Topic 7 :

EBIT-EPS Analysis
(part ii)

Balance Sheet
Current
Current
Assets
Liabilities
Fixed
Assets

Debt and
Preferred

Shareholders
Equity

Financial
Structure

Balance Sheet
Current
Current
Assets
Liabilities
Fixed
Assets

Debt and
Preferred

Shareholders
Equity

Capital
Structure

Why is Capital Structure

Important?
1) Leverage: Higher financial leverage
means higher returns to
stockholders, but higher risk due to
fixed payments.
2) Cost of Capital: Each source of
financing has a different cost. Capital
structure affects the cost of capital.
Optimal Capital Structure is the one
that minimizes the firms cost of
capital and maximizes firm value.

What is the Optimal Capital

Structure?
In

a perfect world environment

with no taxes, no transaction costs
and perfectly efficient financial
markets, capital structure does
not matter.
This is known as the
Independence hypothesis: firm
value is independent of capital
structure.

Capital Structure Management

EBIT-EPS Analysis - Used to help
determine whether it would be better
to finance a project with debt or
equity.

EPS =

(EBIT - I)(1 - t) - P
S

I = interest expense, P = preferred dividends,

S = number of shares of common stock
outstanding.

EBIT-EPS Example
Our firm has 800,000 shares of
common stock outstanding, no debt,
and a marginal tax rate of 40%. We
need $6,000,000 to finance a proposed
project. We are considering two
options:
Sell

200,000 shares of common stock at

$30 per share, or
Borrow $6,000,000 by issuing 10%
bonds.

If we expect EBIT to be
$2,000,000:

Financing
stock
debt
EBIT
2,000,000
2,000,000
- interest
0
(600,000)
EBT
2,000,000
1,400,000
- taxes (40%)
(800,000)
(560,000)
EAT
1,200,000
840,000
# shares outst. 1,000,000
800,000
EPS $1.20
$1.05

If we expect EBIT to be
$4,000,000:

Financing
stock
debt
EBIT
4,000,000
4,000,000
- interest
0
(600,000)
EBT
4,000,000
3,400,000
- taxes (40%)
(1,600,000)
(1,360,000)
EAT
2,400,000
2,040,000
# shares outst. 1,000,000
800,000
EPS $2.40 $2.55

If

EBIT is $2,000,000,
common stock financing
is best.
If EBIT is $4,000,000,
debt financing is best.
So, now we need to find
a breakeven EBIT where
neither is better than the
other.

EPS
3

If we choose stock
financing:
stock
financing

2
1
0

EBIT
$1m

$2m

$3m

$4m

EPS
3

If we choose
bond financing:

bond
financing

2
1
0

EBIT
$1m

$2m

$3m

$4m

Breakeven EBIT
EPS
3

bond
financing
stock
financing

2
1
0

EBIT
$1m

$2m

$3m

$4m

Breakeven Point
Set two EPS calculations equal to each
other and solve for EBIT:
Stock Financing
Financing
(EBIT-I)(1-t) - P
(1-t) - P
S

Debt
=

(EBIT-I)
S

Breakeven Point
Stock Financing
Debt
Financing
(EBIT-I)(1-t) - P =
(EBIT-I)(1-t)
-P
S
S
(EBIT-0) (1-.40) = (EBIT-600,000)
(1-.40)
800,000+200,000
800,000

Breakeven Point
Stock Financing
Financing
.6 EBIT
=
360,000
1
.48 EBIT
360,000

.12 EBIT

Debt
.6 EBIT .8
.6 EBIT 360,000

EBIT = $3,000,000

Breakeven EBIT
EPS
3

bond
financing

For EBIT up to $3 million,

stock financing is best.

stock
financing

2
1
0

EBIT
$1m

$2m

$3m

$4m

Breakeven EBIT
EPS
3

bond
financing

For EBIT up to $3 million,

stock financing is best.

stock
financing

For EBIT greater

than $3 million,
debt financing
is best.

1
0

EBIT
$1m

$2m

$3m

$4m

In-class Problem 1:
Plan

A: Sell 1,200,000 shares

at $10 per share ($12 million
total).
Plan B: Issue $3.5 million in
9% debt and sell 850,000
shares at $10 per share ($12
million total).
Assume a marginal tax rate of
50%.

