Question

EPS and optimal debt ratio Williams Glassware has estimated, at various debt ratios, the expected earnings per share and the standard deviation of the earnings per share as shown in the following table. located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) Debt ratio 0% 20 Earnings per share (EPS) $2.33 3.02 3.52 3.93 3.82 Standard deviation of EPS 2 $1.17 1.81 2.76 3.97 5.55 40 80 a. Estimate the optimal debt ratio on the basis of the relationship between earnings per share and the debt ratio. You will probably find it helpful to graph the relationship. b. Graph the relationship between the coefficient of variation and the debt ratio. Label the areas associated with business risk and financial risk. a. Estimate the optimal debt ratio on the basis of the relationship between earnings per share and the debt ratio. Maximum EPS appears to be at | V debt ratio, with V per share earnings. (Select from the drop-down menus.) b. The coefficient of variation for a debt ratio of 0% is . (Round to two decimal places.) The coefficient of variation for a debt ratio of 20% is . (Round to two decimal places.) The coefficient of variation for a debt ratio of 40% is . (Round to two decimal places.) The coefficient of variation for a debt ratio of 60% is . (Round to two decimal places.) The coefficient of variation for a debt ratio of 80% is . (Round to two decimal places.) Which of the two graphs below correctly depicts the debt ratio vs. the coefficient of variation?

Answer 1

a]

The optimal debt ratio is the one where EPS is maximized

Maximum EPS appears to be at 60% debt ratio, with $3.93 per share earnings

b]

Coefficient of variation = standard deviation of EPS / EPS

Debt CV 1 ratio 2 0% 3 20% 4 40% 60% 6 80% EPS $ $ $ $ $ SD 2.33 $ 3.02 $ 3.52 $ 3.93 $ 3.82 $ 1.17 1.81 2.76 3.97 5.55 0.50 0.60 0.78 1.01 1.45 5

B C A Debt 1 ratio 2 0 3 0.2 4 0.4 5 0.6 6 0.8 EPS 2.33 3.02 3.52 3.93 3.82 SD 1.17 1.81 2.76 3.97 5.55 cv =C2/B2 =C3/B3 =C4/B4 =C5/B5 =C6/86

c]

Graph 1 is correct.

As the debt ratio increases, the financial risk increases