Capital Structure Policy

I EBIT-EPS ANALYSIS

The EBIT-EPS Analysis, as a method to study the effect of leverage, essentially involves the comparison of
alternative methods of financing under various assumptions of EBIT. A firm has the choice to raise funds for
financing its investment proposals from different sources in different proportions. The choice of the
combination of the various sources would be one which, given the level of earnings before interest and
taxes, would ensure the largest EPS.

1. Suppose a firm has a capital structure exclusively comprising of equity shares amounting to Rs. 10, 00,000.
The firm now wishes to raise additional Rs. 10, 00,000 for expansion. The firm has four alternative financial
plans:
(a) It can raise the entire amount in the form of Equity Share Capital.
(b) It can raise 50% as Equity Share Capital and 50% as 5% Debentures.
(c) It can raise the entire amount as 6% Debentures.
(d) It can raise 50% as Equity Share Capital and 50% as 5% Preference Share Capital

Further assume that the existing EBIT are Rs. 1, 20,000, the tax rate is 35%, outstanding equity shares
10,000 and the market price per share is Rs. 100 under all four alternatives.

Which financing plan should the firm select?

II FINANCIAL BREAK EVEN POINT

Financial BEP is the level of EBIT which is equal to firm’s fixed financial costs. In other words, it I the level of
EBIT at which the firm can satisfy all fixed financial charges (i.e. interest and preference dividend). EBIT less
than this level will result in negative EPS.

Financial break-even point = I + Dp/(1-t)

Where, I = Annual interest charges
Dp = Preference Dividend and
t = Tax rate

2. For illustration 1 calculate financial break even point

III INDIFFERENCE POINT

Indifference point is the EBIT level beyond which benefits of financial leverage accrue with respect to EPS.
The EBIT level at which the EPS is the same for two alternative financial plans is referred to as the
indifference point/level.

X = EBIT at the indifference point

N1 = no. of equity shares outstanding if only equity shares are issued
N2 = no. of equity shares outstanding if both debentures and equity shares are issued
N3 = no. of equity shares outstanding if both preference and equity shares are issued

Page 1 of 2
 N4 = no. of equity shares outstanding if both preference shares and debentures are issued
I = interest on debentures
Dp = Preference Dividend
t = corporate income tax
Dt = tax on preference dividend

3.

4.
A firm’s sales, variable costs and fixed cost amount to Rs. 75, 00,000, Rs. 42, 00,000 and Rs. 600,000
respectively. It has borrowed Rs. 45, 00,000 at 9% and its equity capital totals Rs. 55, 00,000.
(a) What is the firm’s ROI?
(b) If the sales drop to Rs. 50,00,000, what will the new EBIT be?
(c) At what level will the EBT of the firm equal to zero?
(d) At what level of EBIT and Sales, EPS of the firm will be equal to zero?

Page 2 of 2