Unit 3 Financial Decision

Capital Structure
According to Gerestenberg, ‘capital structure of a company refers to the composition or make up
of its capitalization and it includes all long term capital resources viz., loans, reserves, shares and
bonds’.

Keown et al. defined capital structure as, ‘balancing the array of funds sources in a proper
manner, i.e. in relative magnitude or in proportions’.

In the words of P. Chandra, ‘capital structure is essentially concerned with how the firm decides
to divide its cash flows into two broad components, a fixed component that is earmarked to meet
the obligations toward debt capital and a residual component that belongs to equity shareholders’.

Concept of Capital Structure

The relative proportion of various sources of funds used in a business is termed as financial
structure. Capital structure is a part of the financial structure and refers to the proportion of the
various long-term sources of financing. It is concerned with making the array of the sources of the
funds in a proper manner, which is in relative magnitude and proportion.

The capital structure of a company is made up of debt and equity securities that comprise a firm’s
financing of its assets. It is the permanent financing of a firm represented by long-term debt,
preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term
borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.

Again, each component of capital structure has a different cost to the firm. In case of companies, it
is financed from various sources. In proprietary concerns, usually, the capital employed, is wholly
contributed by its owners. In this context, capital refers to the total of funds supplied by both—
owners and long-term creditors.

Importance of Capital Structure

(i) Value Maximization

Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed
capital structure the aggregate value of the claims and ownership interests of the shareholders are
maximized.

(ii) Cost Minimization

Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper
mix of fund sources, a firm can keep the overall cost of capital to the lowest.

(iii) Increase in Share Price

Capital structure maximizes the company’s market price of share by increasing earnings per share
of the ordinary shareholders. It also increases dividend receipt of the shareholders.

(iv) Investment Opportunity

Capital structure increases the ability of the company to find new wealth- creating investment
opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.

(v) Growth of the Country

Capital structure increases the country’s rate of investment and growth by increasing the firm’s
opportunity to engage in future wealth-creating investments.

Factors Affecting Capital Structure

1. Cash Flow Position

The decision related to composition of capital structure also depends upon the ability of business
to generate enough cash flow.

The company is under legal obligation to pay a fixed rate of interest to debenture holders, dividend
to preference shares and principal and interest amount for loan. Sometimes company makes
sufficient profit but it is not able to generate cash inflow for making payments.

The expected cash flow must match with the obligation of making payments because if company
fails to make fixed payment it may face insolvency. Before including the debt in capital structure
company must analyse properly the liquidity of its working capital.

A company employs more of debt securities in its capital structure if company is sure of generating
enough cash inflow whereas if there is shortage of cash then it must employ more of equity in its
capital structure as there is no liability of company to pay its equity shareholders.

2. Interest Coverage Ratio (ICR)

It refers to number of time companies earnings before interest and taxes (EBIT) cover the interest
payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities whereas lower ICR
means less borrowed fund securities.

3. Debt Service Coverage Ratio (DSCR)

It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but DSCR
takes care of return of interest as well as principal repayment.

If DSCR is high then company can have more debt in capital structure as high DSCR indicates
ability of company to repay its debt but if DSCR is less then company must avoid debt and depend
upon equity capital only.

4. Return on Investment

Return on investment is another crucial factor which helps in deciding the capital structure. If
return on investment is more than rate of interest then company must prefer debt in its capital
structure whereas if return on investment is less than rate of interest to be paid on debt, then
company should avoid debt and rely on equity capital. This point is explained earlier also in
financial gearing by giving examples.

5. Cost of Debt

If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as
compared to equity.

6. Tax Rate

High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from
income before calculating tax whereas companies have to pay tax on dividend paid to
shareholders. So high end tax rate means prefer debt whereas at low tax rate we can prefer equity
in capital structure.

7. Cost of Equity

Another factor which helps in deciding capital structure is cost of equity. Owners or equity
shareholders expect a return on their investment i.e., earning per share. As far as debt is
increasing earnings per share (EPS), then we can include it in capital structure but when EPS
starts decreasing with inclusion of debt then we must depend upon equity share capital only.

