EBIT-EPS Analysis

Prof. Prapti Paul

Introduction

In addition to leverage analysis, the EBIT-EPS analysis is another way of looking at the effects of different types of capital structures. EBIT-EPS analysis considers the effect on EPS under different types of capital mix.

Given a level of EBIT, a particular combination of different sources (i.e. debt, preference share capital and equity share capital) will result in a particular level of EPS and therefore for different financing patterns there would be different levels of EPS.
For a given level of EBIT, higher the DFL, i.e. higher the level of debt financing, greater would be the EPS ( provided ROI is more than the cost of the debt). However, if the ROI is less than the cost of debt, then the effect of increase in leverage on EPS would be negative. Financial break- even level of EBIT is that level of EBIT at which the EPS of the firm is zero.

Indifference level of EBIT is one at which the EPS remains same

Suppose, ABC Ltd. Which is expecting an EBIT of Rs. 1,50,000 p.a. on its investment of Rs.5,00,000 is considering the finalization of the capital structure or the financial plan. The co. has access to raise funds of varying amounts by issuing equity share capital, 12% preference share and 10% debenture or any combination thereof. Suppose it analyzes the following four options to raise the required funds of Rs.5,00,000. by issuing equity share capital at par 50% funds by equity share capital and 50% funds by preference shares 50% equity share capital, 25% preference shares, and 25% by the issue of 10% debentures. 25% funds by equity share capital, 25% as preference shares and 50% by the issue of 10% debentures.

1. 2. 3. 4.

Assume that the co. belongs to the 50% tax bracket, calculate the EPS under the different financing options. What happens if the return on investment is reduced to 18%?

Indifference Point/ Level

The indifference level of EBIT is one at which the EPS remains same irrespective of the debt equity mix. While designing a capital structure, a firm may evaluate the effect of different financial plans on the level of EPS, for a given level of EBIT. Out of several available financial plans, the firm may have 2 or more financial plans which result in the same level of EPS for a given EBIT. Such a level of EBIT at which the firm has 2 or more financial plans resulting in the same level of EPS, is known as indifference level of EBIT. The use of financial break even level and the return from alternative capital structures is called the indifference point analysis. The EBIT is used as a dependent variable and the EPS from 2 alternative financial plans is used as independent variable, and the exercise is known as indifference point analysis. The indifference level of EBIT is a point at which the after tax cost of debt is just equal to the ROI. At this point the firm would be indifferent whether the funds are raised by the issue of debt securities or by the issue of share capital.

Example:

Suppose PQR &Co. is expecting an EBIT of Rs.55,00,000 after implementing the expansion plan for Rs.50,00,000. The funds requirements needed to implement the plan can be raised either by the issue of further equity share capital at an issue price of Rs. 5,000 each, or by the issue of 10% debenture. Find out the EPS under these 2 alternative plans if the existing capital structure of the firm stands at 10,000 shares. Financial plan 1 No. of existing shares No. of new shares Total no. of shares 10% debenture EBIT (given) -interest PBT -Tax @50% 10,000 1,000 11,000 -----55,00,000 ----55,00,000 27,50,000 Financial plan 2 10,000 -----10,000 50,00,000 55,00,000 5,00,000 50,00,000 25,00,000

PAT EPS

27,50,000 250

25,00,000 250

So at the EBIT level of Rs. 55,00,000, the EPS is expected to be Rs.250 irrespective of the fact whether the additional funds are raised by the issue of equity share capital or by the issue of 10% debt. This EBIT level of Rs.55,00,000 is known as the indifference level of EBIT. However, in case the co. is expecting EBIT of Rs.50,00,000 or Rs. 60,00,000, the EPS for both the financial plans would be: FP 1 FP1 60,00,000 -----60,00,000 FP 2 50,00,000 5,00,000 45,00,000 FP 2 60,00,000 5,00,000 55,00,000 50,00,000 ----50,00,000

EBIT -Interest PBT

-Tax@ 50% PAT No. of eq.sh

25,00,000 25,00,000 11,000

30,00,000 30,00,000 11,000

22,50,000 22,50,000 10,000

27,50,000 27,50,000 10,000

if the EBIT level is below the indifference level of Rs.55,00,000, the EPS is lower at Rs.225 in case of leveraged option (i.e. debt financing) than the EPS of unleveraged option of Rs.227. However if the EBIT is higher than the indifference level, then the EPS is higher at Rs.275 incase of leveraged option than the EPS of Rs.272 under unlevered option.

