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Subject Commerce

Paper No and Title Paper No. 8: Financial Management

Module No and Title Module No. 21: Analysis of Financial Plans: EBIT-EPS
Analysis
Module Tag COM_P8_M21

COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT

MODULE No. : 21 ANALYSIS OF FINANCIAL PLANS: EBIT - EPS
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TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction: EBIT- EPS Analysis
3. Analyzing Alternate Financial Plans
3.1. Constant EBIT with different Financial Patterns
3.2. Varying EBIT with different Financial Patterns
4. Financial Break Even Level/Point
4.1. Meaning
4.2. Computation
5. Indifference Level/Point
5.1. Meaning
5.2. Computation
6. Limitations of EBIT-EPS Analysis.
7. EBIT-EPS Analysis vs. Cash Flow Analysis
8. Summary

1. Learning Outcomes

After studying this module, you will be able to

 Know the basic concept of EBIT-EPS Analysis.

 Analyze different financial plans under constant and varying EBIT situations.
 Understand the meaning and computation of Financial Break Even Level/Point
 Comprehend the meaning and computation of Indifference Point.
 Explain the limitations of EBIT- EPS Analysis.
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 Differentiate between EBIT- EPS and Cash Flow

Analysis.

2. Introduction: EBIT- EPS Analysis

EBIT-EPS Analysis shows the impact of various alternate financial plans on EPS
(earnings per share) at various levels of EBIT (earnings before interest and taxes). In
order to examine the impact of leverage on EPS, EBIT- EPS analysis should be
considered. It makes the comparison of alternate financing methods under various
alternate financing proposals. A firm may raise funds in either of following alternatives:
 Exclusive use of Equity Capital
 Exclusive use of Debt
 Various combinations of equity and debt.
 Various combinations of debt, equity and preference capital.

Format of EBIT- EPS Analysis

Particulars Equity Alternative Debt Alternative
Pessimistic Optimistic Pessimistic Optimistic
EBIT EBIT EBIT EBIT
A.Earnings Before Interest and Taxes(EBIT)
B. Interest on Debt
C. Earnings or Profits Before Tax
(EBT or PBT = A - B)
D. Tax
E. Earnings or Profits After Tax
(EAT or PAT = C - D)
F. Preference Dividend
G. Earnings or Profits for Equity
Shareholders = E – F
H. No. of Equity Shares
I. Earnings Per Share (EPS = G/H)

3. Analyzing Alternate Financial Plans

3.1. Constant EBIT with Different Financial Plans

We can understand the effect of change in leverage on the EPS while keeping EBIT
constant with the help of following illustration:
Illustration 1. EBIT of ABC Ltd. is Rs. 200000 p.a. on an investment of Rs.600000.
The company can finance this amount by issuing equity share capital of Rs. 100 each, 10
% preference shares and 15 % debentures. Suppose, Company analyzes the following
four options to raise the required funds of Rs.600000:
Option I: By issuing equity share capital at par.
Option II: 50% funds by equity share and 50% funds by Preference share capital.
Option III: 50 % funds by equity share capital, 25 % by issue of 10 % preference shares
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and 25 % by issue of 15% debentures.

Option IV: 25 % funds by equity share capital, 25% by
issue of 10 % preference shares
and 50 % by issue of 15 % debentures.
Find and analyze EPS under different options assuming tax rate of 50%.

Solution:
Particulars Option I Option II Option III Option IV
Equity Equity Equity (50%) Equity (25%) +
(100%) (50%) + + Pref. (25%) Pref. (25%) +
Pref. (50 %) + Debt (25%) Debt (50%)
A. EBIT 2,00,000 2,00,000 2,00,000 2,00,000
B. Interest = [15% of (6,00,000 * ……… ……… 22,500 [15% 45,000 [15% of
Proportion of Debt)] of (6,00,000 * (6,00,000 * 50%)]
25%)]
C. Earnings or Profit before tax 2,00,000 2,00,000 1,77,500 1,55,000
(EBT or PBT = A – B)
D. Tax = 50% of C) 1,00,000 1,00,000 88,750 77,500
E. Earnings or Profit after tax 1,00,000 1,00,000 88,750 77,500
(EAT or PAT = C – D)
F. Preference Dividend = [10% …….. 30,000 [10% 15,000 [10% 15,000 [10% of
of (6,00,000 * Proportion of of (6,00,000 of (6,00,000 * (6,00,000 * 50%)]
Preference Capital)] * 50%)] 25%)]
G. Earnings or Profits available
to equity shareholders = E – F 100000 70000 73750 62500
H. No. of Equity shares of Rs. 6000 3000 3000 1500 [(6,00,000
100 each = [(6,00,000* [(6,00,000 [(6,00,000 [(6,00,000 * * 25%) / 100]
Proportion of Equity * 100%) / * 50%) / 100] 50%) / 100]
Capital)/100] 100]
I. Earnings Per Share (EPS) = 16.67 23.33 24.58 41.67
G/H