8. Floatation Costs

Floatation cost is the cost involved in the issue of shares or debentures. These costs include the
cost of advertisement, underwriting statutory fees etc. It is a major consideration for small
companies but even large companies cannot ignore this factor because along with cost there are
many legal formalities to be completed before entering into capital market. Issue of shares,
debentures requires more formalities as well as more floatation cost. Whereas there is less cost
involved in raising capital by loans or advances.

9. Risk Consideration

Financial risk refers to a position when a company is unable to meet its fixed financial charges
such as interest, preference dividend, payment to creditors etc. Apart from financial risk business
has some operating risk also. It depends upon operating cost; higher operating cost means higher
business risk. The total risk depends upon both financial as well as business risk.

If firm’s business risk is low then it can raise more capital by issue of debt securities whereas at
the time of high business risk it should depend upon equity.

10. Flexibility

Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must
maintain some borrowing power to take care of unforeseen circumstances.

11. Control

The equity shareholders are considered as the owners of the company and they have complete
control over the company. They take all the important decisions for managing the company. The
debenture holders have no say in the management and preference shareholders have limited right
to vote in the annual general meeting. So the total control of the company lies in the hands of
equity shareholders.

If the owners and existing shareholders want to have complete control over the company, they
must employ more of debt securities in the capital structure because if more of equity shares are
issued then another shareholder or a group of shareholders may purchase many shares and gain
control over the company.

Equity shareholders select the directors who constitute the Board of Directors and Board has the
responsibility and power of managing the company. So if another group of shareholders gets more
shares then chance of losing control is more.

Debt suppliers do not have voting rights but if large amount of debt is given then debt-holders may
put certain terms and conditions on the company such as restriction on payment of dividend,
undertake more loans, investment in long term funds etc. So company must keep in mind type of
debt securities to be issued. If existing shareholders want complete control then they should prefer
debt, loans of small amount, etc. If they don’t mind sharing the control then they may go for equity
shares also.

12. Regulatory Framework

Issues of shares and debentures have to be done within the SEBI guidelines and for taking loans.
Companies have to follow the regulations of monetary policies. If SEBI guidelines are easy then
companies may prefer issue of securities for additional capital whereas if monetary policies are
more flexible then they may go for more of loans.

13. Stock Market Condition

There are two main conditions of market, i.e., Boom condition. These conditions affect the capital
structure specially when company is planning to raise additional capital. Depending upon the
market condition the investors may be more careful in their dealings.

During depression period in the market business is slow and investors also hesitate to take risk so
at this time it is advisable to issue borrowed fund securities as these are less risky and ensure
fixed

repayment and regular payment of interest but if there is Boom period, business is flourishing and
investors also take risk and prefer to invest in equity shares to earn more in the form of dividend.

14. Capital Structure of other Companies

Some companies frame their capital structure according to Industrial norms. But proper care must
be taken as blindly following Industrial norms may lead to financial risk. If firm cannot afford high
risk it should not raise more debt only because other firms are raising.

Relevance and Irrelevance Theory

Relevance and Irrelevance Theories of Dividend
Dividend is that portion of net profits which is distributed among the shareholders. The dividend
decision of the firm is of crucial importance for the finance manager since it determines the
amount to be distributed among shareholders and the amount of profit to be retained in the
business. Retained earnings are very important for the growth of the firm. Shareholders may also
expect the company to pay more dividends. So both the growth of company and higher dividend
distribution are in conflict. So the dividend decision has to be taken in the light of wealth
maximization objective. This requires a very good balance between dividends and retention of
earnings.

A financial manager may treat the dividend decision in the following two ways:

(i) As a long term financing decision: When dividend is treated as a source of finance, the firm
will pay dividend only when it does not have profitable investment opportunities. But the firm can
also pay dividends and raise an equal amount by the issue of shares. But this does not make any
sense.

