EBIT-EPS

analysis

RISK AND UNCERTAINTY

There are two types of expectations individuals may have
about the future-

Certainty, and
uncertainty
Risk describes a situation where there is not just one
possible outcome, but an array of potential returns. Also
there are various probabilities for each of the probable
returns.
.
2

Risk refers to the variability in the actual returns vis--vis

the estimated returns, in terms of cash flows
Risk may be defined as the chance of future loss that can
be foreseen
Risk exists because of the inability of the decision-maker to
make perfect forecasts
Risk refers to a set of unique outcomes for a given event
which can be assigned probabilities while uncertainty refers
to the outcomes of a given event which are too unsecure to
be assigned probabilities

Types of Risk

Risk

Systematic Risk

Unsystematic Risk
1.

1.
2.
3.
4.

Interest Rate Risk

Market Risk
Purchasing Power Risk
Exchange Rate Risk
2.

Business Risk
a) Internal
Business
Risk
b) External
Business
Risk
Financial Risk

Unsystematic Risk
1. Business Risk is the variability in operating income due
operating conditions of the company. This can be divided
into two types
a. Internal Business Risk
Factors affecting Internal Business Risk are:

Fluctuation in Sale

Research and development

Personnel management

Fixed cost

Single product

b. External Business Risk

Result of operating conditions imposed on the firm
circumstances beyond its control.

Social and regulatory factors

Political Risk

Business cycle

2. Financial Risk
It refers to the variability in return due to capital structure.

Factors affecting capital structure decisions

Financial Leverage or Trading on Equity
Growth and Stability of Sales
Cost of Capital
Risk
Cash flows
Nature and Size of a Firm
Control
Flexibility
Capital market conditions
Legal Considerations

EBIT-EPS analysis: involves a comparison of alternative methods of

financing at various levels of EBIT.
Case: Suppose a firm has a capital structure of exclusively comprising
of ordinary 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 capital.
(b) It can raise 50% as equity capital and 50% as 5% debentures.
(c) It can raise entire amount as 6% debentures.
(d) It can raise 50% as equity capital and 50% as 5% preference
capital.

Further assume that existing EBIT are Rs. 1,20,000, tax

rate 35%, outstanding ordinary shares 10,000 and the
market price per share is Rs. 100 under all four
alternatives.
Which financing plan should the firm select.
If EBIT is (80,000, 1,00,000, 1,30,000, 1,60,000 and
2,00,000) calculate EPS.

Indifference point: is the EBIT level at which the EPS is the same for
two alternative financial plans.
The financial manager of a company has formulated various financial
plans to finance Rs. 30,00,000 requires to implement various capital
budgeting projects:
(i) Either equity capital of Rs. 30,00,000 or Rs. 15,00,000, 10%
debentures and Rs. 15,00,000 equity.
(ii) Either equity capital of Rs. 30,00,000 or 13% preference shares of
Rs. 10,00,000 and Rs. 20,00,000 equity.

(iii) Either equity capital of Rs. 30,00,000 or 13% preference capital of

Rs. 10,00,000 (subject to dividend tax of 10%), Rs. 10,00,000, 10%
debentures and Rs. 10,00,000 equity and
(iv) Either equity share capital of Rs. 20,00,000 and 10% debentures
of Rs. 10,00,000 or 13% preference share capital of Rs. 10,00,000,
10% debentures of Rs. 8,00,000 and Rs. 12,00,000 equity.
You are required to determine the indifference point for each financial
plan assuming 35% tax rate and the face value of equity share is Rs.
100.

ROI-ROE Analysis
Relationship between the Return on Investment (ROI)
& Return on Equity (ROE) for different level of financial leverage.
The influence of ROI & Financial Leverage on ROE is
mathematically as follows,

ROI = (EBIT/Total Assets)

ROE = [ROI+(ROI-r)D/E](1-t)
Where,
r = Cost of Debt
D/E = Debt-Equity Ratio
t = Tax rate

ROI-ROE Analysis
Problem
Korex Limited, requires an investment outlay of Rs. 100 million, is
Considering two capital structures:
Capital Structure A

Capital Structure B

Equity

100 Million

50 Million

Debt

0 Million

50 Million

Average cost of capital is fixed at 10%, the ROI(EBIT/Total Assets) may

vary widely. The Tax rate is 50%.

ROI-ROE Analysis
Capital Structure A

Capital Structure B

5% 10% 15% 20% 25%

5% 10% 15% 20% 25%

10

15

20

25

10

15

20

25

10

15

20

25

10

15

20

2.5 5

7.5

10

12.5

0 2.5

7.5

10

Tax
Profit after Tax 2.5 5

7.5

10

12.5

0 2.5

7.5

10

RIO
EBIT

Interest

Profit before
Tax

Return on
Equity

2.5% 5% 7.5% 10% 12.5%

0% 5% 10% 15% 20%

ROI-ROE Analysis
Looking at the relationship between ROI & ROE we find that,

The ROE under capital structure A is higher than the ROE under
capital structure B, when ROI is less than the cost of Debt.

The ROE under two capital structures is the same when ROI is
equal to the cost of Debt. Hence the indifference/breakeven value
of ROI is equal to the cost of debt.

The ROE under capital structure B is higher than the ROE under
Capital structure A, when ROI is more than the cost of Debt.

Mathematical Relationship
The influence of ROI and Financial Leverage on ROE is mathematically
as follows,
ROI = (EBIT/Total Assets)
ROE = [ROI+(ROI-r)D/E](1-t)
Applying the above equation to Korex Limited, when its D/E ration is 1,
we may calculate the value of ROE for two values of ROI, 15% & 20%.

ROI-ROE Analysis
ROI = 15%
ROE = [15+(15- 10)1](0.5)
= 10.0%
ROI = 20%
ROE = [20 +(20 - 10)1](0.5)
= 15.0%