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EBIT-EPS Analysis in Leverage: Concept, Advantages and Other Details

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as a tool of financial
planning that evaluates various alternatives of financing a project under varying levels of EBIT
and suggests the best alternative having highest EPS and determines the most profitable level of
EBIT.
Concept of EBIT-EPS Analysis:
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative
methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the
effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial
plans.
It examines the effect of financial leverage on the behavior of EPS under different financing
alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of
the combination and of the various sources. It helps select the alternative that yields the highest
EPS.
We know that a firm can finance its investment from various sources such as borrowed capital or
equity capital. The proportion of various sources may also be different under various financial
plans. In every financing plan the firms objectives lie in maximizing EPS.
Advantages of EBIT-EPS Analysis:
We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior
of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining
optimum financial planning having highest EPS.
Various advantages derived from EBIT-EPS analysis may be enumerated below:
Financial Planning:
Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial
planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the
alternatives and finds the level of EBIT that maximizes EPS.
Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines
and markets. It identifies the EBIT earned by these different departments, product lines and from

various markets, which helps financial planners rank them according to profitability and also
assess the risk associated with each.
Performance Evaluation:
This analysis is useful in comparative evaluation of performances of various sources of funds. It
evaluates whether a fund obtained from a source is used in a project that produces a rate of return
higher than its cost.
Determining Optimum Mix:
EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By
emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and
equity in the capital structure. It helps determine the alternative that gives the highest value of
EPS as the most profitable financing plan or the most profitable level of EBIT as the case may
be.
Limitations of EBIT-EPS Analysis:
Finance managers are very much interested in knowing the sensitivity of the earnings per share
with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this
technique also suffers from certain limitations, as described below
No Consideration for Risk:
Leverage increases the level of risk, but this technique ignores the risk factor. When a
corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any
financial planning can be accepted irrespective of risk. But in times of poor business the reverse
of this situation ariseswhich attracts high degree of risk. This aspect is not dealt in EBIT-EPS
analysis.
Contradictory Results:
It gives a contradictory result where under different alternative financing plans new equity shares
are not taken into consideration. Even the comparison becomes difficult if the number of
alternatives increase and sometimes it also gives erroneous result under such situation.
Over-capitalization:
This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point,
additional capital cannot be employed to produce a return in excess of the payments that must be
made for its use. But this aspect is ignored in EBIT-EPS analysis.

Example 5.1:
Ankim Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given as under:

Indifference Points:
The indifference point, often called as a breakeven point, is highly important in financial
planning because, at EBIT amounts in excess of the EBIT indifference level, the more heavily
levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below
the EBIT indifference points the financing plan involving less leverage will generate a higher
EPS.
i. Concept:
Indifference points refer to the EBIT level at which the EPS is same for two alternative financial
plans. According to J. C. Van Home, Indifference point refers to that EBIT level at which EPS
remains the same irrespective of debt equity mix. The management is indifferent in choosing
any of the alternative financial plans at this level because all the financial plans are equally

desirable. The indifference point is the cut-off level of EBIT below which financial leverage is
disadvantageous. Beyond the indifference point level of EBIT the benefit of financial leverage
with respect to EPS starts operating.
The indifference level of EBIT is significant because the financial planner may decide to take the
debt advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will
be able to magnify the effect of increase in EBIT on the EPS.
In other words, financial leverage will be favorable beyond the indifference level of EBIT and
will lead to an increase in the EPS. If the expected EBIT is less than the indifference point then
the financial planners will opt for equity for financing projects, because below this level, EPS
will be more for less levered firm.
ii. Computation:
We have seen that indifference point refers to the level of EBIT at which EPS is the same for two
different financial plans. So the level of that EBIT can easily be computed. There are two
approaches to calculate indifference point: Mathematical approach and graphical approach.
Mathematical Approach:
Under the mathematical approach, the indifference point may be obtained by solving equations.
Let us present the income statement given in Table 5.1 with the following symbols in Table 5.4.
We are starting from EBIT only.

