Fundamentals of Financial Management, Third Edition

14.3 RELEVANCE OF CAPITAL STRUCTURE

In real life, market conditions are not perfect and hence the assumptions of the irrelevance approach are far from reality. More importantly, taxes do exist. Interest payments are tax deductible and hence the introduction of debt into the capital structure lowers the WACC. The introduction of financial leverage thus influences not only the WACC but also has an impact on the earning per share (EPS). In other words, capital structure is of relevance to the financial managers.

14.3.1 Financial Leverage and EPS

The greater the leverage, the higher the EPS. This is because the average cost of capital declines, which in turn increases the earnings-share ratio. The effect can be shown with the help of a simple example. ...