EBIT/EPS ANALYSIS

EBIT-EPS EBIT-EPS analysis analysis is an approach which helps in designing the optimum capital structure for the company or the firm.

To design various alternatives of debt, equity and preference shares in order to maximize the EPS at a given level of EBIT.

It examines how different capital structures affect earnings available to shareholders (Earning Per Share).

It is the analysis of the effect of financing alternatives on earnings per share.

To design the capital structure of the firm in such a way so as to minimize the cost of capital.

EBIT-EPS analysis is a method to study the effect of leverage under alternative methods of financing.

Sales : xxxxx(-)V.C : xxx

=Contribution : xxxxx(-)F.C : xxxx

=EBIT {Earning Before Interest and Taxes}

EBIT : xxxxx(-)INTERSET : xxx

=EBT : xxxxx(-)TAX : xx

=Earning for ESH : xxxxx(÷) No. of E.S : xxx

= EPS {Earning Per Share} xxx

Q: The present capital structure of Gupta Co. ltd. is:4000, 5% Debentures of Rs 100 each Rs 4,00,0002000, 8% P. Shares of Rs 100 each Rs 2,00,0004000, Equity shares of Rs 100 each Rs 4,00,000

Rs 10,00,000The present earning of the company before interest & taxes are 10% of the invested capital every year. The company is in need of Rs 2,00,000 for purchasing a new equipment and it is estimated that additional investment will also produce 10% earning before interest & taxes every year.The company has asked your advice as to whether the requisite amount be obtained in the form of 5% Debenture or 8% P. SharesOr equity shares of Rs 100 each to be issued at par. Examine the problem in all its bearing and advice firm if the Corporate tax rate is 50%.

STATEMENT SHOWING THE EPS UNDER EXISTING & PROPOSED ALTERNATIVE

Particulars Present

iDebenture

iiP. Share

iiiEq. Share

EBIT(-)Interest

1,00,00020,000

1,20,00030,000

1,20,00020,000

1,20,00020,000

EBT(-)Tax 50%

80,00040,000

90,00045,000

1,00,00050,000

1,00,00050,000

EAT(-)P. Dividend

40,00016,000

45,00016,000

50,00032,000

50,00016,000

ESH(÷) No. of Equity Shares

24,0004,000

29,0004,000

18,0004,000

34,0006,000

EPSChange in EPS

Rs 6.00-

Rs 7.25+1.25

Rs 4.50-1.50

Rs 5.67-0.33

ALTENATIVES

The EBIT level at which the EPS is the same for two alternative financial plan is referred to as the indifference point/level.

Financial break even point obtained by a company at a given level of EBIT for which the firm’s EPS is zero.

If EBIT is less than financial break even point, then the EPS is negative.

If EBIT is more than the financial break even point, then more and more fixed cost financing option can be used by a firm.

APPROACHES TO INDIFFERENCE ANALYSIS

•Graphical approach•Algebric approach

BREAKEVEN BREAKEVEN EBITEBITEPSEPS

EBITEBIT$1m $2m $3m $4m$1m $2m $3m $4m

Debt + EquityDebt + Equityalternativealternative

EquityEquityAlternative Alternative

00

33

22

11

Indifference pointIndifference point

Algebric approachBreakeven analysis

For newly formed company:

Equity vs. Debenture =

Equity vs. P. Shares =

Equity vs. P. Shares vs. Debenture=

For an existing company: {When debenture are outstanding}

X(1-T) N1

=(X-I)(1-T) N2

X(1-T) N1

=X(1-I)-P N3

X(1-T) N1

=(X-1)(1-I)-P N4

(X-1)(1-T) N1

=(X-I1)(1-T)-P N4

Where,X = EBITN1 = No. of Eq. shares outstanding if any eq. shares are issuedN2 = No. of Eq. shares outstanding if both eq. shares & debt are issuedN3 = No. of Eq. shares outstanding if both eq. & pref. shares are issuedN4 = No. of Eq. shares outstanding if both pref. shares & debt are issuedI = Interest on debenturesP = Pref. DividendT = Corporate Tax Rate

REFERENCES:

• KHAN, M.Y. & JAIN, P.K.; FINANCIAL MANAGEMENT (TATA MC GRAW- HILL PUBLISHING CO. LTD.),1995

•PANDEY, I.M.; FINANCIAL MANAGEMENT (VIKAS PUBLISHING HOUSE LTD.), 2007

•SAHNI, D.; BUSINESS FINANCE (KEDAR NATH RAM NATH), 2009