illustration1:

ABC Ltd. has a current level of EBIT of Rs. 17,00,000 which is likely to be unchanged. It has decided to raise Rs.5,00,000 of additional capital funds and has identified two mutually exclusive alternative financial plans. Relevant info is as follows: Present capital structure: 3,00,000 eq. sh. of Rs.10 each and 10% bonds of Rs.20,00,000. Tax rate : 50% Current EBIT: Rs.17,00,000 Current EPS: Rs.2.50 Current market price: Rs.25 per share Financial plan 1: 20,000 eq. sh. @ Rs.25 per share

Financial plan 2: 12% debentures of Rs. 5,00,000

Solution 1:

If plan 1 is accepted then the new capital structure of the firm is expected to consist of 3,20,000 eq. sh. and 10% bonds of Rs.20,00,000. The EPS of the firm in this case would be: EPS1 = (EBIT-2,00,000) (1-.50) 3,20,000 = .5 EBIT-1,00,000 3,20,000

If plan 2 is adopted then capital structure of the firm would consist of 3,00,000 eq. sh. , 10% bonds of Rs.20,00,000 and 12% debentures of Rs.5,00,000. the EPS of the firm in this case would be:
EPS 2 = (EBIT-2,00,000- 60,000) (1-.50)

3,00,000
= .5EBIT- 1,30,000 3,00,000

In order to find out the indifference level of EBIT, the EPS under the 2 plans should be equated: .5EBIT-1,00,000 3,20,000 = .5EBIT-1,30,000 3,00,000

On solving we get EBIT = Rs.11,60,000

So the value of EBIT at the indifference level is Rs.11,60,000 and the corresponding values of EPS under both the financial plans would be:
EPS 1= .5(11,60,000) -1,00,000 3,20,000 = Rs. 1.50

EPS 2= .5(11,60,000)-1,30,000
3,00,000

=Rs.1.50

The financial break even levels for the two plans are: Plan 1: Rs.2,00,000 (i.e. 10% interest on Rs. 20,00,000) Plan 2: Rs.2,60,000 ( i.e. 10% interest on Rs.20,00,000 and 12% interest on Rs. 5,00,000).

For an EBIT level less than the indifference level (i.e. less than Rs.11,60,000) plan 1 is better and for an EBIT level more than the indifference level plan 2 is better.

 a)

The indifference level of EBIT for a given set of financial plans can be ascertained as follows: All eq. financing versus debt eq. mix : EBIT (1-t) N1 = (EBIT- interest) (1-t) N2

Where NI & N2 are total no. of eq. sh. under financial plans 1 and 2 respectively.
b) debt-equity mix versus debt equity mix ( different level of debt financing or different rates of interest on debts) (EBIT- interest 1) (1-t) = (EBIT- interest2) (1-t)

N1
c) All eq. plan versus eq. pref. plan: EBIT (1-t) N1 EBIT (1-t) N1 = EBIT(1- t) -PD N2

N2

d) All eq. plan versus eq. pref. debt mix: = (EBIT- interest)(1- t) -PD N2

illustration 2:

ABC ltd is considering a cap struct of Rs.10,00,000 for which mutually exclusive set of options are available. Calculate the indifference level of EBIT between the foll alternative sets:

1.
2. 3. 4.

Equity sh.cap of Rs.10,00,000, or 15% deb of Rs.5,00,000 plus eq. sh. cap of Rs.5,00,000.
Equity sh. cap of Rs.10,00,000 or 13% pref. sh cap of Rs.5,00,000 plus eq. sh cap of Rs.5,00,000. Eq. sh cap of Rs.6,00,000 plus 15% deb of Rs.4,00,000, or eq. sh cap of Rs.4,00,000 plus 13% pref. sh cap of Rs. 2,00,000 plus 15% deb of Rs.4,00,000. Eq. sh cap of Rs. 8,00,000 plus 13% pref. sh cap of Rs. 2,00,000, or eq. sh cap of Rs.4,00,000 plus 13% pref. sh cap of Rs.2,00,000 plus 15% deb of Rs.4,00,000. The issue price of eq. share may be taken at par i.e. Rs.100 each and the tax rate maybe assumed at 50%. Find out the indifference point of EBIT for different sets.

[ answers: 1. EBIT= Rs.1,50,000 ; 2. EBIT=Rs.2,60,000; 3. EBIT= Rs. 2,16,000; 4. EBIT=Rs.1,72,000]