Cooke Company’s current capital structure is as follows:

Cooke Company’s current capital structure is as follows:

Current capital structure
Long-term debt	$ 0
Common stock equity (25,000 shares at $20)	500,000
Total capital (assets)	$ 500,000

Let us assume that the firm is considering seven alternative capital structures. If we measure these structures using the debt ratio, they are associated with ratios of 0, 10, 20, 30, 40, 50, and 60%. Assuming that (1) the firm has no current liabilities, (2) its capital structure currently contains all equity as shown, and (3) the total amount of capital remains constant16 at $500,000, the mix of debt and equity associated with the seven debt ratios would be as shown in Table 12.10. Also

TABLE 12.10
Capital Structures Associated with Alternative Debt Ratios for Cooke Company
	Capital structure ($000)
Debt ratio (1)	Total assetsa (2)	Debt [(1) X (2)] (3)	Equity [(2) - (3)] (4)	Shares of common stock outstanding (000) [(4) ÷  $20]b (5)
0%	$500	$0	$500	25
10	500	50	450	22.5
20	500	100	400	20
30	500	150	350	17.5
40	500	200	300	15
50	500	250	250	12.5
60	500	300	200	10

shown in the table is the number of shares of common stock outstanding under each alternative. Associated with each of the debt levels in column 3 of Table 12.10 would be an interest rate that would be expected to increase with increases in financial leverage. The level of debt, the associated interest rate (assumed to apply to all debt), and the dollar amount of annual interest associated with each of the alternative capital structures are summarized in Table 12.11. Because both the level of debt and the interest rate increase with increasing financial leverage (debt ratios), the annual interest increases as well. Table 12.12 uses the levels of EBIT and associated probabilities developed in Table 12.9, the number of shares of common stock found in column 5 of Table 12.10, and the annual interest values calculated in column 3 of Table 12.11 to calculate the earnings per share (EPS) for debt ratios of 0, 30, and 60%. A 40% tax rate is assumed. Also shown are the resulting expected EPS, the standard deviation of EPS, and the coefficient of variation of EPS associated with each debt ratio.17 Table 12.13 summarizes the pertinent data for the seven alternative capital structures. The values shown for 0, 30, and 60% debt ratios were developed in Table 12.12, whereas calculations of similar values for the other debt ratios (10, 20, 40, and 50%) are not shown. Because the coefficient of variation measures the risk relative to the expected EPS, it is the preferred risk measure for use in comparing capital structures. As the firm’s financial leverage increases, so does its coefficient of variation of EPS. As expected, an increasing level of risk is associated with increased levels of financial leverage. The relative risks of the two extremes of the capital structures evaluated in Table 12.12 (debt ratios0% and 60%) can be illustrated by showing the prob

TABLE 12.11
Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke Company’s Alternative Capital Structures
Capital structure debt ratio	Debt ($000) (1)	Interest rate on all debt (2)	Interest ($000) [(1) X (2)] (3)
0%	$0	0.00%	$0.00
10	50	9	4.5
20	100	9.5	9.5
30	150	10	15
40	200	11	22
50	250	13.5	33.75
60	300	16.5	49.5

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

ability distribution of EPS associated with each of them. Figure 12.3 shows these two distributions. The expected level of EPS increases with increasing financial leverage, and so does risk, as reflected in the relative dispersion of each of the distributions. Clearly, the uncertainty of the expected EPS, as well as the chance of experiencing negative EPS, is greater when higher degrees of financial leverage are employed. Further, the nature of the risk–return tradeoff associated with the seven capital structures under consideration can be clearly observed by plotting the

TABLE 12.13
Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative Capital Structures for Cooke Company
Capital structure debt ratio	Expected EPS (1)	Standard deviation of EPS (2)	Coefficient of variation of EPS [(2) x (1)] (3)
0%	$2.40	$1.70	0.71
10	2.55	1.88	0.74
20	2.72	2.13	0.78
30	2.91	2.42	0.83
40	3.12	2.83	0.91
50	3.18	3.39	1.07
60	3.03	4.24	1.4

expected EPS and coefficient of variation relative to the debt ratio. Plotting the data from Table 12.13 results in Figure 12.4. The figure shows that as debt is substituted for equity (as the debt ratio increases), the level of EPS rises and then begins to fall (graph a). The graph demonstrates that the peak earnings per share occurs at a debt ratio of 50%. The decline in earnings per share beyond that ratio results from the fact that the significant increases in interest are not fully offset by the reduction in the number of shares of common stock outstanding. If we look at the risk behavior as measured by the coefficient of variation (graph b), we can see that risk increases with increasing leverage. A portion of the risk can be attributed to business risk, but the portion that changes in response to increasing financial leverage would be attributed to financial risk.