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

• N2= 20000; N4= 12000 ; i= 100000 i= 80000 ; Dp= 130000

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)

ROI Equit
5% 10% 15% 20% 25% debt
y
(5%+(5%- (10%+(10%- (15%+(15%- (20%+(20%- (25%+(25%-
0)*(0/100))*5 0)*(0/100))*50% 0)*(0/100))*50% 0)*(0/100))*50% 0)*(0/100))*50% 100 0%
ROE
0%

ROE 2.5% 5.0% 7.5% 10.0% 12.50%

Equity debt

ROI 50 50
5% 10% 15% 20% 25%
((5%+(5%- ((10%+(10%- ((15%+(15%- ((20%+(20%- ((25%+(25%-
ROE 10%)*(50/50) 10%)*(50/50))*50 10%)*(50/50)) 10%)*(50/50))* 10%)*(50/50))*50%
)*50% % *50% 50% Cost of
debt is
10%
ROE 0.0% 5.0% 10.0% 15.0% 20.0%
ROI 5% 10% 15% 20% 25%
PBIT 5 10 15 20 25 Capital structure A
Interest 0 0 0 0 0 ( equity =100, debt= 0)
PBT 5 10 15 20 25
tax 2.5 5 7.5 10 12.5
PAT 2.5 5 7.5 10 12.5
ROE 2.5% 5.0% 7.5% 10.0% 12.5%

ROI 5% 10% 15% 20% 25%

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