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Unformatted text preview: an 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 maximized 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. SELF-TEST PROBLEMS
LG1 LG2 ST 12–1 Discuss 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 maximum EPS over the firm’s expected range of EBIT.
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