 # 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. 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. 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.