Indifference EBIT - 

Capital Structure of Corporations

The EBIT-EPS indifference point is a calculation used in determining optimal capital structures. What that means is
firms typically finance their operations with two primary means, equity and debt. Back to the indifference point,
algebraically and graphically when the earnings per share for debt and equity financing alternatives are equal, you
have the EBIT-EPS indifference point. Put another way a firm can finance their operations at the same cost, with
either debt or equity, at the indifference point.
EPS (debt financing) = EPS (equity financing)

Indifference Earnings Before Interest & Taxes (Indifference EBIT) is the point of the capital

structure where the corporation does not care about whether they issue new debt, have no debt and 100%
equity or have a combination of both debt & equity.

From the graph below, you can determine that the Indifference EBIT point is where the With Debt Capital
Structure Line intersects with the No Debt Capital Structure Line. Any point to the left of Indifference
EBIT is risky debt while any point to the right of Indifference EBIT is good debt (interest expense that is
tax deductible).

Indifference EBIT Example

ABC Corp. currently has 200,000 shares outstanding on the stock market with the current price being
$20. The Board of Directors of the Corp want to incur a debt of $1 million by issuing junk bonds that have
a coupon interest rate of 9% annually. At what point of EBIT would the Corp. be indifferent to having debt
or NO debt?

Solution:

Current Capital Structure = $20 x 200,000 shares = $4,000,000 Equity

New Capital Structure = $3,000,000 Equity & $1,000,000 Debt

- Current Stock Price Remains at $20. 
- To attain $3,000,000 of Equity, the # of shares = 150,000.

Annual Interest Expense Coupon Payments = 9% x 1,000,000 = $90,000

  No Debt With Debt  

EBIT - 0 = EBIT - 90,000
Indifference EBIT  
200,000 150,000
150,000 EBIT = 200,000 (EBIT - 90,000)
150,000 EBIT = 200000EBIT - 18000000000
18000000000 = 200,000 EBIT - 150,000 EBIT
Indifference EBIT
18000000000 = 50,000 EBIT
EBIT = 18000000000 / 50,000
EBIT = $360,000

Interpretation of EBIT

At a point where Earnings Before Interest & Taxes is $360,000, ABC Corp. will not care whether it has
any outstanding debt issues, NO debt or a combination of both because at this point, the value of
the Capital Structure is NOT affected.

Question / Case Study

Calculate the EBIT-EPS indifference point.

Emco Products has a present capital structure consisting only of common stock (10 million shares).   The company is planning a
major expansion.  At this time, the company is undecided between the following two financing plans (assume a 40% tax rate).

Plan 1 (equity financing).  Under this plan, an additional 5 million shares of common stock will be sold at $10 each

Plan 2 (debt financing). Under this plan, $50 million of 10% long term debt will be sold.

One piece of information the company desires for its decision analysis is and EBIT-EPS analysis.

A. Calculate the EBIT-EPS indifference point.

B. Graphically determine the EBIT-EPS indifference point.

            Hint: Use EBIT = $10 million and $25 million

C. What happens to the indifference point if the interest rate on debt increases and the common stock sale price remains constant?

D. What happens to the indifference point if the interest rate on debt remains constant and the common stock sales price increases?
 EBIT/EPS Analysis

Glossary

EBIT - Earnings Before Interest and Taxes.  Accountants like to use the term Net

Operating Income for this income statement item, but finance people usually refer to
it as EBIT (pronounced as it is spelled - E, B, I, T).  Either way, on an income
statement, it is the amount of income that a company has after subtracting operating
expenses from sales (hence the term net operating income).  Another way of looking
at it is that this is the income that the company has before subtracting interest and
taxes (hence, EBIT).

EAT - Earnings After Taxes.  Accountants call this Net Income or Net Profit After

Taxes, but finance people usually refer to it as EAT (pronounced E, A, T).

EPS - Earnings Per Share.  This is the amount of income that the common

stockholders are entitled to receive (per share of stock owned).  This income may be
paid out in the form of dividends, retained and reinvested by the company, or a
combination of both. (It is pronounced E, P, S).

The Analysis

I need to raise additional money by issuing either debt, preferred stock, or common
stock.   Which alternative will allow me to have the highest earnings per share?

This question calls for an EBIT/EPS analysis.  Simply put, this simply means that we
will calculate what our earnings per share will be at various levels of sales (and
EBIT).

Actually, it isn't necessary to start with sales.  Since a company's EBIT, or net
operating income, isn't affected by how the company is financed, we can skip down
the income statement to the EBIT line and begin there.  In other words,

1. we assume a certain level of sales,

2. calculate our estimated EBIT at that level, and
 3. then calculate what our EPS will be for each alternative form of financing
(debt, preferred stock, and common stock).

An Illustration

For example, let's assume that the company:

1. is currently financed entirely with common stock (i.e., no debt and no

preferred stock).  The firm has 2,000 shares of common stock outstanding.
2. currently pays no common stock dividend; all earnings are retained and
reinvested into the company.
3. needs to raise $50,000 in new money.  As financial manager, you want to
know which financing alternative should be used.
4. is in the 35% tax bracket.

