LEARNING GOALS

1. DISCUSS LEVERAGE, CAPITAL STRUCTURE, BREAKEVEN ANALYSIS,

THE OPERATING BREAKEVEN POINT, AND THE EFFECT OF
CHANGING COSTS ON IT.
2. UNDERSTAND OPERATING, FINANCIAL, AND TOTAL LEVERAGE
AND THE RELATIONSHIP AMONG THEM.
3. DESCRIBE THE BASIC TYPES OF CAPITAL, EXTERNAL ASSESSMENT
OF CAPITAL STRUCTURE, THE CAPITAL STRUCTURE OF NON-U.S.
FIRMS, AND CAPITAL STRUCTURE THEORY.

MANAGEMENT
12-2
ACCOUNTING 2
LEARNING GOALS
4. EXPLAIN THE OPTIMAL CAPITAL STRUCTURE USING A GRAPHICAL
VIEW OF THE FIRM’S COST OF CAPITAL FUNCTIONS AND A ZERO-
GROWTH VALUATION MODEL.
5. DISCUSS THE EBIT-EPS APPROACH TO CAPITAL STRUCTURE.
6. REVIEW THE RETURN AND RISK OF ALTERNATIVE CAPITAL
STRUCTURES, THEIR LINKAGE TO MARKET VALUE, AND OTHER
IMPORTANT CAPITAL STRUCTURE CONSIDERATIONS RELATED TO
CAPITAL STRUCTURE.

MANAGEMENT
12-3
ACCOUNTING 2
LEVERAGE
• LEVERAGE RESULTS FROM THE USE OF FIXED-COST ASSETS OR
FUNDS TO MAGNIFY RETURNS TO THE FIRM’S OWNERS.

• GENERALLY, INCREASES IN LEVERAGE RESULT IN INCREASES IN RISK

AND RETURN, WHEREAS DECREASES IN LEVERAGE RESULT IN
DECREASES IN RISK AND RETURN.

• THE AMOUNT OF LEVERAGE IN THE FIRM’S CAPITAL STRUCTURE—

THE MIX OF DEBT AND EQUITY—CAN SIGNIFICANTLY AFFECT ITS
VALUE BY AFFECTING RISK AND RETURN.

MANAGEMENT
12-4
ACCOUNTING 2
 LEVERAGE (CONT.)
Table 12.1
General
Income
Statement
Format and
Types of
Leverage

MANAGEMENT
12-5
ACCOUNTING 2
BREAKEVEN ANALYSIS
• BREAKEVEN (COST-VOLUME-PROFIT) ANALYSIS IS USED TO:
• DETERMINE THE LEVEL OF OPERATIONS NECESSARY TO COVER ALL
OPERATING COSTS, AND
• EVALUATE THE PROFITABILITY ASSOCIATED WITH VARIOUS LEVELS OF
SALES.

• THE FIRM’S OPERATING BREAKEVEN POINT (OBP) IS THE LEVEL OF

SALES NECESSARY TO COVER ALL OPERATING EXPENSES.
• AT THE OBP, OPERATING PROFIT (EBIT) IS EQUAL TO ZERO.
MANAGEMENT
12-6
ACCOUNTING 2
BREAKEVEN ANALYSIS (CONT.)
• TO CALCULATE THE OBP, COST OF GOODS SOLD AND OPERATING
EXPENSES MUST BE CATEGORIZED AS FIXED OR VARIABLE.

• VARIABLE COSTS VARY DIRECTLY WITH THE LEVEL OF SALES AND

ARE A FUNCTION OF VOLUME, NOT TIME.

• EXAMPLES WOULD INCLUDE DIRECT LABOR AND SHIPPING.

• FIXED COSTS ARE A FUNCTION OF TIME AND DO NOT VARY WITH
SALES VOLUME.

• EXAMPLES WOULD INCLUDE RENT AND FIXED OVERHEAD.

MANAGEMENT
12-7
ACCOUNTING 2
BREAKEVEN ANALYSIS:
ALGEBRAIC APPROACH
Using the following variables, the operating
portion of a firm’s income statement may be
recast as follows:
P = sales price per unit
Q = sales quantity in units
FC = fixed operating costs per period
VC = variable operating costs per unit

• LETTING EBIT = 0 AND SOLVING FOR Q, WE GET:

EBIT = (P x Q) - FC - (VC x Q) MANAGEMENT
12-8
ACCOUNTING 2
BREAKEVEN ANALYSIS:
ALGEBRAIC APPROACH (CONT.)

