Reviewing the three capital structures plotted for Cooke Company in Figure 12.6, we can see that as…

| January 23, 2015

Reviewing the three capital structures plotted for Cooke Company in Figure 12.6, we can see that as the debt ratio increases, so does the financial risk of each alternative. Both the financial breakeven point and the slope of the capital structure lines increase with increasing debt ratios. If we use the $100,000 EBIT value, for example, the times interest earned ratio (EBIT ÷ interest) for the zero-leverage capital structure is infinity ($100,000 ÷$0); for the 30% debt case, it is 6.67 ($100,000 ÷$15,000); and for the 60% debt case, it is 2.02 ($100,000 ÷ $49,500). Because lower times interest earned ratios reflect higher risk, these ratios support the conclusion that the risk of the capital structures increases with increasing financial leverage. The capital structure for a debt ratio of 60% is riskier than that for a debt ratio of 30%, which in turn is riskier than the capital structure for a debt ratio of 0%

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