Graphically although both debt and equity costs rise

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Unformatted text preview: lthough 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. 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. Graphically, this approach reflects risk in terms of the financial breakeven point and the slope of the capital structure line. The major shortcoming of EBIT–EPS analysis is that it concentrates on maximizing earnings rather than owners’ wealth. LG5 Review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital st...
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