MANAGEMENT
12-9
ACCOUNTING 2
BREAKEVEN ANALYSIS:
ALGEBRAIC APPROACH (CONT.)

Table 12.2 Operating Leverage, Costs, and Breakeven Analysis

MANAGEMENT
12-10
ACCOUNTING 2
BREAKEVEN ANALYSIS:
ALGEBRAIC APPROACH (CONT.)
Example: Cheryl’s Posters has fixed operating
costs of $2,500, a sales price of $10 per
poster, and variable costs of $5 per poster.
Find the OBP.

Q = $2,500 = 500 posters

$10 - $5
• THIS IMPLIES THAT IF CHERYL’S SELLS EXACTLY 500 POSTERS, ITS REVENUES WILL
JUST EQUAL ITS COSTS (EBIT = $0).
MANAGEMENT
12-11
ACCOUNTING 2
BREAKEVEN ANALYSIS:
ALGEBRAIC APPROACH (CONT.)
• WE CAN CHECK TO VERIFY THAT THIS IS THE
CASE BY SUBSTITUTING AS FOLLOWS:

EBIT = (P x Q) - FC - (VC x Q)

EBIT = ($10 x 500) - $2,500 - ($5 x 500)

EBIT = $5,000 - $2,500 - $2,500 = $0

MANAGEMENT
12-12
ACCOUNTING 2
BREAKEVEN ANALYSIS:
GRAPHICAL APPROACH
Figure 12.1
Breakeven
Analysis

MANAGEMENT
12-13
ACCOUNTING 2
BREAKEVEN ANALYSIS: CHANGING COSTS AND THE OPERATING
BREAKEVEN POINT

Assume that Cheryl’s Posters wishes to evaluate the impact

of several options: (1) increasing fixed operating costs to
$3,000, (2) increasing the sale price per unit to $12.50, (3)
increasing the variable operating cost per unit to $7.50, and
(4) simultaneously implementing all three of these changes.

MANAGEMENT
12-14
ACCOUNTING 2
BREAKEVEN ANALYSIS: CHANGING COSTS AND THE OPERATING
BREAKEVEN POINT

(1) Operating BE point = $3,000/($10-$5) = 600 units

(2) Operating BE point = $2,500/($12.50-$5) = 333 units

(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units

(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units

MANAGEMENT
12-15
ACCOUNTING 2
BREAKEVEN ANALYSIS: CHANGING COSTS AND THE OPERATING
BREAKEVEN POINT
Table 12.3
Sensitivity of
Operating
Breakeven
Point
to Increases in
Key
Breakeven
Variables

MANAGEMENT
12-16
ACCOUNTING 2
OPERATING LEVERAGE

• THE POTENTIAL USE OF FIXED OPERATING COSTS TO MAGNIFY THE EFFECTS OF

CHANGES IN SALES ON THE FIRM’S EARNINGS BEFORE INTEREST AND TAXES.

MANAGEMENT
17
ACCOUNTING 2
OPERATING LEVERAGE

Figure 12.2
Operating
Leverage

MANAGEMENT
12-18
ACCOUNTING 2
OPERATING LEVERAGE (CONT.)
Table 12.4 The
EBIT for Various
Sales Levels

MANAGEMENT
12-19
ACCOUNTING 2
OPERATING LEVERAGE: MEASURING THE DEGREE OF OPERATING
LEVERAGE
• THE DEGREE OF OPERATING LEVERAGE (DOL) MEASURES THE
SENSITIVITY OF CHANGES IN EBIT TO CHANGES IN SALES.
• A COMPANY’S DOL CAN BE CALCULATED IN TWO DIFFERENT
WAYS: ONE CALCULATION WILL GIVE YOU A POINT
ESTIMATE, THE OTHER WILL YIELD AN INTERVAL ESTIMATE OF
DOL.
• ONLY COMPANIES THAT USE FIXED COSTS
IN THE PRODUCTION PROCESS WILL EXPERIENCE OPERATING
LEVERAGE.
MANAGEMENT
12-20
ACCOUNTING 2
OPERATING LEVERAGE: MEASURING THE DEGREE OF OPERATING
LEVERAGE (CONT)
DOL = Percentage change in EBIT
Percentage change in Sales