Where, N represents number of equity shares.


In case of financing, three types of sources may be opted: Equity, debt and preference shares. So
we may have four possible combinations Equity, Equity-Debt, Equity- Preference Shares and
Equity- Debt-Preference Shares.

So, EPS under various alternatives will be as follows:

Note:
The symbols have their usual meaning.
The indifference point between any two financial plans may be obtained by equalizing the
respective equations of EPS and solving them to find the value of X.
Example 5.2:
Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external
financing for which it is considering two alternatives. The first alternative calls for issuing
15,000 equity shares of Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the
second alternative requires 10,000 equity shares of Rs 100 each, 2,000 10% Preference Shares of
Rs 100 each and Rs 8,00,000 Debentures carrying 9% interest. The company is in the tax bracket
of 50%. You are required to calculate the indifference point for the plans and verify your answer
by calculating the EPS.
Solution:

Graphical Approach:
The indifference point may also be obtained using a graphical approach. In Figure 5.1 we have
measured EBIT along the horizontal axis and EPS along the vertical axis. Suppose we have two
financial plans before us: Financing by equity only and financing by equity and debt. Different
combinations of EBIT and EPS may be plotted against each plan. Under Plan-I the EPS will be
zero when EBIT is nil so it will start from the origin.

The curve depicting Plan I in Figure 5.1 starts from the origin. For Plan-II EBIT will have some
positive figure equal to the amount of interest to make EPS zero. So the curve depicting Plan-II
in Figure 5.1 will start from the positive intercept of X axis. The two lines intersect at point E
where the level of EBIT and EPS both are same under both the financial plans. Point E is the
indifference point. The value corresponding to X axis is EBIT and the value corresponding to 7
axis is EPS.
These can be found drawing two perpendiculars from the indifference pointone on X axis and
the other on Taxis. Similarly we can obtain the indifference point between any two financial
plans having various financing options. The area above the indifference point is the debt
advantage zone and the area below the indifference point is equity advantage zone.
Above the indifference point the Plan-II is profitable, i.e. financial leverage is advantageous.
Below the indifference point Plan I is advantageous, i.e. financial leverage is not profitable. This
can be found by observing Figure 5.1. Above the indifference point EPS will be higher for same
level of EBIT for Plan II. Below the indifference point EPS will be higher for same level of
EBIT for Plan I. The graphical approach of indifference point gives a better understanding of
EBIT-EPS analysis.

Financial Breakeven Point:


In general, the term Breakeven Point (BEP) refers to the point where the total cost line and sales
line intersect. It indicates the level of production and sales where there is no profit and no loss

because here the contribution just equals to the fixed costs. Similarly financial breakeven point is
the level of EBIT at which after paying interest, tax and preference dividend, nothing remains for
the equity shareholders.
In other words, financial breakeven point refers to that level of EBIT at which the firm can
satisfy all fixed financial charges. EBIT less than this level will result in negative EPS. Therefore
EPS is zero at this level of EBIT. Thus financial breakeven point refers to the level of EBIT at
which financial profit is nil.
Financial Break Even Point (FBEP) is expressed as ratio with the following equation:

Example 5.3:
A company has formulated the following financing plans to finance Rs 15, 00,000 which is
required for financing a new project.

Introduction
The analysis of the effect of different patterns of financing or the financial leverage on
the level of returns available to the shareholders, under different assumptions of EBIT is known
as EBIT-EPS analysis. A firm has various options regarding the combinations of various sources
to finance its investment activities. The firms may opt to be an all-equity firm (and having no
borrowed funds) or equity-preference firm (having no borrowed funds) or any of the numerous