Recommendation: In the above illustration, Option IV seems to be the best with highest
EPS of Rs. 41.67. In this option 50 % debt is used and shareholders will enjoy the
benefits of having low cost capital (debt and preference shares). However, this positive
impact will work when the cost of borrowing is less than the rate of return on investment.
If the cost of borrowing is more than the rate of return on investment then debt should not
be employed as it will have a negative effect on EPS of the equity shareholders.

3.2. Varying EBIT with Different Financial Plans

We all know that future is uncertain; therefore estimating EBIT will also have an element
of uncertainty. So, the assumption of “Constant EBIT” does not hold good as it seems to
be unrealistic. In practice, there is a difference between expected EBIT and actual EBIT

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of a firm. Therefore, EBIT-EPS analysis should be

studied under changing EBIT levels. We can understand
this with the help of following illustration.

Illustration 2. XYZ Ltd. has a share capital of Rs. 2,00,000 divided into shares of Rs. 10
each. For major expansion plan, it requires an investment of Rs. 1,00,000 more.
Following alternatives are considering by the management
Option I: Issue of 10,000 equity shares of Rs. 10 each.
Option II: Issue of 10,000, 10 % preference shares of Rs. 10 each.
Option III: Issue of 10% debentures of Rs. 1,00,000.
Company’s EBIT is Rs. 80,000 p.a. The company is in tax bracket of 50%. Calculate the
effect of each of the above mode of financing on EPS presuming that
(a) EBIT continues to be the same even after expansion.
(b) EBIT declines by Rs.25,000.
(c) EBIT increases by Rs. 20,000.

Solution: (a) EBIT= Rs. 80,000 p.a.

Particulars Present Capital Proposed Proposed Proposed
Structure Structure structure Structure
Option I Option II Option III
EBIT 80,000 80,000 80,000 80,000
Less: Interest ----------------- ------------ ---------- 10,000
Profit Before tax 80,000 80,000 80,000 70,000
Less: Tax (50%) 40,000 40,000 40,000 35000
Profit after tax 40,000 40,000 40,000 35,000
Less: Pref. Div. ----------------- ------------ 10,000 ----------
Earnings to Equity 40,000 40,000 30,000 35000
shareholders
No. of Equity shares 20,000 30,000 20,000 20,000

EPS 2.0 1.33 1.5 1.75

(b) EBIT declines by Rs. 25,000

Particulars Present Capital Proposed Proposed Proposed
structure structure structure structure
Option I Option II Option III
EBIT 80,000 55,000 55,000 55,000
Less: Interest - - - 10,000
Profit Before Tax 80,000 55,000 55,000 45,000

Less: Tax @ 50% 40,000 27,500 27500 22,500

Profit after tax 40,000 27,500 27,500 22,500
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Less: Pref. Div. - - 10,000 -

Profits for equity 40,000 27,500 17,500 22,500
shareholders

No. of Equity shares 20,000 30,000 20,000 20, 000

EPS 2.0 0.917 0.875 1.125

(c) EBIT increases by Rs. 20,000

Particulars Present Capital Proposed Proposed Proposed
structure structure structure structure
Option I Option II Option III
EBIT 80,000 1,00,000 1,00,000 1,00,000
Less: Interest - - - 10,000
Profit Before tax 80,000 1,00,000 1,00,000 90,000
Less: Tax @ 50% 40,000 50,000 50,000 45,000
Profit after tax 40,000 50,000 50,000 45,000
Less: Pref. Div. - - 10,000 -
Profits for equity 40,000 50,000 40,000 45,000
shareholders
No. of Equity shares 20,000 30,000 20,000 20, 000
EPS 2.0 1.67 2.0 2.25

Recommendation: We see that in all the three situations [Cases (a), (b) and (c)], the EPS
is highest in case of Option III, i.e., the option of raising additional Rs. 1,00,000 through
issue of 10% debentures of Rs.1,00,000. So the management should consider adopting
the Option III for financing its expansion plans.