• APPLYING THIS EQUATION TO CASES 1 AND 2 IN TABLE 12.4 YIELDS:

Case 1: DOL = (+100% ÷ +50%) = 2.0

Case 2: DOL = (-100% ÷ -50%) = 2.0

MANAGEMENT
12-21
ACCOUNTING 2
OPERATING LEVERAGE: MEASURING THE DEGREE OF OPERATING
LEVERAGE (CONT)
• A MORE DIRECT FORMULA FOR CALCULATING DOL
AT A BASE SALES LEVEL, Q, IS SHOWN BELOW.

DOL at base Sales level Q = Q X (P – VC)

Q X (P – VC) – FC

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

yields the following result:

DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0

1,000 X ($10 - $5) - MANAGEMENT
$2,500
12-22
ACCOUNTING 2
OPERATING LEVERAGE: FIXED COSTS
AND OPERATING LEVERAGE
Assume that Cheryl’s Posters exchanges a portion of its
variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales
salaries. This exchange results in a reduction in variable
costs per unit from $5.00 to $4.50 and an increase in
fixed operating costs from $2,500 to $3,000

DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.2

1,000 X ($10 - $4.50) MANAGEMENT
- $2,500
12-23
ACCOUNTING 2
OPERATING LEVERAGE: FIXED COSTS
AND OPERATING LEVERAGE (CONT.)
Table 12.5
Operating
Leverage
and
Increased
Fixed Costs

MANAGEMENT
12-24
ACCOUNTING 2
FINANCIAL LEVERAGE
• FINANCIAL LEVERAGE RESULTS FROM THE PRESENCE OF
FIXED FINANCIAL COSTS IN THE FIRM’S INCOME STREAM.
• FINANCIAL LEVERAGE CAN THEREFORE BE DEFINED AS THE
POTENTIAL USE OF FIXED FINANCIAL COSTS TO MAGNIFY
THE EFFECTS OF CHANGES IN EBIT ON THE FIRM’S EPS.
• THE TWO FIXED FINANCIAL COSTS MOST COMMONLY
FOUND ON THE FIRM’S INCOME STATEMENT ARE (1)
INTEREST ON DEBT AND (2) PREFERRED STOCK DIVIDENDS.

MANAGEMENT
12-25
ACCOUNTING 2
FINANCIAL LEVERAGE (CONT.)
Chen Foods, a small Oriental food company, expects EBIT of
$10,000 in the current year. It has a $20,000 bond with a
10% annual coupon rate and an issue of 600 shares of $4
annual dividend preferred stock. It also has 1,000 share of
common stock outstanding.

The annual interest on the bond issue is $2,000 (10% x

$20,000). The annual dividends on the preferred stock are
MANAGEMENT
12-26 $2,400 ($4/share x 600 shares).
ACCOUNTING 2
 FINANCIAL LEVERAGE (CONT.)
Table 12.6
The EPS for
Various EBIT
Levelsa

MANAGEMENT
12-27
ACCOUNTING 2
FINANCIAL LEVERAGE: MEASURING THE DEGREE OF FINANCIAL
LEVERAGE
• THE DEGREE OF FINANCIAL LEVERAGE (DFL) MEASURES THE
SENSITIVITY OF CHANGES IN EPS TO CHANGES IN EBIT.
• LIKE THE DOL, DFL CAN BE CALCULATED IN TWO DIFFERENT
WAYS: ONE CALCULATION WILL GIVE YOU A POINT
ESTIMATE, THE OTHER WILL YIELD AN INTERVAL ESTIMATE OF
DFL.
• ONLY COMPANIES THAT USE DEBT OR OTHER FORMS OF
FIXED COST FINANCING (LIKE PREFERRED STOCK) WILL
EXPERIENCE FINANCIAL LEVERAGE.
MANAGEMENT
12-28
ACCOUNTING 2
FINANCIAL LEVERAGE: MEASURING THE DEGREE OF FINANCIAL
LEVERAGE (CONT)
DFL = Percentage change in EPS
Percentage change in EBIT

