For each of these structures the firm estimated the 1

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Unformatted text preview: e structures the firm estimated the (1) EPS, (2) coefficient of variation of EPS, and (3) required return, ks. These values are shown in columns 1 through 3 of Table 11.10. Note that EPS (in column 1) is maximized at a 50% debt ratio though the risk of EPS measured by its coefficient of variation (in column 2) is constantly increasing. As expected, the estimated required return of owners, ks (in column 3), increases with increasing risk, as measured by the coefficient of variation of EPS (in column 2). Simply stated, for higher degrees of financial leverage— debt ratios—owners require higher rates of return. Estimating Value The value of the firm associated with alternative capital structures can be estimated by using one of the standard valuation models. If, for simplicity, we assume that all earnings are paid out as dividends, we can use a zero-growth valuation model such as that developed in Chapter 7. The model, originally stated in Equation 7.2, is restated here with EPS substituted for dividends (because in each year the dividends would equal EPS): P0 EPS ks (11.12) By substit...
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