(ii) As a wealth maximization decision: Payment of current dividend has a positive impact on
the share price. So to maximize the price per share, the firm must pay more and more dividends.

Dividend and Valuation

There are conflicting opinions as far as the impact of dividend decision on the value of the firm.
According to one school of thought, dividends are relevant to the valuation of the firm. Others
opine that dividends does not affect the value of the firm and market price per share of the
company.

Relevant Theory

If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that
case a change in the dividend payout ratio will be followed by a change in the market value of the
firm. If the dividend is relevant, there must be an optimum payout ratio. Optimum payout ratio is
that ratio which gives highest market value per share.

1. Walter’s Model (Relevant Theory)

Prof. James E Walter argues that the choice of dividend payout ratio almost always affects the
value of the firm. Prof. J. E. Walter has very scholarly studied the significance of the relationship
between internal rate of return (R) and cost of capital (K) in determining optimum dividend policy
which maximizes the wealth of shareholders.

Walter’s model is based on the following assumptions:

(i) The firm finances its entire investments by means of retained earnings only.

(ii) Internal rate of return (R) and cost of capital (K) of the firm remains constant.

(iii) The firms’ earnings are either distributed as dividends or reinvested internally.

(iv) The earnings and dividends of the firm will never change.

(v) The firm has a very long or infinite life.

Walter’s formula to determine the price per share is as follows:

P = market price per share.

D = dividend per share.

E = earnings per share.

R = internal rate of return.

K = cost of capital.

According to the theory, the optimum dividend policy depends on the relationship between the
firm’s internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings,
whereas it should distribute the earnings to the shareholders in case the R<K. The rationale of
R>K is that the firm is able to produce more return than the shareholders from the retained
earnings.

Walter’s view on optimum dividend payout ratio can be summarized as below:

(a) Growth Firms (R>K):- The firms having R>K may be referred to as growth firms. The growth
firms are assumed to have ample profitable investment opportunities. These firms naturally can
earn a return which is more than what shareholders could earn on their own. So optimum payout
ratio for growth firm is 0%.

(b) Normal Firms (R=K):- If R is equal to K, the firm is known as normal firm. These firms earn a
rate of return which is equal to that of shareholders. In this case dividend policy will not have any
influence on the price per share. So there is nothing like optimum payout ratio for a normal firm. All
the payout ratios are optimum.

(c) Declining Firm (R<K):- If the company earns a return which is less than what shareholders can
earn on their investments, it is known as declining firm. Here it will not make any sense to retain
the earnings. So entire earnings should be distributed to the shareholders to maximize price per
share. Optimum payout ratio for a declining firm is 100%.

So according to Walter, the optimum payout ratio is either 0% (when R>K) or 100% (when R<K).

2. Gordon’s Model

Another theory, which contends that dividends are relevant, is the Gordon’s model. This model
which opines that dividend policy of a firm affects its value is based on the following assumptions-

(a) The firm is an all equity firm (no debt).

(b) There is no outside financing and all investments are financed exclusively by retained
earnings.

(c) Internal rate of return (R) of the firm remains constant.

(d) Cost of capital (K) of the firm also remains same regardless of the change in the risk
complexion of the firm.

(e) The firm derives its earnings in perpetuity.

(f) The retention ratio (b) once decided upon is constant. Thus the growth rate (g) is also constant
(g=br).

(g) K>g.

(h) A corporate tax does not exist.

Gordon used the following formula to find out price per share

P = price per share

K = cost of capital

E1 = earnings per share

b = retention ratio

(1-b) = payout ratio

g = br growth rate (r = internal rate of return)

According to Gordon, when R>K the price per share increases as the dividend payout ratio
decreases.

When R<K the price per share increases as the dividend payout ratio increases.

When R=K the price per share remains unchanged in response to the change in the payout ratio.

Thus Gordon’s view on the optimum dividend payout ratio can be summarized as below-

(i) The optimum payout ratio for a growth firm (R>K) is zero.