• APPLYING THIS EQUATION TO CASES 1 AND 2 IN TABLE 12.6 YIELDS:

Case 1: DFL = (+100% ÷ +40%) = 2.5

Case 2: DFL = (-100% ÷ -40%) = 2.5

MANAGEMENT
12-29
ACCOUNTING 2
FINANCIAL LEVERAGE: MEASURING THE DEGREE OF FINANCIAL
LEVERAGE (CONT)
• A MORE DIRECT FORMULA FOR CALCULATING
DFL AT A BASE LEVEL OF EBIT IS SHOWN BELOW.
DFL at base level EBIT = EBIT
EBIT – I – [PD x 1/(1-T)]

Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and

the tax rate, T = 40% yields the following result:

DFL at $10,000 EBIT = $10,000

$10,000 – $2.000 – [$2,400 x 1/(1-.4)]
MANAGEMENT
12-30 DFL at $10,000 EBIT = 2.5
ACCOUNTING 2
TOTAL LEVERAGE
• TOTAL LEVERAGE RESULTS FROM THE COMBINED EFFECT
OF USING FIXED COSTS, BOTH OPERATING AND
FINANCIAL, TO MAGNIFY THE EFFECT OF CHANGES IN
SALES ON THE FIRM’S EARNINGS PER SHARE.
• TOTAL LEVERAGE CAN THEREFORE BE VIEWED AS THE
TOTAL IMPACT OF THE FIXED COSTS IN THE FIRM’S
OPERATING AND FINANCIAL STRUCTURE.

MANAGEMENT
12-31
ACCOUNTING 2
TOTAL LEVERAGE (CONT.)
Cables Inc., a computer cable manufacturer, expects sales of
20,000 units at $5 per unit in the coming year and must meet
the following obligations: variable operating costs of $2 per
unit, fixed operating costs of $10,000, interest of $20,000,
and preferred stock dividends of $12,000. The firm is in the
40% tax bracket and has 5,000 shares of common stock
outstanding. Table 12.7 on the following slide summarizes
these figures. MANAGEMENT
12-32
ACCOUNTING 2
TOTAL LEVERAGE: MEASURING THE DEGREE
OF TOTAL LEVERAGE
DTL = Percentage change in EPS
Percentage change in Sales

• APPLYING THIS EQUATION TO THE DATA TABLE 12.7 YIELDS:

Degree of Total Leverage (DTL) = (300% ÷ 50%) = 6.0

MANAGEMENT
12-33
ACCOUNTING 2
TOTAL LEVERAGE: MEASURING THE DEGREE
OF TOTAL LEVERAGE (CONT.)
• A MORE DIRECT FORMULA FOR CALCULATING DTL
AT A BASE LEVEL OF SALES, Q, IS SHOWN BELOW.
DTL at base sales level = Q x (P – VC) _______
Q x (P – VC) – FC – I – [PD x 1/(1-T)]

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD

= $12,000, and the tax rate, T = 40% yields the following result:

DTL at 20,000 units = 20,000 X ($5 – $2) __________________

20,000 X ($5 – $2) – $10,000 – $20,000 – [$12,000 x 1/(1-.4)]

DTL at 20,000 units = $60,000/$10,000 = 6.0 MANAGEMENT

12-34
ACCOUNTING 2
TOTAL LEVERAGE: THE RELATIONSHIP OF
OPERATING, FINANCIAL AND TOTAL LEVERAGE
The relationship between the DTL, DOL, and DFL is
illustrated in the following equation:

DTL = DOL x DFL

Applying this to our previous example we get:

DTL = 1.2 X 5.0 = 6.0

MANAGEMENT
12-35
ACCOUNTING 2
 TOTAL LEVERAGE (CONT.)
Table 12.7
The Total
Leverage
Effect

