

Maximum

Share Value

Maximum

EPS

Debt Ratio (%)

Estimated Share Value ($)

EPS ($)

EPS

Estimated

Share Value

Maximum Share Value = $23.28

Maximum EPS = $3.18

FIGURE 12.7

Estimating Value
Estimated share value and
EPS for alternative capital
structures for Cooke
Company

Maximizing Value versus Maximizing EPS

Throughout this text, the goal of the financial manager has been specified as max-

imizing owner wealth, not profit. Although there is some relationship between

expected profit and value, there is no reason to believe that profit-maximizing

strategies necessarily result in wealth maximization. It is therefore the wealth of

the owners as reflected in the estimated share value that should serve as the crite-

rion for selecting the best capital structure. A final look at Cooke Company will

highlight this point.

EXAMPLE Further analysis of Figure 12.7 clearly shows that although the firm’s profits

(EPS) are maximized at a debt ratio of 50%, share value is maximized at a 30%

debt ratio. Therefore, the preferred capital structure would be the 30% debt

ratio. The two approaches provide different conclusions because EPS maximiza-

tion does not consider risk.

Some Other Important Considerations

Because there is really no practical way to calculate the optimal capital structure,

any quantitative analysis of capital structure must be tempered with other impor-

tant considerations. Some of the more important additional factors involved in

capital structure decisions are summarized in Table 12.16.