PART 1

EBIT - EPS
ANALYSIS
 EBIT EPS ANALYSIS

1.1 Introduction

The analysis of the effect of different patterns of financing or the financial leverage on
the level of returns available to the shareholders, under different assumptions of EBIT is known
as EBIT-EPS analysis. A firm has various options regarding the combinations of various sources
to finance its investment activities. The firms may opt to be an all-equity firm (and having no
borrowed funds) or equity-preference firm (having no borrowed funds) or any of the numerous
possibility of combinations of equity, preference shares and borrowed funds. However, for all
these possibilities, the sales level and the level of EBIT is irrelevant as the pattern of financing
does not have any bearing on the sales or the EBIT level. In fact, the sales and the EBIT level
are affected by the investment decisions.

Given a level of EBIT, a particular combination of different sources of finance will result
in a particular EPS and therefore, for different financing patterns, there would be different levels
of EPS.

Definition
EBIT-EPS analysis is a technique used to determine the optimal capital structure in which the
value of earnings per share (EPS) has the highest amount for a given amount of earnings before
interest and taxes (EBIT). In other words, the objective of EBIT-EPS analysis is to determine the
effect of using different sources of financing on EPS.
Formula
EBIT-EPS indifference point is an important tool used to choose between two alternative
financing plans. The formula to calculate it is as follows:
(EBIT - IA)(1 - T) - PDA (EBIT - IB)(1 - T) - PDB
=
SA SB
where:
EBIT – earnings before interest and taxes
IA – interest expense in financing plan A
IB – interest expense in financing plan B
T – corporate income tax rate
PDA – preferred dividends payable in financing plan A
PDB – preferred dividends payable in financing plan B
SA – amount of common stock outstanding in financing plan A

1.2 Financial Breakeven Point:

In general, the term Breakeven Point (BEP) refers to the point where the total cost line and sales
line intersect. It indicates the level of production and sales where there is no profit and no loss
because here the contribution just equals to the fixed costs. Similarly financial breakeven point is
the level of EBIT at which after paying interest, tax and preference dividend, nothing remains for
the equity shareholders.

In other words, financial breakeven point refers to that level of EBIT at which the firm can
satisfy all fixed financial charges. EBIT less than this level will result in negative EPS. Therefore
EPS is zero at this level of EBIT. Thus financial breakeven point refers to the level of EBIT at
which financial profit is nil.

Financial Break Even Point (FBEP) is expressed as ratio with the following equation:
 Constant EBIT and Changes in the Financing Patterns: Holding the EBIT constant
while varying the financial leverage or financing patterns, one can imagine the firm increasing its
leverage by issuing bonds and using the proceeds to redeem the capital, or doing the opposite to
reduce leverage.

Suppose, ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per annum on an
investment Rs.5,00,000, is considering the finalization of the capital structure or the financial
plan. The company 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.

1. By issuing equity share capital at par.

2. 50% funds by equity share capital and 50% funds by preference shares.

3. 5% funds by equity share capital, 25% by preference shares and 25% by issue of 10%
debentures.

4. 25% funds by equity share capital, 25% as preference share and 50% by the issue of 10%
debentures.

Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS under the above four options can
be calculated as follows:

Option 1 Option 2 Option 3

Option 4

Equity share capital Rs.5,00,000 Rs.2,50,000 Rs.2,50,000 Rs.1,25,000

Preference share capital --- 2,50,000 1,25,00 1,25,000

10% Debentures --- --- 1,25,000 2,50,000

Total Funds 5,00,000 5,00,000 5,00,000 5,00,000

EBIT 1,50,000 1,50,000 1,50,000 1,50,000

- Interest --- --- 12,500 25,000

 Profit before Tax 1,50,000 1,50,000 1,37,500 1,25,000

- Tax @ 50% 75,000 75,000 68,750 62,500

Profit after Tax 75,000 75,000 68,750 62,500

- Preference Dividend --- 30,000 15,000 15,000

Profit for Equity shares 75,000 45,000 53,750 47,500

No. of Equity shares (of Rs.100 5000 2500 2500 1250

each)

EPS (Rs.) 15 18 21.5 38

In this case, the financial plan under option 4 seems to be the best as it is giving the
highest EPS of S.38. In this plan, the firm has applied maximum financial leverage. The firm is
expecting to earn an EBIT of Rs.1,50,000 on the total investment of Rs.5,00,000 resulting in
30% return. On an after-tax basis, this return comes to 15% i.e., 30% x (1-.5). However, the
after tax cost of 10% debentures is 5% i.e., 10% (1- .5) and the after tax cost of preference shares
is 12% only. In the option 4, the firm has employed 50% debt, 25% preference shares and 25%
equity share capital, and the benefits of employing 50% debt (which has after tax cost of 5%
only) and 25% preference shares (having cost of 12% only) are extended to the equity
shareholders. Therefore the firm is expecting an EPS of Rs.38.

