Graphically the risk of each capital structure can be

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Unformatted text preview: each capital structure can be viewed in light of two measures: (1) the financial breakeven point (EBIT-axis intercept) and (2) the degree of financial leverage reflected in the slope of the capital structure line: The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk. Further assessment of risk can be performed by using ratios. As financial leverage (measured by the debt ratio) increases, we expect a corresponding decline in the firm’s ability to make scheduled interest payments (measured by the times interest earned ratio). EXAMPLE Reviewing the three capital structures plotted for JSG Company in Figure 11.5, we can see that as the debt ratio increases, so does the financial risk of each alternative. Both the financial breakeven point and the slope of the capital structure lines increase with increasing debt ratios. If we use the $100,000 EBIT value, for 448 PART 4 Long-Term Financial Decisions example, the times interest earned ratio (EBIT interest) for the zero-leverage capital structure is infinity ($100,000 $0); for the 30% debt case, it is 6.67 ($100,000 $15,000); and f...
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