possibility of combinations of equity, preference shares and borrowed funds. However, for all
these possibilities, the sales level and the level of EBIT is irrelevant as the pattern of financing
does not have any bearing on the sales or the EBIT level. In fact, the sales and the EBIT level
are affected by the investment decisions.
Given a level of EBIT, a particular combination of different sources of finance will result
in a particular EPS and therefore, for different financing patterns, there would be different levels
of EPS.
Constant EBIT and Changes in the Financing Patterns: Holding the EBIT constant
while varying the financial leverage or financing patterns, one can imagine the firm increasing its
leverage by issuing bonds and using the proceeds to redeem the capital, or doing the opposite to
reduce leverage.
Suppose, ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per annum on an
investment Rs.5,00,000, is considering the finalization of the capital structure or the financial
plan. The company has access to raise funds of varying amounts by issuing equity share capital,
12% preference share and 10% debenture or any combination thereof. Suppose, it analyzes the
following four options to raise the required funds of Rs.5,00,000.
1. By issuing equity share capital at par.
2. 50% funds by equity share capital and 50% funds by preference shares.
3. 5% funds by equity share capital, 25% by preference shares and 25% by issue of 10%
debentures.
4. 25% funds by equity share capital, 25% as preference share and 50% by the issue of 10%
debentures.
Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS under the above four options can
be calculated as follows:
Option 1
Option 2
Option 3
Option 4
Equity share capital

Rs.5,00,000

Rs.2,50,000

Rs.2,50,000

Rs.1,25,000

Preference share capital

---

2,50,000

1,25,00

1,25,000

10% Debentures

---

---

1,25,000

2,50,000

Total Funds

5,00,000

5,00,000

5,00,000

5,00,000

EBIT

1,50,000

1,50,000

1,50,000

1,50,000

- Interest

---

---

12,500

25,000

Profit before Tax

1,50,000

1,50,000

1,37,500

1,25,000

- Tax @ 50%
Profit after Tax
- Preference Dividend
Profit for Equity shares

75,000
75,000
--75,000

75,000
75,000
30,000
45,000

68,750
68,750
15,000
53,750

62,500
62,500
15,000
47,500

No. of Equity shares (of Rs.100 5000


2500
2500
1250
each)
EPS (Rs.)
15
18
21.5
38
In this case, the financial plan under option 4 seems to be the best as it is giving the
highest EPS of S.38. In this plan, the firm has applied maximum financial leverage. The firm is
expecting to earn an EBIT of Rs.1,50,000 on the total investment of Rs.5,00,000 resulting in
30% return. On an after-tax basis, this return comes to 15% i.e., 30% x (1-.5). However, the
after tax cost of 10% debentures is 5% i.e., 10% (1- .5) and the after tax cost of preference shares
is 12% only. In the option 4, the firm has employed 50% debt, 25% preference shares and 25%
equity share capital, and the benefits of employing 50% debt (which has after tax cost of 5%
only) and 25% preference shares (having cost of 12% only) are extended to the equity
shareholders. Therefore the firm is expecting an EPS of Rs.38.
In case, the company opts for all-equity financing only, the EPS is Rs.15 which is just
equal to the after tax return on investment. However, in option 2, where 5% funds are obtained
by the issue of 12% preference shares, the 3% extra is available to the equity shareholders
resulting in increase in of EPS from Rs.15 to Rs.18. In plan 3, where 10% debt is also
introduced, the extra benefit accruing to the equity shareholders increases further (from
preference shares as well a from debt) and the EPS further increases to Rs.21.50. The company
is expecting this increase in EPS when more and more preference share and debt financing is
availed because the after tax cost of preference shares and debentures are less than the after tax
return on total investment.
Hence, the financial leverage has a favourable impact on the EPS-only if the ROI is more
than the cost of debt. It will rather have an unfavourable effect if the ROI is less than the cost of
debt. That is why financial leverage is also called the twin-edged sword.
Varying EBI with Different Patterns: Suppose, there are three firm X & Co., Y & Co.
and Z & Co. These firms are alike in all respect except the leverage. The financial position of
the three firms is presented as follows:
Capital Structure
X & Co.
Y & Co.
Z & Co.
Share Capital (of Rs.100 each)
Rs.2,00,000
Rs.1,00,000 Rs.50,000
6% Debenture
--1,00,000
1,50,000
Total
2,00,000
2,00,000
2,00,000
These firms are expected to earn a ROI at different levels depending upon the economic
conditions. In normal conditions, the ROI is expected to be 8% which may fluctuate by 3% on
either side on the occurrence of bad economic conditions or good economic conditions. How is
return available to the shareholders of the three firms is going to be affected by the variations in
the level of EBIT due to differing economic conditions? The relevant presentations have been
shown as follows:
Poor
Normal
Good
Eco. Cond. Eco. Cond. Eco. Cond.
Total Assets
Rs.2,00,000 Rs.2,00,00 Rs.2,00,000
0

