Cooke Company’s current capital structure is as follows:
Cooke Company’s current capital structure is as follows:
Current capital structure 

Longterm 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 

Capital structure ($000) 

Debt ratio (1) 
Total assets^{a} (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
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