(ii) There no optimum ratio for a normal firm (R=K).

(iii) Optimum payout ratio for a declining firm R<K is 100%.

Thus the Gordon’s Model’s is conclusions about dividend policy are similar to that of Walter. This
similarity is due to the similarities of assumptions of both the models.

3. Bird in Hand Argument

(Dividends and Uncertainty)

Gordon revised this basic model later to consider risk and uncertainty. Gordon’s model, like
Walter’s model, contends that dividend policy is relevant. According to Walter, dividend policy will
not affect the price of the share when R = K. But Gordon goes one step ahead and argues that
dividend policy affects the value of shares even when R=K. The crux of Gordon’s argument is
based on the following 2 assumptions.

(i) Investors are risk averse and

(ii) They put a premium on a certain return and discount (penalise) uncertain return.

The investors are rational. Accordingly they want to avoid risk. The term risk refers to the
possibility of not getting the return on investment. The payment of dividends now completely
removes any chance of risk. But if the firm retains the earnings the investors can expect to get a
dividend in the future. But the future dividend is uncertain both with respect to the amount as well
as the timing. The rational investors, therefore prefer current dividend to future dividend. Retained
earnings are considered as risky by the investors. In case earnings are retained, therefore the
price per share would be adversely affected. This behaviour of investor is described as “Bird in
Hand Argument”. A bird in hand is worth two in bush. What is available today is more important
than what may be available in the future. So the rational investors are willing to pay a higher price
for shares on which more current dividends are paid. Therefore the discount rate (K) increases
with retention rate. This is shown below.

Modigliani-Miller Model
(Irrelevance Theory)

According to MM, the dividend policy of a firm is irrelevant, as it does not affect the wealth of
shareholders. The model which is based on certain assumptions, sidelined the importance of the
dividend policy and its effect thereof on the share price of the firm. According to the theory the
value of a firm depends solely on its earnings power resulting from the investment policy and not
influenced by the manner in which its earnings are split between dividends and retained earnings.

Assumptions:

(i) Capital markets are perfect:- Investors are rational information is freely available, transaction
cost are nil, securities are divisible and no investor can influence the market price of the share.

(ii) There are no taxes:- No difference between tax rates on dividends and capital gains.

(iii) The firm has a fixed investment policy which will not change. So if the retained earnings are
reinvested, there will not be any change in the risk of the firm. So K remains same.

(iv) Floatation cost does not exist.

The substance of MM arguments may be stated as below:

If the company retains the earnings instead of giving it out as dividends, the shareholders enjoy
capital appreciation, which is equal to the earnings, retained.
If the company distributes the earnings by the way of dividends instead of retention, the
shareholders enjoy the dividend, which is equal to the amount by which his capital would have
been appreciated had the company chosen to retain the earnings.

Hence, the division of earnings between dividends and retained earnings is irrelevant from the
point of view of shareholders.

Leverage Analysis: Financial, Operating and

Combined Leverage
Financial Leverage is the degree to which a company uses fixed-income securities such as debt
and preferred equity. The more debt financing a company uses, the higher its financial leverage. A
high degree of financial leverage means high interest payments, which negatively affect the
company’s bottom-line earnings per share.

Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred
equities in a company’s capital structure. As a company increases debt and preferred equities,
interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A
company should keep its optimal capital structure in mind when making financing decisions to
ensure any increases in debt and preferred equity increase the value of the company.

When purchasing assets, three options are available to the company for obtaining financing: using
equity, debt, and leases. Apart from equity, the rest of the options incur fixed costs that are lower
than the income that the company expects to earn from the asset. In this case, we assume that
the company uses debt to finance the asset acquisition.

Example

Assume that Company X wants to acquire an asset that costs $100,000. The company can either
use equity or debt financing. If the company opts for the first option, it will own 100% of the asset,
and there will be no interest payments. If the asset appreciates in value by 30%, the asset’s value
will increase to $130,000 and the company will earn a profit of $30,000. Similarly, if the asset
depreciates by 30%, the asset will be valued at $70,000 and the company will incur a loss of
$30,000.