ROI
EBIT

5%
Rs.10,000
X & Co. (No Financial Leverage)
EBIT
10,000
- Interest
--Profit before Tax
10,000
- Tax @ 50%
5,000
Profit After Tax
5,000
Number of Shares
2,000
EPS (Rs.)
2.5
Y & Co. (50% Leverage)
EBIT
- Interest
Profit before Tax
- Tax @ 50%
Profit After Tax
Number of Shares
EPS (Rs.)
Z & Co. (75% Leverage)

10,000
6,000
4,000
2,000
2,000
1,000
2

8%
11%
Rs.16,000
Rs.22,000
(Figures in Rs.)
16,000
22,000
----16,000
22,000
8,000
11,000
8,000
11,000
2,000
2,000
4
5.5
(Figures in Rs.)
16,000
22,000
6,000
6,000
10,000
16,000
5,000
8,000
5,000
8,000
1,000
1,000
5
8

(Figures in Rs.)
EBIT
10,000
16,000
22,000
- Interest
9,000
9,000
9,000
Profit before Tax
1,000
7,000
13,000
- Tax @ 50%
500
3,500
6,500
Profit After Tax
500
3,500
6,500
Number of Shares
500
500
500
EPS (Rs.)
1
7
13
On the basis of the figures given above, it may be analyzed as to how the financial
leverage affects the returns available to the shareholders under varying EBIT level. For this
purpose, the normal rate of return i.e. 8% and EPS of different firms in normal economic
conditions, both may be taken at 100 and position of other figures of EBIT and EPS may be
shown on relative basis as follows:

EBIT
X & Co.
EPS
% change from normal
Y & Co.
EPS
% change from normal
Z & Co.
EPS
% change from normal

Poor Eco. Cond.


62.5
62.5
- 37.5%

Normal Eco. cond. Good Eco. cond.


100
137.5
100
----

137.5
+ 37.5%

40
-60%

100
-----

160
+60%

14.3
-85.7%

100
-----

185.7
+85.7%

It is evident from the above figures that when economic conditions change from normal
to good conditions, the EBIT level increases by 37.5% (i.e. from 8% to 11%). The firm X & Co.
having no leverage, is not able to have the magnifying effect of its EBIT and therefore its EPS
increases only by 37.5%. On the other hand the firm Y& Co.(having 50% leverage) is able to
have an increase in EPS (from Rs. 5 to Rs. 8). Similarly, the firm Z & Co.(having still higher
leverage of 75%) is able to have an increase of 85.7% in EPS (from Rs. 7 to Rs.13). Thus, higher
the leverage, greater is the magnifying effect on the EPS in case when economic condition
improves
On the other hand just reverse is the situation in case when economic conditions worsen
and the EBIT level is reduced by 37.5% (i.e. from 8% ROI to 5% ROI). In this case the EPS of X
& Co. reduces only by 37.5%(from Rs 4 to Rs 2.5) whereas the EPS of Y & Co. (50% leverage)
reduces by 60% (from Rs. 5 to Rs.2). In case of Z & Co. the decrease is more pronounced and
EPS reduces by 85.7% (from Rs. 7 to Rs. 13). Thus, higher the leverage, greater is the
magnifying effect on the EPS in case when the economic conditions improve.
On the other hand, just reverse is the situation in case when the economic conditions
worsen and the EBIT level reduced by 37.5% ) i.e. from 8% ROI to 5% ROI ). In this case, the
EPS of X & Co. reduces only by 37.5% (from Rs. 4 to Rs. 2.5 ), whereas the EPS of Y &Co.
(50% leverage) reduces by 60%(from Rs. 5 to Rs. 2). In case of Z & Co. the decrease is more
pronounced and EPS reduces by 85.7% (from Rs. 7 to Rs.1).
Financial Break-Even Level
In case the EBIT level of a firm is just sufficient to cover the fixed financial charges then
such level of EBIT is known as financial break-even level. The financial break-even level of
EBIT may be calculated as follows:
If the firm has employed debt only (and no preference shares), the financial break-even
EBIT level is :
Financial break-even EBIT = Interest Charge
If the firm has employed debt as well as preference share capital, then its financial breakeven EBIT will be determined not only by the interest charge but also by the fixed preference
dividend. It may be noted that the preference divided is payable only out of profit after tax,

