EPS-Maximizing Capital Structure

A simple EPS-maximizing model delivers a rich set of capital-structure implications. The earnings cost of equity is a firm’s earnings yield. The earnings cost of debt is the interest expense on the next dollar borrowed. CEOs lever up when creditors want less earnings than shareholders for the marginal dollar. There is an EPS-maximizing leverage before adding frictions. “Value stocks” have earnings yields above the riskfree rate. They see riskfree debt as cheap, lever up, and repurchase shares. “Growth stocks” have earnings yields below the riskfree rate. They see equity as cheaper, remain unlevered, and hold cash. Data support these predictions.