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Submitted by raymason Tue, 10 Aug 2010
There is not a single method or a technique that allows the company to efficiently determine the appropriate capital structure. While making decisions on capital structure we realize that it is not amendable to one concrete solution. In general, a variety of analyses are done to get the most appropriate capital structure. One such method to determine the capital structure is the EBIT-EPS analysis. The two factors essential to arrive at the most appropriate capital structure using the above mentioned method are the earnings per share (EPS) and earnings before interest and tax (EBIT). The relationship between the two is given below: EPS= (EBIT-I)*(1-t)/n Where µI' - The interest burden, µn'-Number of equity shares and 't'- Tax rate If the risk factors are taken into consideration the financial manager may do two things and they are as the follows a)Assessing the probability of EBIT falling below its indifference value. b)Comparing the expected value of EBIT with its indifference value. If the most likely value of EBIT exceeds the indifference value of EBIT, then the debt financing option is likely to be more beneficial. The larger the difference between the two values, the stronger the case for debt financing. Given the variability of EBIT, that could arise out of the business risk of the company; the probability of EBIT falling below the difference level of EBIT may be assessed. If such probability is negligible, the debt financing alternative can be considered risky