whereas the financial break-even level is before tax. The financial break-even level in such a
case may be determined as follows:
Financial break-even EBIT = Interest Charge + Pref. Div./(1-t)
Indifference Point/Level
The indifference level of EBIT is one at which the EPS remains same irrespective of the
debt equity mix. While designing a capital structure, a firm may evaluate the effect of different
financial plans on the level of EPS, for a given level of EBIT. Out of several available financial
plans, the firm may have two or more financial plans which result in the same level of EPS for a
given EBIT. Such a level of EBI at which the firm has two or more financial plans resulting in
same level of EPS, is known as indifference level of EBIT.
The use of financial break-even level an the return from alternative capital structures is
called the indifference point analysis. The EBIT is used as a dependent variable and the EPS
from two alternative financial plans is used as independent variable and the exercise is known as
indifference point analysis. The indifference level of EBIT is a point at which the after tax cost of
debt is just equal to the ROI. At this point the firm would be indifferent whether the funds are
raised by the issue of debt securities or by the issue of share capital. The following example will
illustrate this point.
Suppose, PQR & Co. is expecting an EBIT of Rs.55,00,000 after implementing the
expansion plan for Rs.50,00,000. The funds requirements needed to implement the plan can be
raised either by the issue of further equity share capital at an issue price of Rs.5,000 each, or by
the issue of 10% debenture. Find out the EPS under these two alternative plans if the existing
capital structure of the firm stands at 10,000 shares. The above situation can be analyzed as
follows:
Financial Plan 1
Financial Plan 2
Number of existing shares
10,000
10,000
Number of new shares
1,000
--Total Number of shares
11,000
10,000
10% Debenture
--Rs.50,00,000
EBIT (Given)
Rs.55,00,000
Rs.55,00,000
- Interest
--5,00,000
Profit before Tax
55,00,000
50,00,00
Tax @ 50%
27,50,000
25,00,000
Profit after Tax
27,50,000
25,00,000
EPS (Rs.)
250
250
So, at the EBIT level of Rs.55,00,000, the EPS is expected to be Rs.250 irrespective of
the fact whether the additional funds are raised by the issue of equity share capital or by the issue
of 10% debt. This EBIT level of Rs.55,00,000 is known as the indifference level of EBIT.
However, in case the company is expecting EBIT of Rs.50,00,000 or Rs.60,00,000, the EPS for
both the financial plans has been calculated in the following table.
Financial Plan 1
Financial Plan 2
EBIT
Rs.50,00,00 Rs.60,00,00 Rs.50,00,00 Rs.60,00,00

