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EBIT-EPS (or Indifference) Analysis:

Different financing decisions will have differing impacts on EPS. We can examine the
effects of various financing alternatives through an EPS-EBIT analysis, which involves
determining the crossover or 'indifference' EBIT at which the EPS is the same between
two financing alternatives. Suppose that the firm is comparing the two possible capital
structures, 1 and 2. Then, EBIT*, the indifference EBIT, is such that

EPS 1 = EPS 2

( EBIT * − I 1 )(1 − T ) − D p1 ( EBIT * − I 2 )(1 − T ) − D p 2


=
N1 N2
where

EBIT* =the indifference EBIT


I = the interests
T= tax rate
DP = the dividends for the preferred shares
N = the number of shares outstanding

In the absence of tax and preferred shares in the capital structure of the firm, the above
expression becomes

EBIT * − I 1 EBIT * − I 2
=
N1 N2

Other Capital Structure Analysis Tools:

(1) Coverage ratios.


(2) Lender requirements or debt covenants
(3) Bond ratings
(4) Industry norms
(5) Detailed cash flow analysis including sensitivity and scenario analysis

Example 1 (An EBIT-EPS Indifference Analysis)


The NBA Corporation is comparing two different capital structures, an all-equity plan
(Plan I) and a levered plan (Plan II). Under Plan I, NBA would have 200 shares of stock
outstanding. Under Plan II, NBA would have 100 shares of stock and $5,000 in debt
outstanding. The interest rate is 12 percent and there are no taxes.
(a) If EBIT is $1,000, which plan results in the higher EPS?
(b) If EBIT is $2,000, which plan results in the higher EPS?
(c) What is the break-even EBIT; that is, what EBIT generates exactly the same EPS
under both plans?
Solutions

(a) If EBIT is $1,000, which plan results in the higher EPS?

Plan I
EBIT 1000
EPS I = = = $5
N 200
Plan II
EBIT − I 1000 − 5000 ( 0.12 ) 1000 − 600
EPS II = = = = $4
N 100 100

The plan I has a higher EPS given EBIT = $1000.

(b) If EBIT is $2,000, which plan results in the higher EPS?

Plan I
EBIT 2000
EPS I = = = $10
N 200
Plan II
EBIT − I 2000 − 5000 (0.12 ) 2000 − 600
EPS II = = = = $14
N 100 100

The plan II has a higher EPS given EBIT = $2000.

(c) What is the break-even EBIT; that is, what EBIT generates exactly the same EPS
under both plans?

EPS I = EPS II
EBIT *
EBIT * − I
=
NI N II
EBIT * EBIT * − 600
=
200 100
EBIT = $1200
*

EPS * = $6

For financial leverage to be beneficial, operations must be reasonably profitable.

Example 2
A firm presently has 100,000 common shares outstanding and currently has $1M of
bonds outstanding with annual interest of 10%. Their effective tax rate is 40%. They
need to raise $500,000. The following options are available.
(1) Issue common shares at $50 each (i.e. n2 = $500,000/$50 = 10,000 new shares).
(2) Issue new debt at 12% annually.
Which should they choose if they expect EBIT to be $1 million for the upcoming year?

Solution

The EPS equations for the financing alternatives are given below:

( EBIT − I (1) )(1 − T ) − Dp ( EBIT − 100 ,000 )( 0.60 ) − 0 .6 EBIT − 60 ,000


EPS (1) = = =
n(1) 110 ,000 110 ,000
( EBIT − I ( 2 ) )(1 − T ) − D p ( EBIT − 160 ,000 )( 0.60 ) − 0 .6 EBIT − 96,000
EPS ( 2 ) = = =
n( 2 ) 100 ,000 100 ,000

Setting EPS (1 )
= EPS ( 2) and solving for EBIT*, we obtain EBIT * =$760,000

Therefore, since expected EBIT >$760,000, then the plan with more debt (i.e., plan (2))
($1 m )(. 60 ) − 60 ,000 )
will be preferred. I.e., EPS (1) = = $4.90 , and
110 ,000
($1 m)(. 60 ) − 96 ,000 )
EPS ( 2 ) = = $5.04
100 ,000
If expected EBIT <$760,000, then the plan with less debt (i.e., plan (1)) will be preferred.