EBIT-EPS analysis is used to understand the effect of leverage and compare different financing options such as exclusive equity, debt, preference shares, or combinations. An example compares EPS for a company financed by all equity, 50% debentures, 100% debentures, or 50% preference shares. Observations show plan B with interest expense deducted before tax has a higher EPS. The financial breakeven point is the minimum EBIT needed to cover fixed financing costs. Indifference points are the EBIT levels where EPS is equal for different plans. The document provides calculations to determine the indifference point for various financing plans of a company requiring $30 million, assuming a 35% tax rate.
EBIT-EPS analysis is used to understand the effect of leverage and compare different financing options such as exclusive equity, debt, preference shares, or combinations. An example compares EPS for a company financed by all equity, 50% debentures, 100% debentures, or 50% preference shares. Observations show plan B with interest expense deducted before tax has a higher EPS. The financial breakeven point is the minimum EBIT needed to cover fixed financing costs. Indifference points are the EBIT levels where EPS is equal for different plans. The document provides calculations to determine the indifference point for various financing plans of a company requiring $30 million, assuming a 35% tax rate.
EBIT-EPS analysis is used to understand the effect of leverage and compare different financing options such as exclusive equity, debt, preference shares, or combinations. An example compares EPS for a company financed by all equity, 50% debentures, 100% debentures, or 50% preference shares. Observations show plan B with interest expense deducted before tax has a higher EPS. The financial breakeven point is the minimum EBIT needed to cover fixed financing costs. Indifference points are the EBIT levels where EPS is equal for different plans. The document provides calculations to determine the indifference point for various financing plans of a company requiring $30 million, assuming a 35% tax rate.
EBIT-EPS analysis is used to understand the effect of leverage and compare different financing options such as exclusive equity, debt, preference shares, or combinations. An example compares EPS for a company financed by all equity, 50% debentures, 100% debentures, or 50% preference shares. Observations show plan B with interest expense deducted before tax has a higher EPS. The financial breakeven point is the minimum EBIT needed to cover fixed financing costs. Indifference points are the EBIT levels where EPS is equal for different plans. The document provides calculations to determine the indifference point for various financing plans of a company requiring $30 million, assuming a 35% tax rate.
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EBIT-EPS analysis
EBIT-EPS analysis • EBIT-EPS analysis is used to understand the effect of leverage • Is used to compare the different financing options like: i. Exclusive equity financing ii. Exclusively debt iii. Exclusive use of preference iv. Combination of i and ii v. Combination of I,ii and iii vi. Combination of i and iii Example: Fund required 50% debentures at 100%debentures 50% preference shares at 1000000 All equity 5% interest rate at 6% rate 5% rate A B C D EBIT 120000 120000 120000 120000 less interest 0 25000 60000 0 Earnings before tax 120000 95000 60000 120000 tax 35% 42000 33250 21000 42000 Earnings after tax 78000 61750 39000 78000 less preference dividend 0 0 0 25000 earnings to ordinary share holders 78000 61750 39000 53000 no of shares 20000 15000 10000 15000
EPS 3.90 4.12 3.90 3.53
• Observations: • For A and C companies EPS is equal. • For B and D companies, B company EPS is more because interest expense is before tax expenditure; dividend on preference capital is after tax expenditure. • Over all plan B is better option Fixed expenditure for • A plan is 0 • Plan B is 25,000 • Plan C is 60000 • Plan d is 25000/(1-35%)=38462.