Breakeven EBIT
Stock Financing
Financing
(EBIT-I) (1-t) - P
-P
S
EBIT-0 (1-.50)
315,000)(1-.50)
1,200,000

Levered
=

(EBIT-I) (1-t)
S

(EBIT850,000

EBIT = $1,080,000

Analytical Income
Statement

Stock
EBIT
1,080,000
Interest
0
(315,000)
EBT
1,080,000
Tax
(540,000)
NI
540,000
Shares
850,000
EPS

Bond
1,080,000

765,000
(382,500)
382,500

1,200,000
.45

.45

Breakeven EBIT
levered
financing

EPS
.65

stock
financing

.45
.25
0

EBIT
$.5m

$1m

$1.5m

$2m

Breakeven EBIT
For EBIT up
levered
to
$1.08
m,
stock
EPS
financing
stock
financing
.65
financing is
best.
.45
.25
0

EBIT
$.5m

$1m

$1.5m

$2m

Breakeven EBIT
For EBIT up
levered
to
$1.08
m,
stock
EPS
financing
stock
financing
.65
financing is
best.
For EBIT greater
than $1.08 m,
.45
the levered plan
is best.
.25
0

EBIT
$.5m

$1m

$1.5m

$2m

In-class Problem 2:
Plan

A: Sell 1,200,000 shares

at $20 per share ($24 million
total).
Plan B: Issue $9.6 million in
9% debt and sell shares at $20
per share
($24 million
total).
Assume a 35% marginal tax
rate.

Breakeven EBIT
Stock Financing
Financing
(EBIT-I) (1-t) - P
t) - P
S
(EBIT-0) (1-.35)
864,000)(1-.35)
1,200,000
720,000

Levered
=

(EBIT-I) (1S

(EBIT-

EBIT = $2,160,000

Analytical Income
Statement
EBIT
Interest
EBT
Tax
NI
Shares
720,000
EPS
1.17

Stock
2,160,000
0
2,160,000
(756,000)
1,404,000
1,200,000
1.17

Levered
2,160,000
(864,000)
1,296,000
(453,600)
842,400

Breakeven EBIT
levered
financing

EPS
1.5

stock
financing

1.17

.5
0

EBIT
$1m

$2m

$3m

$4m

Breakeven EBIT
For EBIT up
levered
to $2.16 m,
stock
EPS
financing
stock
financing
1.5
financing is
best.
1.17

.5
0

EBIT
$1m

$2m

$3m

$4m

Breakeven EBIT
For EBIT up
levered
to $2.16 m,
stock
EPS
financing
stock
financing
1.5
financing
is best.
For EBIT greater
than $2.16 m,
1.17
the levered plan
is best.
.5
0

EBIT
$1m

$2m

$3m

$4m

EXERCISE 1:

The MAX Corporation is planning a $4 million expansion this year. The expansion can be
financed by issuing either common stock or bonds. The new common stock can be sold for $60
per share. The bonds can be issued with a 12% coupon rate. The firms existing shares of
preferred stock pay dividends of $2.00 per share. The companys corporate income tax rate is
46%. The companys balance sheet prior to expansion is as follows:
MAX Corporation
Current assets
$ 2,000,000
Fixed assets
8,000,000
Total assets
$10,000,000
Current liabilities
$ 1,500,000
Bonds:
(8%, $1,000 par value)
1,000,000
(10%, $1,000 par value)
4,000,000
Preferred stock:
($100 par value)
500,000
Common stock:
($2 par value)
700,000
Retained earnings
2,300,000
Total liabilities and equity
$10,000,000
a. Calculate the indifference level of EBIT between the two plans.
b. If EBIT is expected to be $3 million, which plan will result in higher EPS?

EXERCISE 2 :

In order to generate RM 140,000 capital investment Amy is

trying to decide proposed options. Under Plan I,the project
will be financed by issuing new common stocks that can be
sold for RM 20per share. Plan II, use financial leverage whre
a 10year bonds can be issued with 7% coupon rates. The
company tax 40% and prefereed stock pay dividends of
RM5 per share. The existing capital structure as follows:

Bonds: (9% RM1000 par value)

RM25,000
Preferred stock: (RM25 par value)
RM20,000
Common Stock(RM 2 par value) RM30,000

Calculate indifference point of EBIT-EPS for two financial

proposals.
If EBIT expected to be 30,000 which plan should you select?
Why? (Show chart and calculation)

EXERCISE 3 :
The management of MH & Co. is considering
an expansion project for their current
business. RM125,000 is needed for the
expansion and two options has been
proposed. Under Option I, the project will be
financed by issuing new common stocks that
can be sold for RM5 per share. Option II
involves the use of financial leverage. A 10year bonds can be issued with 8% coupon
rates. The company corporate income tax is
30% and the existing preferred stock pay
dividends of RM4 per share.

The existing capital structure for MH &

Co. are as follows:
Bonds:
RM
(9% RM1,000 par value)
20,000
Preferred Stock:
(RM 25 par value)
15,000
Common Stock :
(RM2 par value)
25,000

Questions:
Explain the meaning of EBIT-EPS indifference
point and why is it important for
management.
Calculate the indifference point of EBIT-EPS
for the two financial proposals.
If EBIT is expected to be RM 20,000, which
financial proposal should you select? Why?
(show your calculation).
Draw your EBIT-EPS analysis chart.
Prepare an analytical income statement that
proves EPS will be the same regardless of the
plan chosen.