MANAGEMENT
12-36
ACCOUNTING 2
THE FIRM’S CAPITAL STRUCTURE
• CAPITAL STRUCTURE IS ONE OF THE MOST COMPLEX
AREAS OF FINANCIAL DECISION MAKING DUE TO ITS
INTERRELATIONSHIP WITH OTHER FINANCIAL DECISION
VARIABLES.
• POOR CAPITAL STRUCTURE DECISIONS CAN RESULT IN A
HIGH COST OF CAPITAL, THEREBY LOWERING PROJECT
NPVS AND MAKING THEM MORE UNACCEPTABLE.
• EFFECTIVE DECISIONS CAN LOWER THE COST OF
CAPITAL, RESULTING IN HIGHER NPVS AND MORE
ACCEPTABLE PROJECTS, THEREBY INCREASING THE
VALUE OF THE FIRM.
MANAGEMENT
12-37
ACCOUNTING 2
TYPES OF CAPITAL

MANAGEMENT
12-38
ACCOUNTING 2
EXTERNAL ASSESSMENT OF CAPITAL
STRUCTURE
Table 12.8
Debt Ratios
for Selected
Industries
and Lines of
Business
(Fiscal Years
Ended
4/1/05
through
3/31/06)

MANAGEMENT
12-39
ACCOUNTING 2
CAPITAL STRUCTURE OF NON-U.S. FIRMS
• IN RECENT YEARS, RESEARCHERS HAVE FOCUSED ATTENTION
NOT ONLY ON THE CAPITAL STRUCTURES OF U.S. FIRMS, BUT
ON THE CAPITAL STRUCTURES OF FOREIGN FIRMS AS WELL.
• IN GENERAL, NON-U.S. COMPANIES HAVE MUCH HIGHER
DEGREES OF INDEBTEDNESS THAN THEIR U.S. COUNTERPARTS.
• IN MOST EUROPEAN AND PACIFIC RIM COUNTRIES, LARGE
COMMERCIAL BANKS ARE MORE ACTIVELY INVOLVED IN THE
FINANCING OF CORPORATE ACTIVITY THAN HAS BEEN TRUE
IN THE U.S.
MANAGEMENT
12-40
ACCOUNTING 2
CAPITAL STRUCTURE
OF NON-U.S. FIRMS (CONT.)
• FURTHERMORE, BANKS IN THESE COUNTRIES ARE PERMITTED TO MAKE
LARGE EQUITY INVESTMENTS IN NON-FINANCIAL CORPORATIONS—A
PRACTICE FORBIDDEN IN THE U.S.
• HOWEVER, SIMILARITIES ALSO EXIST BETWEEN U.S. FIRMS AND THEIR
FOREIGN COUNTERPARTS.
• FOR EXAMPLE, THE SAME INDUSTRY PATTERNS OF CAPITAL STRUCTURE
TEND TO BE FOUND AROUND THE WORLD.
• IN ADDITION, THE CAPITAL STRUCTURES OF U.S.-BASED MNCS TEND TO
BE SIMILAR TO THOSE OF FOREIGN-BASED MNCS.
MANAGEMENT
12-41
ACCOUNTING 2
CAPITAL STRUCTURE THEORY
• ACCORDING TO FINANCE THEORY, FIRMS POSSESS A
TARGET CAPITAL STRUCTURE THAT WILL MINIMIZE ITS COST
OF CAPITAL.
• UNFORTUNATELY, THEORY CAN NOT YET PROVIDE
FINANCIAL MANGERS WITH A SPECIFIC METHODOLOGY
TO HELP THEM DETERMINE WHAT THEIR FIRM’S OPTIMAL
CAPITAL STRUCTURE MIGHT BE.
• THEORETICALLY, HOWEVER, A FIRM’S OPTIMAL CAPITAL
STRUCTURE WILL JUST BALANCE THE BENEFITS OF DEBT
FINANCING AGAINST ITS COSTS.
MANAGEMENT
12-42
ACCOUNTING 2
CAPITAL STRUCTURE THEORY (CONT.)
• THE MAJOR BENEFIT OF DEBT FINANCING IS THE TAX
SHIELD PROVIDED BY THE FEDERAL GOVERNMENT
REGARDING INTEREST PAYMENTS.
• THE COSTS OF DEBT FINANCING RESULT FROM:
• THE INCREASED PROBABILITY OF BANKRUPTCY CAUSED BY
DEBT OBLIGATIONS,
• THE AGENCY COSTS RESULTING FROM LENDERS MONITORING
THE FIRM’S ACTIONS, AND
• THE COSTS ASSOCIATED WITH THE FIRM’S MANAGERS HAVING
MORE INFORMATION ABOUT THE FIRM’S PROSPECTS THAN DO
INVESTORS (ASYMMETRIC INFORMATION).
MANAGEMENT
12-43
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
TAX BENEFITS
• ALLOWING COMPANIES TO DEDUCT INTEREST PAYMENTS
WHEN COMPUTING TAXABLE INCOME LOWERS THE AMOUNT
OF
CORPORATE TAXES.
• THIS IN TURN INCREASES FIRM CASH FLOWS AND MAKES
MORE CASH AVAILABLE TO INVESTORS.
• IN ESSENCE, THE GOVERNMENT IS SUBSIDIZING THE COST OF
DEBT FINANCING RELATIVE TO EQUITY FINANCING.
MANAGEMENT
12-44
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY
• THE PROBABILITY THAT DEBT OBLIGATIONS WILL LEAD TO
BANKRUPTCY DEPENDS ON THE LEVEL OF A COMPANY’S
BUSINESS RISK AND FINANCIAL RISK.
• BUSINESS RISK IS THE RISK TO THE FIRM OF BEING UNABLE
TO COVER OPERATING COSTS.
• IN GENERAL, THE HIGHER THE FIRM’S FIXED COSTS
RELATIVE TO VARIABLE COSTS, THE GREATER THE FIRM’S
OPERATING LEVERAGE AND BUSINESS RISK.
• BUSINESS RISK IS ALSO AFFECTED BY REVENUE AND COST
STABILITY.
MANAGEMENT
12-45
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• THE FIRM’S CAPITAL STRUCTURE—THE MIX BETWEEN DEBT
VERSUS EQUITY—DIRECTLY IMPACTS FINANCIAL LEVERAGE.
• FINANCIAL LEVERAGE MEASURES THE EXTENT TO WHICH A
FIRM EMPLOYS FIXED COST FINANCING SOURCES SUCH AS
DEBT AND PREFERRED STOCK.
• THE GREATER A FIRM’S FINANCIAL LEVERAGE, THE GREATER
WILL BE ITS FINANCIAL RISK—THE RISK OF BEING UNABLE TO
MEET ITS FIXED INTEREST AND PREFERRED STOCK DIVIDENDS.
MANAGEMENT
12-46
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• BUSINESS RISK
Cooke Company, a soft drink manufacturer, is preparing to
make a capital structure decision. It has obtained
estimates of sales and EBIT from its forecasting group as
show in Table 12.9.

