Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has...

Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates of sales and the associated levels of earnings before interest and taxes (EBIT) from its forecasting group: There is a 25% chance that sales will total $400,000, a 50% chance that sales will total $600,000, and a 25% chance that sales will total $800,000. Fixed operating costs total $200,000, and variable operating costs equal 50% of sales. These data are summarized, and the resulting EBIT calculated, in Table 12.9. The table shows that there is a 25% chance that the EBIT will be $0, a 50% chance that it will be $100,000, and a 25% chance that it will be $200,000. When developing the firm’s capital structure, the financial manager must accept as given these levels of EBIT and their associated probabilities. These EBIT data effectively reflect a certain level of business risk that captures the firm’s operating leverage, sales revenue variability, and cost predictability.

 

TABLE 12.9
Sales and Associated EBIT Calculations for Cooke Company ($000)
Probability of sales	0.25	0.5	0.25
Sales revenue	$400	$600	$800
Less: Fixed operating costs	200	200	200
Less: Variable operating costs (50% of sales)	200	300	400
Earnings before interest and taxes (EBIT)	$0	$100	$200