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EBIT - Earnings Before Interest and Taxes. Accountants like to use the term Net Operating Income for this income statement item, but finance people usually refer to it as EBIT. Either way, on an income statement, it is the amount of income that a company has after subtracting operating expenses from sales (hence the term net operating income). Another way of looking at it is that this is the income that the company has before subtracting interest and taxes (hence, EBIT). EAT - Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but finance people usually refer to it as EAT. EPS - Earnings Per Share. This is the amount of income that the common stockholders are entitled to receive (per share of stock owned). This income may be paid out in the form of dividends, retained and reinvested by the company, or a combination of both. The Analysis I need to raise additional money by issuing either debt, preferred stock, or common stock. Which alternative will allow me to have the highest earnings per share? This question calls for an EBIT/EPS analysis. Simply put, this simply means that we will calculate what our earnings per share will be at various levels of sales (and EBIT). Actually, it isn't necessary to start with sales. Since a company's EBIT, or net operating income, isn't affected by how the company is financed, we can skip down the income statement to the EBIT line and begin there. In other words, we assume a certain level of sales, calculate our estimated EBIT at that level, and then calculate what our EPS will be for each alternative form of financing (debt, preferred stock, and common stock). An Illustration For example, let's assume that the company:
e. needs to raise $50. 3.2.000 + 50. 4. Let's pick a beginning level for EBIT of $10.00 N/A $100.500 6. The number of shares of common stock will remain unchanged.000 -0 10.000 -0 10. debt . you are considering three alternatives: 1. common stock .The dividend yield on preferred stock will have to be 7.000. all earnings are retained and reinvested into the company.500 Debt N/A 4.3.3% $100.000 $150.000 $150.000 $150.The company can sell additional shares at the current price of $50 per share.00 7. To raise the $50.Taxes (@35%) EAT (Net Income) $50. As financial manager.2.000 .000 $10.000 $10. you want to know which financing alternative should be used. is in the 35% tax bracket.000 + 50.. is currently financed entirely with common stock (i.000 . The firm has 2. 2.000.0% $100.000 .800 5. We can then calculate what the earnings per share will be for each financing alternative. 3.500 Preferred Stock $40.000/$50 per share).200 .000 in new money.) The number of shares of common stock will remain unchanged.000 .3.500 6.Interest Expense (@4%) Earnings Before Taxes . Common Stock Price per share Annual Rate Common Stock + Additional Funds Total Funds EBIT (Net Operating Income) .000 shares of common stock outstanding.The interest rate on any new debt will be 4% per year. no debt and no preferred stock). currently pays no common stock dividend.3% of the amount of money raised.000 $10.1. preferred stock .000 + 50. This means that 1. (The preferred can be sold for $40 per share.000 new shares of common stock will need be to be sold ($50.000 8. 2.
we would eventually like to draw a graph of the EPS over a range of sales and EBIT. . We simply plot the earnings per share under each alternative for each of our EBIT levels and connect the dots to draw the lines.60 The above table shows us the earnings per share at an EBIT level of $10.000 also.650 2. This will allow us to understand the relationship between sales and EPS more fully. If we think that the highest that EBIT will be for the next few years is $30.000.000 $1. so we can reproduce the table for that level of EBIT.000.3%) Earnings Available to Common (EATC) No.000.17 .200 2. $10. As sales (and EBIT) increase. we can draw the graph below. In other words. and the preferred stock alternative results in the lowest level of EPS.000.Preferred Dividends (@7.000 $2. we will construct the table for four values of EBIT: $2. While we're at it.43 -0 5.000 $2. what will happen to earnings per share? This is easily answered .) -0 6.. If sales are sufficiently high to give us an EBIT level of $10. then our EPS will be highest by issuing debt.000. $20. Let's assume that we don't think that our company's EBIT will fall below 2.500 3. let's throw in an EBIT of $20. However.000. The EBIT/EPS Graph Once the tables have been constructed.850 2. of Common Shares Earnings Per Share (EATC/# of shares).000 and $30.3. common stock yields the next highest EPS. then we might choose that level also.we just repeat the above table for a different level of EBIT.000.
and b. the interest rate is less than the preferred dividend yield) because it enjoys greater protection in the event of default). Since both options pay a fixed rate (e. debt is the cheaper form of financing (i..e. This means that the EPS will always be higher under debt financing than under preferred stock financing. This will always be the case because debt has two distinct advantages over preferred stock: a. The preferred stock line is parallel to the debt line and lies below the debt line.g.Relationships Notice the following points: 1. 4% .. interest on the debt is tax-deductible and preferred stock dividends are not tax-deductible.
Our EPS will be higher than the other two alternatives as long as sales are weak enough to keep us below the $6. If the expected level of EBIT is: • less than $6. We estimate the future level of sales and calculate our expected level of EBIT for this sales level. but debt financing will always offer the higher earnings per share . etc. • At an EBIT level of $16.000 EBIT level.800. • Summary So which of the three financing alternatives should we use to raise the $50. the rate of return on capital employed is equal to the cost of debt and this is also known as break-even level of EBIT for alternative financial plans. Both will give you the same EPS (of $1.and 7. the fact that we don't have to pay a fixed interest or dividend payment is a big advantage and offers the company a great deal of flexibility.000. Preferred stock may offset this quantitative advantage with some qualitative ones (less restrictive provisions. Since common stock financing offers a smaller degree of leverage.000. you would be indifferent between common stock financing and preferred stock financing. As sales and EBIT fall. At this level of EBIT.30 per share). we would tend to use common stock financing. they offer similar effects of leverage . . 3. This leads to two "crossover points" where the common stock line crosses the other two lines. you would be indifferent between common stock financing and debt financing.64 per share). 2. the slope of the common stock line is lower than the other two lines.leading to the parallel lines above. These are indifference points. It refers to that EBIT level at which EPS remains the same irrespective of different alternatives of debt equity mix. At an EBIT level of $6.000? It all depends on our sales forecast.a big advantage.3%). Both will give you the same EPS (of $3.).
• above $6. As sales increase. We would not consider using preferred stock financing at all unless there is some compelling reason to do so.000 EBIT level. EPS under debt financing will always be higher than the preferred stock alternative.to avoid restrictive debt covenants. However. to gain greater flexibility. we would use tend to use debt financing. There are a number of qualitative factors that will increase in importance and you would tend to weigh these factors closely in making the debt vs. . the higher financial leverage causes EPS to rise at a much faster rate than common stock financing would do. from a quantitative standpoint. to avoid using up all of your debt capacity at the present time.000. What if the forecasted sales level is equal to (or very close to) the indifference point of $6. equity decision. There may be reasons for doing this . etc. The EPS level is maximized by using debt as long as sales are high enough to keep us above the $6.000? Then you would not make the decision based on the basis of EPS.
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