Table 12.9 Sales and

Associated EBIT
Calculations for
Cooke Company
($000)
MANAGEMENT
12-47
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• BUSINESS RISK
When developing the firm’s capital structure, the
financial manager must accept as given these
levels of EBIT and their associated probabilities.
These EBIT data effectively reflect a certain level
of business risk that captures the firm’s operating
leverage, sales revenue variability, and cost
predictability. MANAGEMENT
12-48
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK

Let us assume that (1) the firm has no current liabilities, (2) its
capital structure currently contains all equity, and (3) the total
MANAGEMENT
amount of capital remains constant at $500,000, the mix of
12-49 debt and equity associated with various debt ratios would be
as shown in Table 12.10. ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK
Table 12.10
Capital
Structures
Associated with
Alternative Debt
Ratios for Cooke
Company

MANAGEMENT
12-50
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK
Table 12.11 Level of
Debt, Interest Rate,
and Dollar Amount
of Annual Interest
Associated with
Cooke Company’s
Alternative Capital
Structures

MANAGEMENT
12-51
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK
Table 12.12
Calculation of EPS
for Selected Debt
Ratios ($000) for
Cooke Company
(cont.)

MANAGEMENT
12-52
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK

Table 12.12
Calculation of EPS
for Selected Debt
Ratios ($000) for
Cooke Company
(cont.)

