EBIT levels

A firm is considering two alternative capital structures, and has calculated its profitability at various EBIT levels under each structure. What should the firm do if its projected EBIT is:

a. Below the indifference point? In this case, choose the capital structure with the lower degree of financial leverage. If EBIT is below (to the left of) the financing indifference point, higher financial leverage would decrease EPS (lower return) as it increases the volatility of the EPS stream (higher risk). However, lower financial leverage would increase EPS (higher return) and decrease the volatility of the EPS stream (lower risk), the combination preferred by risk-averse investors.

b. Above the indifference point? In this case, the choice of capital structure is not obvious, since there is a tradeoff between the effects of financial leverage on risk and return. If EBIT is above (to the right of) the indifference point, higher financial leverage would increase EPS (higher return) but also increase the volatility of the EPS stream (higher risk). Lower financial leverage would decrease EPS (lower return) and decrease the volatility of the EPS stream (lower risk). Further analysis is required to identify which capital structure provides investors with the best risk-return combination.