EBIT/EPS Analysis

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:

000 + 50.. needs to raise $50.000 .) The number of shares of common stock will remain unchanged. 3.000 -0 10.000 8.0% $100. As financial manager.200 .000 $150.2.000 $150. This means that 1.500 6. no debt and no preferred stock). The firm has 2. all earnings are retained and reinvested into the company. The number of shares of common stock will remain unchanged.Interest Expense (@4%) Earnings Before Taxes . (The preferred can be sold for $40 per share.000 $10. is currently financed entirely with common stock (i.3.The dividend yield on preferred stock will have to be 7.500 6. Common Stock Price per share Annual Rate Common Stock + Additional Funds Total Funds EBIT (Net Operating Income) .000/$50 per share).3. common stock .The interest rate on any new debt will be 4% per year.000 -0 10. you want to know which financing alternative should be used.000 .00 N/A $100.000.000 $10.000.000 new shares of common stock will need be to be sold ($50.The company can sell additional shares at the current price of $50 per share. is in the 35% tax bracket.e. 2.1.800 5.000 .500 Debt N/A 4.000 + 50.000 $150.3% of the amount of money raised. 2. debt . We can then calculate what the earnings per share will be for each financing alternative.000 .000 in new money.3% $100. Let's pick a beginning level for EBIT of $10.00 7. currently pays no common stock dividend.500 Preferred Stock $40.000 $10.Taxes (@35%) EAT (Net Income) $50.000 + 50.000 shares of common stock outstanding.2. 4. 3. To raise the $50. preferred stock . you are considering three alternatives: 1.

000. let's throw in an EBIT of $20. While we're at it.500 3.650 2. . As sales (and EBIT) increase.43 -0 5.000 also.000. we would eventually like to draw a graph of the EPS over a range of sales and EBIT.3. The EBIT/EPS Graph Once the tables have been constructed. common stock yields the next highest EPS..3%) Earnings Available to Common (EATC) No.000 $2.000. In other words.000.000 $1. $10. of Common Shares Earnings Per Share (EATC/# of shares). If we think that the highest that EBIT will be for the next few years is $30.) -0 6.000. so we can reproduce the table for that level of EBIT.000. we can draw the graph below. $20. then we might choose that level also. We simply plot the earnings per share under each alternative for each of our EBIT levels and connect the dots to draw the lines. If sales are sufficiently high to give us an EBIT level of $10. then our EPS will be highest by issuing debt. we will construct the table for four values of EBIT: $2.17 .850 2. and the preferred stock alternative results in the lowest level of EPS.we just repeat the above table for a different level of EBIT.200 2. This will allow us to understand the relationship between sales and EPS more fully.Preferred Dividends (@7.60 The above table shows us the earnings per share at an EBIT level of $10. Let's assume that we don't think that our company's EBIT will fall below 2. However.000 and $30.000 $2. what will happen to earnings per share? This is easily answered .000.

Since both options pay a fixed rate (e.g. The preferred stock line is parallel to the debt line and lies below the debt line. the interest rate is less than the preferred dividend yield) because it enjoys greater protection in the event of default).e. 4% .. This will always be the case because debt has two distinct advantages over preferred stock: a. and b.Relationships Notice the following points: 1.. This means that the EPS will always be higher under debt financing than under preferred stock financing. interest on the debt is tax-deductible and preferred stock dividends are not tax-deductible. debt is the cheaper form of financing (i.

As sales and EBIT fall. 3. We estimate the future level of sales and calculate our expected level of EBIT for this sales level. the slope of the common stock line is lower than the other two lines. It refers to that EBIT level at which EPS remains the same irrespective of different alternatives of debt equity mix. 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. Both will give you the same EPS (of $1.000. you would be indifferent between common stock financing and debt financing. Both will give you the same EPS (of $3. At an EBIT level of $6.800. • At an EBIT level of $16.30 per share).000? It all depends on our sales forecast. we would tend to use common stock financing. Since common stock financing offers a smaller degree of leverage. This leads to two "crossover points" where the common stock line crosses the other two lines.000.leading to the parallel lines above. Preferred stock may offset this quantitative advantage with some qualitative ones (less restrictive provisions. 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. but debt financing will always offer the higher earnings per share .and 7. If the expected level of EBIT is: • less than $6.3%). • Summary So which of the three financing alternatives should we use to raise the $50.000 EBIT level. etc. Our EPS will be higher than the other two alternatives as long as sales are weak enough to keep us below the $6. At this level of EBIT.a big advantage. These are indifference points.). . they offer similar effects of leverage .64 per share). you would be indifferent between common stock financing and preferred stock financing. 2.

to avoid using up all of your debt capacity at the present time. The EPS level is maximized by using debt as long as sales are high enough to keep us above the $6. etc. equity decision. What if the forecasted sales level is equal to (or very close to) the indifference point of $6. There may be reasons for doing this . to gain greater flexibility. 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.000? Then you would not make the decision based on the basis of EPS. However. . EPS under debt financing will always be higher than the preferred stock alternative. As sales increase.000 EBIT level.000.to avoid restrictive debt covenants. from a quantitative standpoint. we would use tend to use debt financing. We would not consider using preferred stock financing at all unless there is some compelling reason to do so.• above $6. the higher financial leverage causes EPS to rise at a much faster rate than common stock financing would do.

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