Introduction to Finance

TA B L E 1 8 . 4
Scenario Analysis with Current and Proposed Capital Structures
Current—No Debt, 4 Million Shares
(Millions Omitted)
EBIT 50% Below 
Expectations
Expected
EBIT 50% Above 
Expectations
EBIT $6.00 $12.00
$18.00
– I
0.00
0.00
0.00
NI $6.00 $12.00
$18.00
eps
$1.50
$3.00
$4.50
Current—No Debt, 4 Million Shares
(Millions Omitted)
EBIT 50% Below 
Expectations
Expected
EBIT 50% Above 
Expectations
EBIT $6.00 $12.00 $18.00
– I
5.00
5.00 
5.00
NI 
$1.00 
$7.00 
$13.00
eps 
$0.50 
$3.50
$6.50
eps
8
6
4
2
0
–2
–4
3
6
Proposed
Current
9
10
EBIT
12
15
18
FIGURE 18.6
 EBIT/eps 
Analysis, Bennett Corporation

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C H A PT E R 1 8 Capital Structure and The Cost of Capital
Second, EBIT fl uctuates over time, depending on sales growth, industry competitive condi-
tions, and the fi rm’s operating leverage. Variations in EBIT will produce changes in earnings per 
share. Should the fi rm’s expected EBIT lie above the indiff erence EBIT level, the fi rm’s managers 
will need to consider potential variation of earnings in their EBIT forecast. Depending on its 
uncertainty, management may decide to use a more conservative fi nancing strategy with less debt.
This shows the drawback of using EBIT/eps analysis. It inadequately captures the risk 
facing investors and how it aff ects shareholder wealth. We seek a capital structure that max-
imizes the fi rm’s value, not earnings per share. Although eps may rise with fi nancial leverage 
under certain EBIT values, the eps value that maximizes fi rm value will likely be less than the 
maximum earnings per value. The fi rm’s investors, both lenders and shareholders, consider 
the risk of cash fl ows when valuing investments. A relationship among debt, eps, and fi rm 
value appears in 
Figure 18.7
. Because of the risk of excessive debt, the maximum fi rm value 
occurs at a lower debt ratio compared to maximum earnings per share.
A fi rm’s 
business risk
is measured by its variability in EBIT over time. Business risk is 
aff ected by several factors, including the business cycle, competitive pressures, and the fi rm’s oper-
ating leverage or its level of fi xed operating costs. The following section reviews business risk and 
the combined eff ects of business and fi nancial risk on management’s choice of a capital structure.