West Island 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.
Debt ratio Earnings per share (EPS) Standard deviation of EPS
0%............................... US$2.30...............................US$1.15
20..............................3.00...............................................1.80
40..............................3.50....................................2.80
60..............................3.95....................................3.95
80..............................3.80....................................5.53
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.