Behaviour of EPS when EBIT changes:

From the above illustration we can easily draw some points about the behaviour of EPS
when EBIT changes:
 When EBIT is Rs. 80,000, in alternate I, EPS is 1.33
 When EBIT declines by Rs. 25000 (31.25 %), EPS also decreases by the same
percentage. We can say that when capital structure is having only equity capital,
the percentage change in EPS is equal to the percentage change in EBIT.
 When EBIT increases by Rs. 20,000, EPS also increases by the same proportion.
So, when there is no debt content in the capital structure of a firm, percentage
change in EPS is equal to percentage change in EBIT.

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4. Financial Break-Even Point/ Level

4.1. Meaning
Financial Break Even Level/Point is the level of Earnings before interest and tax (EBIT)
at which the firm's Earnings per share (EPS) is zero. The higher this point, the higher is
the financial risk of investment in the firm’s shares. Alternatively, it can be defined as the
level of EBIT which is just sufficient to cover the fixed financial charges.

4.2. Computation

Financial Break Even Level EBIT can be computed under different situations as follows:
Case I: If the firm has employed only debt and no preference share capital, then
Financial Break Even Level EBIT = Interest on Debt.
Case II: If the firm has employed both debt and preference share capital, then
Financial Break Even Level EBIT = Interest on Debt + {Preference Dividend / (1-t)}
where, t = corporate tax rate.
Case III: If the firm has employed both debt and preference share capital and has to pay
corporate dividend tax on dividends apart from corporate tax then
Financial Break Even Level EBIT = Interest on Debt + [{Preference Dividend +
Corporate Dividend Tax} / (1-t)].

Illustration 3. Calculate Financial Break Even Level EBIT of a firm in following cases:
Case I: Firm has a debt of Rs. 2,00,000 carrying interest of 10%.
Case II: Firm has a debt of Rs. 2,00,000 carrying interest of 10% and Preference
Dividend is Rs. 36,000. Corporate tax rate = 40%.
Case III: Firm has a debt of Rs. 2,00,000 carrying interest of 10% and Preference
Dividend is Rs. 36,000. Corporate tax rate = 40% and Corporate Dividend Tax rate =
20%.

Solution:
Case I: Financial Break Even Level EBIT
= Interest on Debt
= 10% of Rs. 2,00,000 = Rs. 20,000.

Case II: Financial Break Even Level EBIT

= Interest on Debt + {Preference Dividend / (1-t)}
= 20,000 + {36,000/ (1- 0.4)}
= 20,000 + {36,000/ 0.6}
= 20,000 + 60,000
= Rs. 80,000.

Case III: Financial Break Even Level EBIT

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= Interest on Debt + [{Preference Dividend +

Corporate Dividend Tax} / (1-t)]
= 20,000 + [{36,000 + 20% of 36,000} / (1- 0.40)]
= 20,000 + [{36,000 + 7,200} / (0.60)]
= 20,000 + [43,200 / 0.60]
= 20,000 + 72,000
= Rs. 92,000.

5. Indifference Point/ Level

5.1. Meaning

Indifference Point is the level of EBIT under two financing alternatives where EPS is the
same irrespective of the debt-equity mix used.
 When expected level of EBIT > Indifference level of EBIT: Use Debt financing to
maximize EPS.
 When expected level of EBIT > Indifference level of EBIT: Use Equity financing
to maximize EPS.
 When expected level of EBIT > Indifference level of EBIT: Indifferent because
both Debt and Equity financing will have same impact on EPS.
EBIT is used as a dependent variable and EPS from two alternatives is taken as an
independent variable. At indifference level of EBIT, after tax cost of debt is equal to
return on investment.

5.2. Computation

Following formula can be used to ascertained indifference point between the two
financing alternatives using both debt and equity:
(EBIT- I1) (1-t)/ N1 = (EBIT- I2) (1-t) / N2
Where, I1 = Interest payment of Plan I; I2 = Interest payment of Plan II;
N1 = Number of shares in Plan I; N2 = Number of shares in Plan II;
t = tax rate and EBIT = Earnings before interest and taxes

The indifference point of EBIT between two financing alternatives of equity financing
versus preference, debt and equity capital will be:
(EBIT) (1-t)/ N1 = (EBIT- I) (1-t) - PD / N2.
Where, PD = Preference Dividend.

Illustration 4. Sakshi Ltd. is setting up a project with a total capital of Rs. 9,00,000.
Following two alternatives are available:
Plan I: 100 % Equity finance.
Plan II: Debt-Equity ratio of 2:1.
The rate of interest payable on debt is 8%. The corporate tax rate is 50%.
Calculate indifference point between two alternative methods of financing.