Alternatively, the company may go with the second option and finance the asset using 50%
common stock and 50% debt. If the asset appreciates by 30%, the asset will be valued at
$130,000. It means that if the company pays back the debt of $50,000, it will remain with $80,000,
which translates into a profit of $30,000. Similarly, if the asset depreciates by 30%, the asset will
be valued at $70,000. It means that after the paying the debt of $50,000, the company will remain
with $20,000 which translates to a loss of $30,000 ($50,000 – $20,000).

Risks of Financial Leverage

Although financial leverage may result in enhanced earnings for a company, it is also likely to
result in disproportionate losses. Losses may occur when the interest expense payments for the
asset overwhelm the borrower because the returns from the asset are not sufficient. It may occur
when the asset declines in value or interest rates rise to unmanageable levels.

(i) Volatility of Stock Price

Increased amounts of financial leverage may result in large swings in company profits. As a result,
the company’s stock price will rise and fall more frequently, and it will hinder the proper accounting
of stock options owned by the company employees. Increased stock prices will mean that the
company will pay higher interest to the shareholders.

(ii) Bankruptcy
In a business where there are low barriers to entry, revenues and profits are more likely to
fluctuate than in a business with high barriers to entry. The fluctuations in revenues may easily
push a company into bankruptcy since it will be unable to meet its rising debt obligations and pay
its operating expenses. With looming unpaid debts, creditors may file a case at the bankruptcy
court to have the business assets auctioned in order to retrieve their owed debts.

(iii) Reduced Access to More Debts

When lending out money to companies, financial providers assess the firm’s level of financial
leverage. For companies with a high debt-to-equity ratio, lenders are less likely to advance
additional funds since there is a higher risk of default. However, if the lenders agree to advance
funds to a highly-leveraged firm, it will lend out at a higher interest rate that is sufficient to
compensate for the higher risk of default.

(iv) Operating Leverage

Operating leverage is defined as the ratio of fixed costs to variable costs incurred by a company in
a specific period. If the fixed costs exceed the amount of variable costs, a company is considered
to have high operating leverage. Such a firm is sensitive to changes in sales volume and the
volatility may affect the firm’s EBIT and returns on invested capital.

High operating leverage is common in capital-intensive firms such as manufacturing firms since
they require a huge number of machines to manufacture their products. Regardless of whether the
company makes sales or not, the company needs to pay fixed costs such as depreciation on
equipment, overhead on manufacturing plants, and maintenance costs.

EBIT EPS Analysis

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial
planning that evaluates various alternatives of financing a project under varying levels of EBIT and
suggests the best alternative having highest EPS and determines the most profitable level of
EBIT’.

Concept of EBIT-EPS Analysis

The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative
methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the
effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial
plans.

It examines the effect of financial leverage on the behavior of EPS under different financing
alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of
the combination and of the various sources. It helps select the alternative that yields the highest
EPS.
We know that a firm can finance its investment from various sources such as borrowed capital or
equity capital. The proportion of various sources may also be different under various financial
plans. In every financing plan the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of
EPS under various financing plans with varying levels of EBIT. It helps a firm in determining
optimum financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below-

(i) Financial Planning

Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial
planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the
alternatives and finds the level of EBIT that maximizes EPS.

(ii) Comparative Analysis

EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines and
markets. It identifies the EBIT earned by these different departments, product lines and from
various markets, which helps financial planners rank them according to profitability and also
assess the risk associated with each.

(iii) Performance Evaluation

This analysis is useful in comparative evaluation of performances of various sources of funds. It

evaluates whether a fund obtained from a source is used in a project that produces a rate of return
higher than its cost.

(iv) Determining Optimum Mix

EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By
emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and
equity in the capital structure. It helps determine the alternative that gives the highest value of EPS
as the most profitable financing plan or the most profitable level of EBIT as the case may be.