In case, the company opts for all-equity financing only, the EPS is Rs.15 which is just
equal to the after tax return on investment. However, in option 2, where 5% funds are obtained
by the issue of 12% preference shares, the 3% extra is available to the equity shareholders
resulting in increase in of EPS from Rs.15 to Rs.18. In plan 3, where 10% debt is also
introduced, the extra benefit accruing to the equity shareholders increases further (from
preference shares as well a from debt) and the EPS further increases to Rs.21.50. The company
is expecting this increase in EPS when more and more preference share and debt financing is
availed because the after tax cost of preference shares and debentures are less than the after tax
return on total investment.
 Hence, the financial leverage has a favourable impact on the EPS-only if the ROI is more
than the cost of debt. It will rather have an unfavourable effect if the ROI is less than the cost of
debt. That is why financial leverage is also called the twin-edged sword.

Varying EBI with Different Patterns: Suppose, there are three firm X & Co., Y & Co.
and Z & Co. These firms are alike in all respect except the leverage. The financial position of
the three firms is presented as follows:

Capital Structure X & Co. Y & Co. Z & Co.

Share Capital (of Rs.100 each) Rs.2,00,000 Rs.1,00,000 Rs.50,000

6% Debenture --- 1,00,000 1,50,000

Total 2,00,000 2,00,000 2,00,000

These firms are expected to earn a ROI at different levels depending upon the economic
conditions. In normal conditions, the ROI is expected to be 8% which may fluctuate by 3% on
either side on the occurrence of bad economic conditions or good economic conditions. How is
return available to the shareholders of the three firms is going to be affected by the variations in
the level of EBIT due to differing economic conditions? The relevant presentations have been
shown as follows:

Poor Normal
Good
Eco. Cond. Eco. Cond.
Eco. Cond.

Total Assets Rs.2,00,000 Rs.2,00,000 Rs.2,00,000

ROI 5% 8% 11%

EBIT Rs.10,000 Rs.16,000 Rs.22,000

 X & Co. (No Financial Leverage) (Figures in Rs.)

EBIT 10,000 16,000 22,000

- Interest --- --- ---

Profit before Tax 10,000 16,000 22,000

- Tax @ 50% 5,000 8,000 11,000

Profit After Tax 5,000 8,000 11,000

Number of Shares 2,000 2,000 2,000

EPS (Rs.) 2.5 4 5.5

Y & Co. (50% Leverage) (Figures in Rs.)

EBIT 10,000 16,000 22,000

- Interest 6,000 6,000 6,000

Profit before Tax 4,000 10,000 16,000

- Tax @ 50% 2,000 5,000 8,000

Profit After Tax 2,000 5,000 8,000

Number of Shares 1,000 1,000 1,000

EPS (Rs.) 2 5 8
 Z & Co. (75% Leverage) (Figures in Rs.)

EBIT 10,000 16,000 22,000

- Interest 9,000 9,000 9,000

Profit before Tax 1,000 7,000 13,000

- Tax @ 50% 500 3,500 6,500

Profit After Tax 500 3,500 6,500

Number of Shares 500 500 500

EPS (Rs.) 1 7 13

On the basis of the figures given above, it may be analyzed as to how the financial
leverage affects the returns available to the shareholders under varying EBIT level. For this
purpose, the normal rate of return i.e. 8% and EPS of different firms in normal economic
conditions, both may be taken at 100 and position of other figures of EBIT and EPS may be
shown on relative basis as follows:

Poor Eco. Cond. Normal Eco. cond. Good Eco. cond.

EBIT 62.5 100 137.5

X & Co.

EPS 62.5 100 137.5

% change from normal - 37.5% ---- + 37.5%

Y & Co.