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Solution:
Plan I: Issue of equity shares of 90,000 of Rs.10 each.
Plan II: Debt - Equity ratio is 2:1. Therefore, Rs. 6,00,000 will be raised through debt
[Rs. 9,00,000 * 2/3] and remaining Rs. 3,00,000 through issue of 30,000 equity shares of
Rs. 10 each [Rs. 9,00,000 * 1/3].
Interest on debt = 8% of Rs. 6,00,000 = Rs. 48,000.
Indifference Point Between two alternatives:
(EBIT-0) (1-0.5) / 90,000 = (EBIT – 48,000) (1-0.5) / 30,000
EBIT * 0.5 / 90,000 = (EBIT- 48,000)* 0.5 / 30,000
EBIT * 0.5 = (EBIT- 48,000)* 0.5 * 90,000 / 30,000
EBIT * 0.5 = (EBIT- 48,000)* 0.5 * 3
EBIT = (EBIT- 48,000)* 0.5 * 3 / 0.5
EBIT = (EBIT- 48,000) * 3
EBIT = 3 EBIT – 1, 44,000
2 EBIT = 1, 44,000
EBIT = Rs.72,000.
Hence, Indifference Level EBIT = Rs.72,000.

6. Limitations of EBIT-EPS Analysis

EBIT- EPS Analysis has following limitations:

 Focus is on maximization of EPS not on maximization of share price. As

discussed in module 2, maximization of EPS is not the same as maximization of
shareholder’s wealth.
 It ignores increased financial risk due to use of more debt.
 The unpredictability of EPS due to increased risk is ignored under EBIT-EPS
Analysis.
 The main objective of EBIT-EPS Analysis is to decide which capital structure
would be beneficial to the firm. But, more weightage is being given to the EPS
which in turn depends on the profitability of the company.
 EBIT-EPS Analysis ignores the time value of money.

 Sometimes for a given set of alternative financial plans, indifference point occurs
at a negative value of EBIT, which is imaginary.
 If both financial plans not involve issue of new equity shares, then no EBIT
indifference point will exist.

7. EBIT-EPS Analysis vs. Cash Flow Analysis

EBIT – EPS Analysis Cash Flow Analysis

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 Under EBIT – EPS analysis capital  In Cash Flow Analysis capital

structure of a firm is evaluated on structure of a firm is evaluated on
the basis of profitability. the basis of liquidity.

 A Capital Structure which is  Generally, Capital Structure which

expected to result in maximizing ensures maximum net cash flows is
EPS would be selected. preferred.
 EBIT – EPS Analysis does not  Cash Flow Analysis considers
consider financial risk of default in financial risk of default in payment
payment of fixed financial charges of fixed financial charges (interest
(interest on debt and preference on debt and preference dividend).
dividend).
 EBIT – EPS technique analyzes  Cash Flow Analysis focuses on
alternative financial plans from liquidity requirement, thus
equity shareholder’s point of view. emphasizes on meeting
commitments of debt and
preference capital investors.

8. Summary

 EBIT-EPS Analysis shows the impact of various alternate financial plans on EPS
(earning per share) at various levels of EBIT (earnings before interest and taxes).
 EBIT-EPS Analysis can be done by either keeping EBIT constant with different
Financial Patterns or Varying EBIT with different Financial Patterns.
 Generally, the financial pattern which maximizes EPS is preferred and chosen.
 When capital structure is having only equity capital, the percentage change in
EPS is equal to the percentage change in EBIT.
 Financial Break Even Level is the level of Earnings before interest and tax (EBIT)
at which the firm's Earnings per share (EPS) is zero.
 Financial Break Even Level EBIT = Interest on Debt + [{Preference Dividend +
Corporate Dividend Tax} / (1-t)].
 Indifference Point is the level of EBIT under two financing alternatives where
EPS is the same irrespective of debt equity mix.
 The indifference point of EBIT between two financing alternatives of equity
financing versus preference, debt and equity capital will be:
(EBIT) (1-t)/ N1 = (EBIT- I) (1-t) - PD / N2.
 EBIT-EPS Analysis focuses on maximization of EPS rather than share price;
ignores increased financial risk; ignores variability in EPS; ignores time value of
money; depends on profitability and may give a negative Indifference level EBIT.

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 EBIT-EPS analysis is based on profitability;

chooses plan which maximizes EPS; ignores
increased financial risk and analyzes from shareholder’s viewpoint. On the other
hand, Cash Flow Analysis is based on liquidity; chooses plan which maximizes
net cash flows; considers increased financial risk and analyzes with focus on
meeting commitments of debt and preference capital investors.

COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT

MODULE No. : 21 ANALYSIS OF FINANCIAL PLANS: EBIT - EPS
ANALYSIS