Limitations of EBIT-EPS Analysis

Finance managers are very much interested in knowing the sensitivity of the earnings per share
with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this
technique also suffers from certain limitations, as described below

(i) No Consideration for Risk

Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation,
on its borrowed capital, earns more than the interest it has to pay on debt, any financial planning
can be accepted irrespective of risk. But in times of poor business the reverse of this situation
arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis.
(ii) Contradictory Results

It gives a contradictory result where under different alternative financing plans new equity shares
are not taken into consideration. Even the comparison becomes difficult if the number of
alternatives increase and sometimes it also gives erroneous result under such situation.

(iii) Over-capitalization

This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point,
additional capital cannot be employed to produce a return in excess of the payments that must be
made for its use. But this aspect is ignored in EBIT-EPS analysis.

Point of Indifference
Another important tool that managers use to help them choose between alternative cost structures is
the indifference point. The indifference point is the level of volume at which total costs, and hence profits,
are the same under both cost structures. If the company operated at that level of volume, the alternative used
would not matter because income would be the same either way. At the cost indifference point, total costs
(fixed cost and variable cost) associated with the two alternatives are equal.

There may be two methods or two alternatives of doing a thing, say two methods of production. It is also
possible at a particular level of activity; one production method is superior to another, and vice versa. There
is a need to know at which level of production, it will be desirable to shift from one production method to
another production method. This level or point is known as cost indifference point and at this point total cost
of two production methods is same.

Cost indifference point can be calculated as follows-

Cost Indifference Point = Differential fixed cost/Differential variable cost per unit

Alternatively, we may calculate the indifference point by setting up an equation where each side represents
total cost under one of the alternatives. (Because selling price is the same under both of these alternatives,
profits will be the same when total costs are the same.) At unit volumes below the indifference point, the
alternative with the lower fixed cost gives higher profits; at volumes above the indifference point, the
alternative with the higher fixed cost is more profitable.

For example, assume indifference point for a company’s new product is 18,333 units, calculated as follows,
with Q equal to unit volume.

Assume the following details about two methods of production, A and B for the new product-

Production Method A = Fixed Rs 40,000; Variable cost per unit Rs 7

Production Method B = Fixed cost Rs 95,000; Variable cost per unit Rs 4

Selling price for both production methods Rs 10 per unit

The indifference point will be 18,333 units, calculated as follows, Q indicates unit Volume.

Total Cost for Production A = Total Cost for Production B

Fixed cost + variable cost = Fixed cost + variable cost

Rs 40,000 + Rs 7 Q = Rs 95,000 + Rs 4Q

Rs 3Q = Rs 55,000

Q = 18,333 units (rounded)

At volumes below 18,333 units, production A gives lower total costs (and higher profits); above 18,333
units, production B gives higher profits.

The line Rs 3Q = Rs 55,000 gives a clue to the trade-off between the alternatives. The company gains Rs 3
per unit in reduced variable costs by increasing fixed costs Rs 55,000. The indifference point shows that the
company needs 18,333 units to make the trade-off desirable.

It may be noticed that break-even point for the two methods are:

Production method A= Rs 40,000/Rs 3 = 13,333 units

Production method B= Rs 95,000/Rs 6 = 15,833 units

Managers may have no correct answer in their choice of cost structure. Analytical tools such as the
indifference point, margin of safety, and CVP graph help them evaluate alternatives, but the decision
depends on their attitudes about risk and return. If they want to avoid risk, they will choose production A,
forgoing the potential for higher profits from production B. If they are venturesome, they probably will be
willing to take some risk for the potentially higher returns and choose production B.

Cost indifference point is useful in many decision situations, such as quality improvement programmes,
different marketing plans, production plans or methods etc.

Cost indifference point should be distinguished from break-even point. Break-even point compares total
sales and total cost of a product. Also, at break-even point total cost line intersects total sales line. As stated
above, cost indifference signifies equality of total costs of two alternatives. At cost indifference point, total
cost lines of two alternatives intersect each other.