EPS 40 100 160

% change from normal -60% ----- +60%

Z & Co.
EPS 14.3 100 185.7

% change from normal -85.7% ----- +85.7%

It is evident from the above figures that when economic conditions change from normal
to good conditions, the EBIT level increases by 37.5% (i.e. from 8% to 11%). The firm X & Co.
having no leverage, is not able to have the magnifying effect of its EBIT and therefore its EPS
increases only by 37.5%. On the other hand the firm Y& Co.(having 50% leverage) is able to
have an increase in EPS (from Rs. 5 to Rs. 8). Similarly, the firm Z & Co.(having still higher
leverage of 75%) is able to have an increase of 85.7% in EPS (from Rs. 7 to Rs.13). Thus, higher
the leverage, greater is the magnifying effect on the EPS in case when economic condition
improves

On the other hand just reverse is the situation in case when economic conditions worsen
and the EBIT level is reduced by 37.5% (i.e. from 8% ROI to 5% ROI). In this case the EPS of X
& Co. reduces only by 37.5%(from Rs 4 to Rs 2.5) whereas the EPS of Y & Co. (50% leverage)
reduces by 60% (from Rs. 5 to Rs.2). In case of Z & Co. the decrease is more pronounced and
EPS reduces by 85.7% (from Rs. 7 to Rs. 13). Thus, higher the leverage, greater is the
magnifying effect on the EPS in case when the economic conditions improve.

On the other hand, just reverse is the situation in case when the economic conditions
worsen and the EBIT level reduced by 37.5% ) i.e. from 8% ROI to 5% ROI ). In this case, the
EPS of X & Co. reduces only by 37.5% (from Rs. 4 to Rs. 2.5 ), whereas the EPS of Y &Co.
(50% leverage) reduces by 60%(from Rs. 5 to Rs. 2). In case of Z & Co. the decrease is more
pronounced and EPS reduces by 85.7% (from Rs. 7 to Rs.1).

Financial Break-Even Level

In case the EBIT level of a firm is just sufficient to cover the fixed financial charges then
such level of EBIT is known as financial break-even level. The financial break-even level of
EBIT may be calculated as follows:

If the firm has employed debt only (and no preference shares), the financial break-even
EBIT level is :
 Financial break-even EBIT = Interest Charge

If the firm has employed debt as well as preference share capital, then its financial break-
even EBIT will be determined not only by the interest charge but also by the fixed preference
dividend. It may be noted that the preference divided is payable only out of profit after tax,
whereas the financial break-even level is before tax. The financial break-even level in such a
case may be determined as follows:

Financial break-even EBIT = Interest Charge + Pref. Div./(1-t)

1.3 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 two or more financial plans which result in the same level of EPS for a
given EBIT. Such a level of EBI at which the firm has two or more financial plans resulting in
same level of EPS, is known as indifference level of EBIT.

The use of financial break-even level an the return from alternative capital structures is
called the indifference point analysis. The EBIT is used as a dependent variable and the EPS
from two 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. The following example will
illustrate this point.

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 two alternative plans if the existing
capital structure of the firm stands at 10,000 shares. The above situation can be analyzed as
follows
 Financial Plan 1 Financial Plan 2

Number of existing shares 10,000 10,000

Number of new shares 1,000 ---

Total Number of shares 11,000 10,000

10% Debenture --- Rs.50,00,000

EBIT (Given) Rs.55,00,000 Rs.55,00,000

- Interest --- 5,00,000

Profit before Tax 55,00,000 50,00,00

Tax @ 50% 27,50,000 25,00,000

Profit after Tax 27,50,000 25,00,000

EPS (Rs.) 250 250

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 company is expecting EBIT of Rs.50,00,000 or Rs.60,00,000, the EPS for
both the financial plans has been calculated in the following table.
 Financial Plan 1 Financial Plan 2

EBIT Rs.50,00,000 Rs.60,00,000 Rs.50,00,000 Rs.60,00,000

- Interest --- --- 5,00,000 5,00,000

Profit before Tax 50,00,000 60,00,000 45,00,000 55,00,000

Tax @ 50% 25,00,000 30,00,000 22,50,000 27,50,000

Profit after Tax 25,00,000 30,00,000 22,50,000 27,50,000

Number of Equity shares 11,000 11,00 10,000 10,000

EPS (Rs.) 227 272 225 275

The above figures show that for an EBIT level 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 in case of levered option than the EPS of Rs.272 under unlevered
option.

If the firm expects to generate exactly the same amount of EBIT at which the EBIT-EPS
lines intersect, ten from the point of view of the equity shareholders, the firm would be
indifferent as to choice of capital structure because the same EPS would result from either of the
alternatives.

