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EBIT-EPS Analysis

By Yuriy Smirnov Ph.D.

Definition

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.

Formula

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
SA SB

where:

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.

EBIT-EPS graph

Let’s assume that management of a company is considering two alternative capital structures.

  1. Financing plan A with high financial leverage (debt financing)
  2. Financing plan B with low financial leverage (equity financing)

The EBIT-EPS graph for both alternative capital structures is given in the figure below.

EBIT-EPS graph

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.

Example

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
1,500,000 800,000

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.

EBIT-EPS analysis

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.

Advantages and disadvantages of EBIT-EPS analysis

Advantages

  1. Financial planning. Applying EBIT-EPS analysis allows earnings per share to be maximized for any given value of earnings before interest and taxes. It helps to choose the best financing plan.
  2. Comparative analysis. Such analysis is possible not only for a company as a whole but also for a specific product, project, department, or market.
  3. Determination of target capital structure. Depending on the expected EBIT, management of a company is able to determine the target capital structure for maximizing EPS.

Disadvantages

  1. Risk is not taken into account. EBIT-EPS analysis does not take into account the risks associated with debt financing. In other words, a higher EPS associated with using financial leverage implies a higher risk that has to be taken into account by management.
  2. Complexity. The more alternative financing plans are considered, the higher the complexity of the calculations.
  3. Limitations. The technique does not account for limitations in raising various sources of financing.