EBIT
– EPS relationship
While
deciding on the appropriate capital structure for an organisation,
the first thing is to understand the affect on Earning Per
Share (EPS) due to the changes in Earning Before Interest
and Taxes (EBIT) under different financing alternatives.
The
relationship between EBIT and EPS is as follows:
(EBIT – I) (1-t)
EPS = ---------------------
n
Where,
EBIT
= earnings before interest and taxes
EPS
= earnings per share
I
= interest
t
= tax rate
n
= number of equity shares
Break-even
EBIT level
Break-even
EBIT level is the indifferent point where EPS under alternative
financing plan is the same. Mathematically, the break-even
EBIT level is:
(EBIT* - I1) (1 – t)
(EBIT* - I2) (1- t)
---------------------------
=
-------------------------
n1
n2
Where,
EBIT*
= indifference point between the two alternative financing
plans
I1,
I2 =
interest expenses
t =
income-tax rate
n1,
n2 =
number of equity shares outstanding after adopting financing
plans 1and 2
Illustration
Consider
a company XYZ ltd., which is considering the following two
financing options:
- Financing
a new project by issuing equity in the market to raise the
number of outstanding equity shares from 1,000,000 to 2,000,000
- Financing,
a new project by issuing bonds which will carry interest
expenses of Rs.1,400,000 and keeping the number of outstanding
equity shares the same
Applying
the above equation for XYZ ltd. (considering the tax rate
is 50%), we get,
(EBIT* - 0) (0.5)
(EBIT* - 1,400,000) (0.5)
-----------------------
= ------------------------------------
2,000,000
1,400,000
EBIT*
= Rs.2,800,000
Therefore, the break-even EBIT level, is
Rs.2,800,000 for XYZ ltd. If the present EBIT level of XYZ
ltd is more than the break-even EBIT, then it would be better
off to finance the new project by issuing bond. The equity
finance option will be favourable if the present level of
EBIT is below the break-even EBIT level.
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