Figure shows that if the firm expects the EBIT at a level higher than the indifference
level, plan I is better and the PS will be higher than EPS under plan II. However, if the expected
level of EBIT is less than the indifference level of EBIT, than plan II is better as the EPS under
plan II will be higher. It is only in such a situation when the expected EBIT is just equal to the
indifference level of EBIT that the EPS under both the plans would be same.
 The EBIT-EPS line or a particular financial plan also shows the financial break even
level of EBIT. The intercepts on the horizontal axis OA (in case of plan II) and OB (in case of
plan I) are the financial break even level of EBIT under respective financial plans.

1.4 Graphical Approach:

The indifference point may also be obtained using a graphical approach. In Figure 5.1 we have
measured EBIT along the horizontal axis and EPS along the vertical axis. Suppose we have two
financial plans before us: Financing by equity only and financing by equity and debt. Different
combinations of EBIT and EPS may be plotted against each plan. Under Plan-I the EPS will be
zero when EBIT is nil so it will start from the origin.

The curve depicting Plan I in Figure 5.1 starts from the origin. For Plan-II EBIT will have some
positive figure equal to the amount of interest to make EPS zero. So the curve depicting Plan-II
in Figure 5.1 will start from the positive intercept of X axis. The two lines intersect at point E
where the level of EBIT and EPS both are same under both the financial plans. Point E is the
indifference point. The value corresponding to X axis is EBIT and the value corresponding to 7
axis is EPS.

These can be found drawing two perpendiculars from the indifference point—one on X axis and
the other on Taxis. Similarly we can obtain the indifference point between any two financial
plans having various financing options. The area above the indifference point is the debt
advantage zone and the area below the indifference point is equity advantage zone.

Above the indifference point the Plan-II is profitable, i.e. financial leverage is advantageous.
Below the indifference point Plan I is advantageous, i.e. financial leverage is not profitable. This
can be found by observing Figure 5.1. Above the indifference point EPS will be higher for same
level of EBIT for Plan II. Below the indifference point EPS will be higher for same level of
EBIT for Plan I. The graphical approach of indifference point gives a better understanding of
EBIT-EPS analysis.
 

1.5 Shortfalls of EBIT-EPS Analysis

EBIT-EPS analysis helps in making a choice for a better financial plan. However, it may
have two complications namely:

1. If neither of the two mutually exclusive alternative financial plans involves issue of new
equity shares, then no EBIT indifference point will exist. For example, a firm has a capital
consisting of 1,00,000 equity shares and wants to raise Rs. 10,00,000 additional funds for
which the following two plans are available: (i) to issue 10% bonds of Rs. 10,00,000, or(ii) to
issue 12% preference shares of Rs. 100 each. Assuming tax rate to be 50% the indifference
level of EBIT for the two plans would be as follows:

(EBIT – 1,00,000) (1 - .5)/1,00,000 = EBIT (1 - .5) – 1,20,000

.5 EBIT – 50,000 = 5 EBIT – 1,20,000

0 = - 70,000

So, there is an inconsistent result and it indicates that there is no indifference point of
EBIT. If the EBIT-EPS lines of these two plans are drawn graphically, these will be parallel
and no intersection point will emerge.
2. Sometimes, a given set of alternative financial plans may give negative EPS to cause an
indifference level of EBIT. For example, a firm having 1,00,000 equity shares already
issued, requires additional funds of Rs.10,00,000 for which the following two options are
available : (i) to issue 20,000 equity shares of Rs.25 each and to raise to Rs.5,00,000 by the
issue of 9% bonds, or (ii) to issue 30,000 equity shares at Rs.25 each and to issue 2,500 12%
preference shares of Rs. 100 each. Assuming the tax rate to be 50%, the indifference level of
EBIT for the two plans would be as follows :

= EBIT = Rs. – 1,35000

So, the indifference point occurs at a negative value of EBIT, which is imaginary.

1.6 Conclusion

 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 particular combination of different sources will result in a

particular level of EPS, and therefore for different financing patterns, there would be
different levels of EPS.

 Financial break even level of EBIT is that level of EBIT at which EPS of a firm is zero.

Indifference level of EBIT is one at which the EPS remains same under two different financial
plans. At the difference level of EBIT, the firm would be indifferent whether funds are raised by
one capital mix or another both will have same level of EPS.
 PART 2
NET INCOME
APPROACH
 NET INCOME APPROACH

This approach has been propounded by Durand David in 1959 (Pandey, 2005). According to this
approach, the market value of equity shares is based on the earning available for equity
shareholders after the payment of interest on debt if it is included in the Capital Structure. The
earning of the firm after the payment of all other expenses except interest on debt is called Net
Operating Income (NOI) and the earning available for equity shareholders after the payment of
interest is called as “Net Income (NI).

