12-1

The EPS-EBIT approach to capital structure

involves selecting the capital structure that
maximizes EPS over the expected range of EBIT.

Using this approach, the emphasis is on

maximizing the owners returns (EPS).

A major shortcoming of this approach is the fact

that earnings are only one of the determinants
of shareholder wealth maximization.

This method does not explicitly consider the

impact of risk.

12-2

Example
EBIT-EPS coordinates can be found by assuming specific
EBIT values and calculating the EPS associated with them.
Such calculations for three capital structuresdebt ratios of
0%, 30%, and 60%for Cooke Company were presented
earlier in Table 12.2. For EBIT values of $100,000 and
$200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.
12-3

Figure 12.6
EBITEPS
Approach

12-4

Although EPS maximization is generally

good for the firms shareholders, the basic
shortcoming of this method is that it does
not necessary maximize shareholder
wealth because it fails to consider risk.

If shareholders did not require risk

premiums (additional return) as the firm
increased its use of debt, a strategy
focusing on EPS maximization would work.

Unfortunately, this is not the case.

12-5

The following discussion will attempt to create

a framework for making capital budgeting
decisions that maximizes shareholder wealth
i.e., considers both risk and return.
Perhaps the best way to demonstrate this is
through the following example:
Cooke Company, using as risk measures the
coefficients of variation of EPS associated with each
of seven alternative capital structures, estimated the
associated returns as shown in Table 12.14
12-6

Table 12.14 Required Returns for Cooke Companys

Alternative Capital Structures

12-7

By substituting the level of EPS and the associated

required return into Equation 12.12, we can
estimate the per share value of the firm, P0.

12-8

Table 12.15 Calculation of Share Value Estimates

Associated with Alternative Capital Structures for Cooke
Company

12-9

Figure 12.7
Estimating Value

12-10

12-11