• EBIT levels of 0, 25000, 60000 and 38462 for a, b, c and D respectively are the minimum to achieve financial break even. • The level of EBIT necessary for the firm to meet its fixed expenditure is called financial leverage. • EBIT below to this levels, then EPS is negative. Financial Breakeven point • Financial Breakeven point= ( this is the level of EBIT where EPS =0) • i=annual interest charges • =preference dividend • T= tax rate. Beyond the financial break-even point, increase in EPS is more than the proportionate increase in EBIT. EBIT-EPS at different levels of EBIT • EBIT = 80000 ( 4% return on total assets) • EBIT= 100000 (5% return on total assets) • EBIT = 1,60,000 (6.5% return on total assets) • EBIT=200000 (10% return on total assets) • Indifference point • The EBIT level for which the EPS is the same for two alternative finance plans is referred as the indifference level/point. • Indifference point defined as the level of EBIT beyond which the financial leverage will be favourable and leads to an increase in EPS . • Less then indifference point, the advantage of EPS would be available from the use if equity capital. EBIT-EPS Analysis Indifference point calculation • Equity shares vs debentures:
• Equity shares vs preference shares:
• • Equity shares vs preference shares (with tax on preference dividend) • • Equity shares Vs preference shares and debentures: • X= EBIT at indifference point • = no. of equity shares, if only equity shares are issued • = no. of equity shares, if both debentures and equity shares are issued • = no. of equity shares, if both preference shares and equity shares are issued • = no. of equity shares, if both preference shares and debentures are issued • i= amount of interest on debentures
• T= corporate tax • = tax on preference dividend The financial Manager of a company has formulated various financial plans to finance 30,00,000 required to implement various Capital budgeting projects. 1. Either equity capital of 30,00,000 or 15,00,000 10%debentures and 15,00,000 equity; 2. Either equity capital of 30,00,000 or 13% preference shares of 10,00,000 and 20,00,000 equity; 3. Either equity capital of 30,00,000 or 13% preference capital of 10,00,000 (subject to dividend tax of 10%), 10,00,000 10% debentures and 10,00,000 equity and 4. Either equity share capital of 20,00,000 and 10% debentures of 10,00,000 or 13% preference capital of 10,00,000 , 10% debentures of 8,00,000 and 12,00,000 equity You are required to determine the indifference point for each financial plan , assuming 35 % corporate tax rate and the face value of equity shares as 100 i). Either equity capital of 30,00,000 or 15,00,000 10%debentures and 15,00,000 equity; • • T= 35%; i= 1,50,000 , • 0.65* X = (1.3* X) -195000 N1( no of equity shares if only equity)= 30,00,000/100= 30000 • O.65 *X = 195000
N2( no of equity share if equity and • X= 195000/0.65 = 300000.
debentures)= 1500000/100= 15000 X= EBIT = 300000 conclusion: at EBIT
Equity shares vs Equity and debentures: level 3,00,000 EPS is same between • these two financing options. • 1. Either equity capital of 30,00,000 or 15,00,000 10%debentures and 15,00,000 equity; •ii. Either equity capital of 30,00,000 or 13% preference shares of 10,00,000 and 20,00,000 equity; N3 ( no of equity when preference and equity )= 20000 DP= 130000 • Equity shares vs preference shares:
• X= 600000 1. Either equity capital of 30,00,000 or 13% preference shares of 10,00,000 and 20,00,000 equity; • iii) Either equity capital of 30,00,000 or
13% preference capital of 10,00,000 (subject to dividend tax of 10%), 10,00,000 10% debentures and 10,00,000 equity and
• Equity shares Vs preference shares and debentures:
• N4= 10,000 ; i= 100000 ; dp= 130000
• X= 4,80,000 1. Either equity capital of 30,00,000 or 13% preference capital of 10,00,000 (subject to dividend tax of 10%), 10,00,000 10% debentures and 10,00,000 equity and • iv) Either equity share capital of 20,00,000 and 10% debentures of 10,00,000 or
13% preference capital of 10,00,000 , 10% debentures of 8,00,000 and 12,00,000 equity
X= 5,50,000 1. Either equity share capital of 20,00,000 and 10% debentures of 10,00,000 or 13% preference capital of 10,00,000 , 10% debentures of 8,00,000 and 12,00,000 equity ROI-ROE analysis ROI-ROE analysis • ROI=
• ROE= • Korex ltd which requires an investment outlay of ₹ 100millions is considering two capital structures:
A B
Equity 100 Equity 50
Debt 0 Debt 50
Average cost of debt is fixed at 10% , tax rate is 50%
Estimate the relationship between ROI and ROE under the two capital structures. ROE= [ROI +(ROI-r)*(D/E)] *(1-Tax)
PBIT 5 10 15 20 25 Interest 5 5 5 5 5 PBT 0 5 10 15 20 Capital structure B tax 0 2.5 5 7.5 10 ( equity =50, debt= 50) PAT 0 2.5 5 7.5 10 ROE 0.0% 5.0% 10.0% 15.0% 20.0% Observations: • If ROI is same as cost of capital (ROI= Cost of debt) • ROE under two capital structures is same
• ROE is indifference when ROI value is equals to cost of debt
• If ROI is less than cost of capital ( ROI < cost of debt)
• ROE of Capital structure A is better
• If ROI is greater than cost of capital ( ROI > Cost of debt)
• ROE of Capital structure B is better Not there for exam • Trade –off theory • Signalling theory • Pecking order theory • Agency cost
