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Glossary EBIT - Earnings Before Interest and Taxes.

Accountants like to use the term Net Operating Income for this income statement item, but finance people usually ref er to it as EBIT (pronounced as it is spelled - E, B, I, T). Either way, on an income statement, it is the amount of income that a company has after subtractin g 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 subt racting interest and taxes (hence, EBIT). EAT - Earnings After Taxes. Accountants call this Net Income or Net Profit Afte r Taxes, but finance people usually refer to it as EAT (pronounced E, A, T). EPS - Earnings Per Share. This is the amount of income that the common stockhol ders are entitled to receive (per share of stock owned). This income may be pai d out in the form of dividends, retained and reinvested by the company, or a com bination of both. (It is pronounced E, P, S). The Analysis I need to raise additional money by issuing either debt, preferred stock, or com mon stock. Which alternative will allow me to have the highest earnings per sh are? This question calls for an EBIT/EPS analysis. Simply put, this simply means tha t we will calculate what our earnings per share will be at various levels of sal es (and EBIT). Actually, it isn't necessary to start with sales. Since a company's EBIT, or ne t operating income, isn't affected by how the company is financed, we can skip d own 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: is currently financed entirely with common stock (i.e., no debt and no prefe rred stock). The firm has 2,000 shares of common stock outstanding. currently pays no common stock dividend; all earnings are retained and reinv ested into the company. needs to raise $50,000 in new money. As financial manager, you want to know which financing alternative should be used. is in the 35% tax bracket. To raise the $50,000, you are considering three alternatives: common stock - The company can sell additional shares at the current price o f $50 per share. This means that 1,000 new shares of common stock will need be to be sold ($50,000/$50 per share). preferred stock - The dividend yield on preferred stock will have to be 7.3% of the amount of money raised. (The preferred can be sold for $40 per share.) The number of shares of common stock will remain unchanged. debt - The interest rate on any new debt will be 4% per year. The number of shares of common stock will remain unchanged. Let's pick a beginning level for EBIT of $10,000. We can then calculate what th

e earnings per share will be for each financing alternative. Common Stock Preferred Stock Debt Price per share $50.00 $40.00 N/A Annual Rate N/A 7.3% 4.0% Common Stock $100,000 $100,000 $100,000 + Additional Funds + 50,000 + 50,000 + 50,000 Total Funds $150,000 $150,000 $150,000 EBIT (Net Operating Income) $10,000 - Interest Expense (@4%) - 0 - 0 Earnings Before Taxes 10,000 10,000 - Taxes (@35%) - 3,500 - 3,500 EAT (Net Income) 6,500 6,500 5,200 - Preferred Dividends (@7.3%) - 0 - 3,650 Earnings Available to Common (EATC) 6,500 No. of Common Shares 3,000 2,000 2,000 Earnings Per Share (EATC/# of shares).) $10,000 - 2,000 8,000 - 2,800 2,850 $2.17 - 0 5,200 $1.43 $2.60 $10,000

The above table shows us the earnings per share at an EBIT level of $10,000. If sales are sufficiently high to give us an EBIT level of $10,000, then our EPS w ill be highest by issuing debt, next highest by issuing common stock, and lowest by issuing preferred stock. However, we would eventually like to draw a graph of the EPS over a range of sal es and EBIT. This will allow us to understand the relationship between sales an d EPS more fully. As sales (and EBIT) increase, what will happen to earnings pe r share? This is easily answered - we just repeat the above table for a different level o f EBIT. Let's assume that we don't think that our company's EBIT will fall belo w 2,000, so we can reproduce the table for that level of EBIT. If we think that the highest value for EBIT during the next few years will be $30,000, then we m ight choose that level also. While we're at it, let's throw in an EBIT of $20,0 00 also. In other words, we will construct the above table for four values of E BIT: $2,000, $10,000, $20,000 and $30,000. The EBIT/EPS Graph Once the tables have been constructed, we can draw the graph below. We simply pl ot the earnings per share under each alternative for each of our EBIT levels and connect the dots to draw the lines. Relationships Notice the following points: The preferred stock line is parallel to the debt line and lies below the deb t line. This will always be the case because debt has two distinct advantages o ver preferred stock: debt is the cheaper form of financing (i.e., the interest rate is less t han the preferred dividend yield) because it enjoys greater protection in the ev ent of bankruptcy or default), and interest on the debt is tax-deductible and preferred stock dividends are not tax-deductible. This means that the EPS will always be higher under debt financing than unde r preferred stock financing. Since both options pay a fixed rate (e.g., 4% and

7.3%), they offer similar ove. Preferred stock may ve ones (less restrictive r the higher earnings per

effects of leverage - leading to the parallel lines ab offset this quantitative advantage with some qualitati provisions, etc.), but debt financing will always offe share - a big advantage.

Since common stock financing offers a smaller degree of leverage, the slope of t he common stock line is less than the other two lines. This leads to two "crosso ver points" where the common stock line crosses the other two lines. These are indifference points. At an EBIT level of $6,000, you would be indifferent between common stock fi nancing and debt financing. Both will give you the same EPS (of $1.30 per share ). At an EBIT level of $16,800, you would be indifferent between common stock f inancing and preferred stock financing. Both will give you the same EPS (of $3. 64 per share). However, this point is relatively unimportant since preferred sto ck won't likely be used by the company (since using debt always yields a higher EPS than preferred stock). Summary So which of the three financing alternatives should we use to raise the $50,000? It all depends on our sales forecast. We estimate the future level of sales a nd calculate our expected level of EBIT for this sales level. If the expected level of EBIT is: less than $6,000, we would tend to use common stock financing. Our EPS will be higher than the other two alternatives as long as sales are weak enough to k eep us below the $6,000 EBIT level. As sales and EBIT fall, the fact that we do n't have to pay a fixed interest or dividend payment is a big advantage and offe rs the company a great deal of flexibility. above $6,000, we would use tend to use debt financing. The EPS level is max imized by using debt as long as sales are high enough to keep us above the $6,00 0 EBIT level. As sales increase, the higher financial leverage causes EPS to ri se at a much faster rate than common stock financing would do. What if the forecasted sales level is equal to (or very close to) the indifferen ce point of $6,000? Then you would not make the decision based on the basis of EPS. 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. equity decision. We would not consider using preferred stock financing at all unless there is som e compelling reason to do so. There may be reasons for doing this - to avoid re strictive debt covenants, to gain greater flexibility, to avoid using up all of your debt capacity at the present time, etc. However, from a quantitative stand point, EPS under debt financing will always be higher than the preferred stock a lternative.