The EBIT-EPS analysis, as a method to study the effect of leverage, essentially involves the comparison of alternative methods of financing under various assumptions of EBIT. A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. For instance, it can (i) exclusively use equity capital
(ii) exclusively use debt
(iii) exclusively use preference capital
(iv) use a combination of (i) and (ii) in different proportions (v) a combination of (i), (ii) and (iii) in different proportions (vi) a combination of (i) and (iii) in different proportions and so on. The choice of the combination of the various sources would be one which, given the level of earnings before interest and taxes, would ensure the largest EPS. Generally cost of debt is lower than cost of equity. Therefore raising debt (trading onequity) increases EPS and it gives benefit to the shareholders. However, excess of debt will create more risk and therefore it is not advisable. A firm can identify an ideal level of quantum of debt and equity so that it is within proportion. EBIT can be calculated by subtracting variable and fixed cost from net sales. EPS can be obtained by dividing the result of tax and interest subtracted from EBIT by No. of shares. i.e EPS = [( EBIT – I ) ( 1 – T ) – PREF] / S
A company with long-term capitalization of $ 10 million consisting entirely of common stock wishes to raise another $5 million for expansion through one of the three possible financing plans.The company may finance with
1.All common stock
2.All debt at 9%
3.All preferred stock with 7% dividend
EBIT is $ 1,400,000 and tax rate is 50%. 200,000 shares of stock are presently outstanding.Common stock can be sold at $ 50 per share.( 100,000 additional shares) To determine the EBIT breakeven, EPS is calculated for a hypothetical level of EBIT. In this example, the hypothetical level of EBIT is $ 2million. All common All debt All preferred
EBIT 2,000,000 2,000,000 2,000,000
Interest ------- 450,000 -------
Earnings before taxes 2,000,000 1,550,000 2,000,000
Taxes 1,000,000 775,000 1,000,000
Net Income 1,000,000 775,000 1,000,000
Preferred stock dividend --------- --------- 350,000
Earnings available to
Shareholders 1,000,000 775,000 650,000
Number of shares 300,000 200,000 200,000
Earnings per share $3.33 $3.88 $3.25
Interest on debt is deducted before taxes while preferred stock dividends are deducted after taxes.As a result, earnings available to stockholders are higher under debt alternative than they are under preferred stock alternative despite the fact that the interest rate on debt is higher than the preferred stock dividend rate.
EBIT necessary to cover fixed financial costs for a particular financing plan is calculated for debt altenative, an EBIT of $ 450,000 is needed to cover fixed charges. For preferred dividends,annual dividends are divided by 1-Tax rate to obtain EBIT necessary to cover the dividends.In the above example, $ 700,000 EBIT is needed to cover $350,000 dividends and $350,000 taxes. So, it takes higher EBIT to cover the dividends than for interest charges.
Once the relationship between EBIT and EPS is plotted for different capital structures, the investor can analyze the graph, focusing on two key challenges. The level of EBIT where EPS is zero, called the break-even point, and the graph's slope, which visually...