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.
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|
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
SB – amount of common stock outstanding in financing plan B
The indifference point is the value of EBIT where both financing plans would bring the same EPS. In other words, there is no difference in the two alternative financing plans.
Let’s assume that management of a company is considering two alternative capital structures.
The EBIT-EPS graph for both alternative capital structures is given in the figure below.
When EBIT reaches the EBIT-EPS indifference point, both financing plans generate equal EPS. However, if EBIT has a lower value, equity financing will generate higher EPS than debt financing. For any value of EBIT to the right of the indifference point, debt financing will give a higher value of EPS because of a higher degree of financial leverage.
Management of Total S.E. Inc. is considering two alternative financing plans. The detailed information is given in the table below.
The par value of common stock is $10, preferred stock has $100 par value and 15% dividend, and long-term debt is presented by 10-year bonds of $1,000 par value and a fixed annual coupon rate of 8%. The corporate income tax rate is 30%.
The first step of EBIT-EPS analysis is to find the indifference point. Thus, we have to calculate interest expense and preferred dividends for each financing plan.
IA = $5,000,000 × 8% = $400,000
IB = $13,000,000 × 8% = 1,040,000
PDA = $3,000,000 × 15% = $450,000
PDB = $2,000,000 × 15% = $300,000
SA = $15,000,000 ÷ 10 = 1,500,000
SB = $8,000,000 ÷ 10 = 800,000
Let’s make an equation using the data above.
|(EBIT - $400,000)(1 - 0.3) - $450,000||=||(EBIT - $1,040,000)(1 - 0.3) - $300,000|
Having solved this equation, we get an indifference point of $1,955,102, that is, for such a value of EBIT, each financing plan will give the same earnings per share of $0.4257. The EBIT-EPS graph is shown below.
If the expected EBIT is lower than $1,955,102, financing plan A will demonstrate a higher EPS. Otherwise, the capital structure of financing plan B should be preferred.