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Unformatted text preview: or 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) as the firm increased
the proportion of debt in its capital structure, a strategy involving maximizing
EPS would also maximize owner wealth. But because risk premiums increase
with increases in financial leverage, the maximization of EPS does not ensure
owner wealth maximization. To select the best cap...
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This document was uploaded on 03/30/2014.
- Spring '14