Therefore, Net Income = Net Operating Income (NOI) - Interest on debt (I).

As per the preposition of this theory, the market value of equity shares is decided on the basis of
net income available for equity shareholders and hence, this theory is called as NI approach. The
market value of the firm is decided by adding the market value of debt 88 to the market value of
equity shares. As the net income and cost of capital differs with the use of debt in Capital
Structure, the market value of the equity shares also changes accordingly. This phenomenon
ultimately changes the market value of the firm and hence; as per this approach, capital structure
decision becomes relevant to the valuation to the firm. In other words, a change in the capital
structure brings a corresponding change in the overall cost of capital as well the total value of the
firm.

Assumptions To The Approach

According to this approach, as the debt increases, overall or weighted average cost of capital
decreases and vice versa. Therefore increase in debt results in the increase in the value of the
firm and consequently increases the value of the equity shares of the company. Net Income
approach is based on the following three assumptions:
(i) There are no corporate taxes.
(ii) The cost of debt is less than the cost of equity i.e. the capitalization rate of debt is less than
the rate of equity capitalization. This prompts the firm to borrow.
(iii) The debt capitalization rate and the equity capitalization rate remain constant.
(iv) The proportion of the debt does not affect the risk perception of the investors. Investors are
only concerned with their desired return.
(v) The cost of debt remains constant at any level of debt.
(vi) Dividend pay out ratio is 100%. As per this approach, the firms try to optimize the capital
structure by introducing more and more debt having less cost than equity in the capital structure.

Therefore, when the financial leverage is increased the proportion of cheaper source of funds i.e.
debt increases and overall cost of capital declines which consequently increases the market value
of the firm and also the value of the equity share of the firm.
Hence, the optimum capital structure exists when the firm employs 100% debt or maximum debt
in the capital structure. According to this approach, the value of the firm and the value of equity
are determined as under.

Market Value of the firm (V) = Market value of equity (E) + Market value of debt (D)
MI Market value of Equity (E) = Ke
Market Value of Debt (D) = ~ Kd
Where, NI = Net income available for equity share holders i.e.
NOI-I NOI =Net Operating Income
I = Interest on debt
Ke = Rate of equity capitalization (Cost of Equity)
Kd = Rate of debt capitalization (Cost of Debt)
Cost of Capital (Ko) or Weighted Average Cost of Capital (WACC)
From the diagram, it is clear that as the debt is replaced by equity in the capital structure the
weighted average cost of capital (Ko) decreases. The WACC decreases because the debt is
cheaper than the equity and therefore as the debt increases and equity reduces, the funds having
less cost is replaced by the funds having more cost.

Optimum Capital Structure under NI Approach

The capital structure is said to be optimum at that stage of debt-equity mix where the overall
cost of capital is minimum. As per this approach the cost of capital is minimum at 100% level of
debt, therefore the capital structure is optimized at the 100% debt level.
Practical Problem
A company expects its annual EBIT to be $50,000. The company has $200,000 in 10%
bonds and the cost of equity is 12.5(ke)%.
Calculation of the Value of the firm:

Effect of change in the capital structure: (Increase in debt capital)

Let us assume that the firm decides to retire $100,000 worth of equity by using the
proceeds of new debt issue worth the same amount. The cost of debt and equity would remain
the same as per the assumptions of the NI approach. This is because one of the assumptions is
that the use of debt does not change the risk perception of the investors.

Calculation of new value of the Firm

Please note:
Overall cost of capital can also be calculated by using the weights of debt and equity
contents with the respective cost of capitals.

This proves that the use of additional financial leverage (debt) causes the value of the firm
to increase and the overall cost of capital to decrease.

Criticisms of NI Approach

However, NI approach takes into consideration the earning available for equity shareholders for
calculating the market value of equity shares, it is more realistic and reflects the impact of
financial leverage on market value of the firm, it suffers from some drawbacks. The NI approach
is criticized on following grounds: The effect of leverage on the cost of capital under NI
approach Financial Leverage

(i) The assumption of constant cost of debt at any level of debt is not correct. The funds
providers insist for more rate of interest above certain level of debt.

(ii) The assumption of risk perception of equity share holders is also not correct. As the debt
increases the financial risk also increases and equity share holders will expect more return on
their investment and hence the rate equity capitalization also increases with the increase in
financial leverage.

(iii) 100% dividend payout and absence of corporate tax are not practically possible