Example reviewing the three capital structures

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Unformatted text preview: ases, so does the financial risk of each alternative. Both the financial breakeven point and the slope of the capital structure lines increase with increasing debt ratios. If we use the $100,000 EBIT value, for example, the times interest earned ratio (EBIT interest) 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 earnings rather than maximizing owner wealth. The use of an EPS-maximizing approach generally ignores risk. If investors did not require risk premiums (additional returns...
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