MANAGEMENT
12-53
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK
Table 12.12
Calculation of EPS
for Selected Debt
Ratios ($000) for
Cooke Company

MANAGEMENT
12-54
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK

Table 12.13
Expected EPS,
Standard Deviation,
and Coefficient of
Variation for
Alternative Capital
Structures for Cooke
Company

MANAGEMENT
12-55
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK

Figure 12.3
Probability
Distributions

MANAGEMENT
12-56
ACCOUNTING 2
 CAPITAL STRUCTURE THEORY:
PROBABILITY OF BANKRUPTCY (CONT.)
• FINANCIAL RISK

Figure 12.4
Expected EPS
and
Coefficient of
Variation
of EPS

MANAGEMENT
12-57
ACCOUNTING 2
CAPITAL STRUCTURE THEORY: AGENCY COSTS
IMPOSED BY LENDERS
• WHEN A FIRM BORROWS FUNDS BY ISSUING DEBT, THE INTEREST
RATE CHARGED BY LENDERS IS BASED ON THE LENDER’S
ASSESSMENT OF THE RISK OF THE FIRM’S INVESTMENTS.
• AFTER OBTAINING THE LOAN, THE FIRM’S STOCKHOLDERS
AND/OR MANAGERS COULD USE THE FUNDS TO INVEST IN
RISKIER ASSETS.
• IF THESE HIGH RISK INVESTMENTS PAY OFF, THE STOCKHOLDERS
BENEFIT BUT THE FIRM’S BONDHOLDERS ARE LOCKED IN AND
ARE UNABLE TO SHARE IN THIS SUCCESS.
MANAGEMENT
12-58
ACCOUNTING 2
CAPITAL STRUCTURE THEORY: AGENCY COSTS
IMPOSED BY LENDERS (CONT.)
• TO AVOID THIS, LENDERS IMPOSE VARIOUS
MONITORING COSTS ON THE FIRM.

• EXAMPLES WOULD OF THESE MONITORING

COSTS WOULD:
• INCLUDE RAISING THE RATE ON FUTURE DEBT ISSUES,
• DENYING FUTURE LOAN REQUESTS,
• IMPOSING RESTRICTIVE BOND PROVISIONS.
MANAGEMENT
12-59
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
ASYMMETRIC INFORMATION
• ASYMMETRIC INFORMATION RESULTS WHEN MANAGERS OF
A FIRM HAVE MORE INFORMATION ABOUT OPERATIONS
AND FUTURE PROSPECTS THAN DO INVESTORS.
• ASYMMETRIC INFORMATION CAN IMPACT THE FIRM’S
CAPITAL STRUCTURE AS FOLLOWS:

Suppose management has identified an extremely lucrative investment

opportunity and needs to raise capital. Based on this opportunity,
management believes its stock is undervalued since the investors have
no information about the investment.
MANAGEMENT
12-60
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
ASYMMETRIC INFORMATION (CONT.)
• ASYMMETRIC INFORMATION RESULTS WHEN MANAGERS
OF A FIRM HAVE MORE INFORMATION ABOUT
OPERATIONS AND FUTURE PROSPECTS THAN DO
INVESTORS.
• ASYMMETRIC INFORMATION CAN IMPACT THE FIRM’S
CAPITAL STRUCTURE AS FOLLOWS:
In this case, management will raise the funds using debt since they
believe/know the stock is undervalued (underpriced) given this
information. In this case, the use of debt is viewed as a positive
signal to investors regarding the firm’s prospects.
MANAGEMENT
12-61
ACCOUNTING 2
CAPITAL STRUCTURE THEORY:
ASYMMETRIC INFORMATION (CONT.)
• ASYMMETRIC INFORMATION RESULTS WHEN MANAGERS
OF A FIRM HAVE MORE INFORMATION ABOUT
OPERATIONS AND FUTURE PROSPECTS THAN DO
INVESTORS.
• ASYMMETRIC INFORMATION CAN IMPACT THE FIRM’S
CAPITAL STRUCTURE AS FOLLOWS:
On the other hand, if the outlook for the firm is poor, management
will issue equity instead since they believe/know that the price of
the firm’s stock is overvalued (overpriced). Issuing equity is
therefore generally thought of as a “negative” signal.
MANAGEMENT
12-62
ACCOUNTING 2
THE OPTIMAL CAPITAL STRUCTURE
• IN GENERAL, IT IS BELIEVED THAT THE MARKET VALUE OF A
COMPANY IS MAXIMIZED WHEN THE COST OF CAPITAL (THE
FIRM’S DISCOUNT RATE) IS MINIMIZED.
• THE VALUE OF THE FIRM CAN BE DEFINED ALGEBRAICALLY AS
FOLLOWS:

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 THE OPTIMAL CAPITAL STRUCTURE

Figure 12.5
Cost Functions
and Value

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EPS-EBIT APPROACH
TO CAPITAL STRUCTURE
• THE EPS-EBIT APPROACH TO CAPITAL STRUCTURE INVOLVES SELECTING
THE CAPITAL STRUCTURE THAT MAXIMIZES EPS OVER THE EXPECTED
RANGE OF EBIT.
• USING THIS APPROACH, THE EMPHASIS IS ON MAXIMIZING THE OWNERS
RETURNS (EPS).
• A MAJOR SHORTCOMING OF THIS APPROACH IS THE FACT THAT
EARNINGS ARE ONLY ONE OF THE DETERMINANTS OF SHAREHOLDER
WEALTH MAXIMIZATION.
• THIS METHOD DOES NOT EXPLICITLY CONSIDER THE IMPACT OF RISK.
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EPS-EBIT APPROACH
TO CAPITAL STRUCTURE (CONT.)
Example

EBIT-EPS coordinates can be found by assuming specific EBIT

values and calculating the EPS associated with them. Such
calculations for three capital structures—debt ratios of 0%, 30%,
and 60%—for Cooke Company were presented earlier in Table
12.2. For EBIT values of $100,000 and $200,000, the associated EPS
values calculated are summarized in the table with Figure 12.6.

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 EPS-EBIT APPROACH
TO CAPITAL STRUCTURE (CONT.)

Figure 12.6
EBIT–EPS
Approach

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BASIC SHORTCOMING
OF EPS-EBIT ANALYSIS
• ALTHOUGH EPS MAXIMIZATION IS GENERALLY GOOD FOR
THE FIRM’S SHAREHOLDERS, THE BASIC SHORTCOMING OF
THIS METHOD IS THAT IT DOES NOT NECESSARY MAXIMIZE
SHAREHOLDER WEALTH BECAUSE IT FAILS TO CONSIDER RISK.
• IF SHAREHOLDERS DID NOT REQUIRE RISK PREMIUMS
(ADDITIONAL RETURN) AS THE FIRM INCREASED ITS USE OF
DEBT, A STRATEGY FOCUSING ON EPS MAXIMIZATION
WOULD WORK.
• UNFORTUNATELY, THIS IS NOT THE CASE.
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CHOOSING THE OPTIMAL CAPITAL STRUCTURE
• THE FOLLOWING DISCUSSION WILL ATTEMPT TO
CREATE A FRAMEWORK FOR MAKING CAPITAL
BUDGETING DECISIONS THAT MAXIMIZES
SHAREHOLDER WEALTH—I.E., CONSIDERS BOTH
RISK AND RETURN.
• PERHAPS THE BEST WAY TO DEMONSTRATE THIS IS
THROUGH THE FOLLOWING EXAMPLE:

Cooke Company, using as risk measures the coefficients

of variation of EPS associated with each of seven
alternative capital structures, estimated the associated
returns as shown in Table 12.14 MANAGEMENT
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 CHOOSING THE OPTIMAL
CAPITAL STRUCTURE (CONT.)
Table 12.14
Required
Returns for
Cooke
Company’s
Alternative
Capital
Structures

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CHOOSING THE OPTIMAL
CAPITAL STRUCTURE (CONT.)
By substituting the level of EPS and the
associated required return into Equation 12.12,
we can estimate the per share value of the firm,
P0.

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CHOOSING THE OPTIMAL
CAPITAL STRUCTURE (CONT.)
Table 12.15 Calculation of Share Value Estimates Associated with
Alternative Capital Structures for Cooke Company

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CHOOSING THE OPTIMAL
CAPITAL STRUCTURE (CONT.)

Figure 12.7
Estimating
Value

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TABLE 12.16 IMPORTANT FACTORS TO CONSIDER IN MAKING CAPITAL
STRUCTURE DECISIONS

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TABLE 12.16 IMPORTANT FACTORS TO CONSIDER IN
MAKING CAPITAL STRUCTURE DECISIONS

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REFERENCE:

• GITMAN, L. J.(2009), MANAGERIAL FINANCE 12TH EDITION, PEARSON PRENTICE

HALL

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