To raise the $50,000, you are considering three alternatives:

1. common stock - The company can sell additional shares at the current price of
$50 per share.  This means that 1,000 new shares of common stock will need
be to be sold ($50,000/$50 per share).
2. preferred stock - The dividend yield on preferred stock will have to be 7.3% of
the amount of money raised.  (The preferred can be sold for $40 per share.)
The number of shares of common stock will remain unchanged.
3. debt - The interest rate on any new debt will be 4% per year.  The number of
shares of common stock will remain unchanged.

Let's pick a beginning level for EBIT of $10,000.  We can then calculate what the
earnings per share will be for each financing alternative.

Common Preferred
Stock   Stock   Debt 

   Price per share $50.00 $40.00 N/A

   Annual Rate N/A 7.3% 4.0%

   Common Stock $100,000 $100,000 $100,000

+ Additional Funds + 50,000 + 50,000 + 50,000

   Total Funds $150,000 $150,000 $150,000

 

  EBIT (Net Operating Income) $10,000 $10,000 $10,000

- Interest Expense (@4%) -0 -0 - 2,000

  Earnings Before Taxes 10,000 10,000 8,000

- Taxes (@35%) - 3,500 - 3,500 - 2,800

  EAT (Net Income) 6,500 6,500 5,200

- Preferred Dividends (@7.3%) -0 - 3,650 -0

  Earnings Available to Common (EATC) 6,500 2,850 5,200

  No. of Common Shares 3,000 2,000 2,000

  Earnings Per Share (EATC/# of shares).) $2.17 $1.43 $2.60

The above table shows us the earnings per share at an EBIT level of $10,000.  If sales
are sufficiently high to give us an EBIT level of $10,000, then our EPS will be highest
by issuing debt, next highest by issuing common stock, and lowest by issuing
preferred stock.

However, we would eventually like to draw a graph of the EPS over a range of sales
and EBIT.  This will allow us to understand the relationship between sales and EPS
more fully.  As sales (and EBIT) increase, what will happen to earnings per share?

This is easily answered - we just repeat the above table for a different level of EBIT. 
Let's assume that we don't think that our company's EBIT will fall below 2,000, so we
can reproduce the table for that level of EBIT.  If we think that the highest value for
EBIT during the next few years will be $30,000, then we might choose that level
also.  While we're at it, let's throw in an EBIT of $20,000 also.  In other words, we
will construct the above table for four values of EBIT:  $2,000, $10,000, $20,000 and
$30,000.

The EBIT/EPS Graph

Once the tables have been constructed, we can draw the graph below. We simply plot
the earnings per share under each alternative for each of our EBIT levels and connect
the dots to draw the lines.
Relationships

Notice the following points:

1. The preferred stock line is parallel to the debt line and lies below the debt line. 
This will always be the case because debt has two distinct advantages over
preferred stock:

a. debt is the cheaper form of financing (i.e., the interest rate is less than the
preferred dividend yield) because it enjoys greater protection in the event of
bankruptcy or default), and
b. interest on the debt is tax-deductible and preferred stock dividends are not
tax-deductible.

This means that the EPS will always be higher under debt financing than under
preferred stock financing.  Since both options pay a fixed rate (e.g., 4% and 7.3%),
they offer similar effects of leverage - leading to the parallel lines above.  Preferred
stock may offset this quantitative advantage with some qualitative ones (less
restrictive provisions, etc.), but debt financing will always offer the higher earnings
per share - a big advantage.

Since common stock financing offers a smaller degree of leverage, the slope of the
common stock line is less than the other two lines. This leads to two "crossover
points" where the common stock line crosses the other two lines.  These are
indifference points.

1. At an EBIT level of $6,000, you would be indifferent between common stock

financing and debt financing.  Both will give you the same EPS (of $1.30 per
share).
2. At an EBIT level of $16,800, you would be indifferent between common stock
financing and preferred stock financing.  Both will give you the same EPS (of
$3.64 per share). However, this point is relatively unimportant since preferred
stock won't likely be used by the company (since using debt always yields a
higher EPS than preferred stock).

Summary

So which of the three financing alternatives should we use to raise the $50,000?  It all
depends on our sales forecast.  We estimate the future level of sales and calculate our
expected level of EBIT for this sales level.

If the expected level of EBIT is:

 less than $6,000, we would tend to use common stock financing.  Our EPS will
be higher than the other two alternatives as long as sales are weak enough to
keep us below the $6,000 EBIT level.  As sales and EBIT fall, the fact that we
don't have to pay a fixed interest or dividend payment is a big advantage and
offers the company a great deal of flexibility.

 above $6,000, we would use tend to use debt financing.  The EPS level is
maximized by using debt as long as sales are high enough to keep us above the
$6,000 EBIT level.  As sales increase, the higher financial leverage causes EPS
to rise at a much faster rate than common stock financing would do.

What if the forecasted sales level is equal to (or very close to) the indifference
point of $6,000?  Then you would not make the decision based on the basis of EPS. 
There are a number of qualitative factors that will increase in importance and you
would tend to weigh these factors closely in making the debt vs. equity decision.

We would not consider using preferred stock financing at all unless there is some
compelling reason to do so.  There may be reasons for doing this - to avoid restrictive
debt covenants, to gain greater flexibility, to avoid using up all of your debt capacity
at the present time, etc.  However, from a quantitative standpoint, EPS under debt
financing will always be higher than the preferred stock alternative.