544 PART 4 Long-Term Financial Decisions
on securities issuance and less reliance on banks for
financing.
Research suggests that there is an optimal capital
structure that balances the firm’s benefits and costs of
debt financing. The major benefit of debt financing is
the tax shield. The costs of debt financing include the
probability of bankruptcy, caused by business and
financial risk; agency costs imposed by lenders; and
asymmetric information, which typically causes
firms to raise funds in a pecking order of retained
earnings, then debt, and finally external equity
financing, in order to send positive signals to the mar-
ket and thereby enhance the wealth of shareholders.
Explain the optimal capital structure using a
graphical view of the firm’s cost-of-capital
functions and a zero-growth valuation model.The
zero-growth valuation model can be used to define
the firm’s value as its after-tax EBIT divided by its
weighted average cost of capital. Assuming that
EBIT is constant, the value of the firm is maxi-
mized by minimizing its weighted average cost of
capital (WACC). The optimal capital structure is
the one that minimizes the WACC. Graphically,
although both debt and equity costs rise with
increasing financial leverage, the lower cost of debt
causes the WACC to decline and then rise with
increasing financial leverage. As a result, the firm’s
WACC exhibits a U-shape, whose minimum value
defines the optimal capital structure that maximizes
owner wealth.
LG4Discuss the EBIT–EPS approach to capital
structure. The EBIT–EPS approach evaluates
capital structures in light of the returns they provide
the firm’s owners and their degree of financial risk.
Under the EBIT–EPS approach, the preferred capital
structure is the one that is expected to provide max-
imum EPS over the firm’s expected range of EBIT.
Graphically, this approach reflects risk in terms of
the financial breakeven point and the slope of the
capital structure line. The major shortcoming of
EBIT–EPS analysis is that it concentrates on maxi-
mizing earnings rather than owners’ wealth.Review the return and risk of alternative capi-
tal structures, their linkage to market value,
and other important considerations related to capi-
tal structure.The best capital structure can be se-
lected by using a valuation model to link return
and risk factors. The preferred capital structure is
the one that results in the highest estimated share
value, not the highest EPS. Other important non-
quantitative factors, such as revenue stability, cash
flow, contractual obligations, management prefer-
ences, control, external risk assessment, and timing,
must also be considered when making capital struc-
ture decisions.LG6LG5LG1 LG2SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 12–1 Breakeven point and all forms of leverage TOR most recently sold 100,000
units at $7.50 each; its variable operating costs are $3.00 per unit, and its fixed
operating costs are $250,000. Annual interest charges total $80,000, and the
firm has 8,000 shares of $5 (annual dividend) preferred stock outstanding. It
currently has 20,000 shares of common stock outstanding. Assume that the firm
has a 40% tax rate.
a. At what level of sales (in units) would the firm break even on operations (that
is, EBIT$0)?
b. Calculate the firm’s earnings per share (EPS) in tabular form at (1) the cur-
rent level of sales and (2) a 120,000-unit sales level.
c. Using the current $750,000 level of sales as a base,calculate the firm’s degree
of operating leverage (DOL).