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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
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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- Spring '14