0
0
0
0
- Interest
----5,00,000
5,00,000
Profit before Tax
50,00,000
60,00,000
45,00,000
55,00,000
Tax @ 50%
25,00,000
30,00,000
22,50,000
27,50,000
Profit after Tax
25,00,000
30,00,000
22,50,000
27,50,000
Number of Equity shares
11,000
11,00
10,000
10,000
EPS (Rs.)
227
272
225
275
The above figures show that for an EBIT level below the indifference level of Rs.55,00,000, the
EPS is lower at Rs. 225 in case of leveraged option (i.e., debt financing) than the EPS of
unleveraged option of Rs.227. However, if the EBIT is higher than the indifference level, then
the EPS is higher at Rs.275 in case of levered option than the EPS of Rs.272 under unlevered
option.
If the firm expects to generate exactly the same amount of EBIT at which the EBIT-EPS
lines intersect, ten from the point of view of the equity shareholders, the firm would be
indifferent as to choice of capital structure because the same EPS would result from either of the
alternatives.
Figure shows that if the firm expects the EBIT at a level higher than the indifference
level, plan I is better and the PS will be higher than EPS under plan II. However, if the expected
level of EBIT is less than the indifference level of EBIT, than plan II is better as the EPS under
plan II will be higher. It is only in such a situation when the expected EBIT is just equal to the
indifference level of EBIT that the EPS under both the plans would be same.
The EBIT-EPS line or a particular financial plan also shows the financial break even level
of EBIT. The intercepts on the horizontal axis OA (in case of plan II) and OB (in case of plan I)
are the financial break even level of EBIT under respective financial plans.
Shortfalls of EBIT-EPS Analysis
EBIT-EPS analysis helps in making a choice for a better financial plan. However, it may have
two complications namely:
1.
If neither of the two mutually exclusive alternative financial plans involves issue of new
equity shares, then no EBIT indifference point will exist. For example, a firm has a capital
consisting of 1,00,000 equity shares and wants to raise Rs. 10,00,000 additional funds for
which the following two plans are available: (i) to issue 10% bonds of Rs. 10,00,000, or(ii) to
issue 12% preference shares of Rs. 100 each. Assuming tax rate to be 50% the indifference
level of EBIT for the two plans would be as follows:
(EBIT 1,00,000) (1 - .5)/1,00,000 = EBIT (1 - .5) 1,20,000
.5 EBIT 50,000 = 5 EBIT 1,20,000
0 = - 70,000
So, there is an inconsistent result and it indicates that there is no indifference point of
EBIT. If the EBIT-EPS lines of these two plans are drawn graphically, these will be parallel
and no intersection point will emerge.
2. Sometimes, a given set of alternative financial plans may give negative EPS to cause an
indifference level of EBIT. For example, a firm having 1,00,000 equity shares already

issued, requires additional funds of Rs.10,00,000 for which the following two options are
available : (i) to issue 20,000 equity shares of Rs.25 each and to raise to Rs.5,00,000 by the
issue of 9% bonds, or (ii) to issue 30,000 equity shares at Rs.25 each and to issue 2,500 12%
preference shares of Rs. 100 each. Assuming the tax rate to be 50%, the indifference level of
EBIT for the two plans would be as follows :
= EBIT = Rs. 1,35000

So, the indifference point occurs at a negative value of EBIT, which is imaginary.
Lets Sum Up

EBIT-EPS Analysis is another way of looking at the effects of different types of capital
structures. EBIT EPS Analysis considers the effect on EPS under different types of capital
mix.

Given a level of EBIT particular combination of different sources will result in a


particular level of EPS, and therefore for different financing patterns, there would be
different levels of EPS.

Financial break even level of EBIT is that level of EBIT at which EPS of a firm is zero.

Indifference level of EBIT is one at which the EPS remains same under two different
financial plans. At the difference level of EBIT, the firm would be indifferent whether funds
are raised by one capital mix or another both will have same level of EPS.
QUESTIONS
1. What is EBIT EPS Analysis? How is it different from leverage analysis?
2. Examine effects of change in EBIT of a firm on the EPS under (i) same capital structure and
(ii) different capital structure?
3. What are the shortcomings if any of the EBITEPS Analysis?

EBIT-EPS Analysis
EBIT-EPS analysis is a very strong and important tool in the hands of the finance manager. This
is an alternative technique to measure the impact of financial leverage on the returns available to
equity shareholders. Under EBIT-EPS analysis, an attempt is made to analyse the impact of
change in the capital structure on earnings available to equity shareholders. Thus, EBIT-EPS
analysis shows the relationship between EBIT and EPS at various financing pattern i.e. debt
equity ratio. The financing mix, which yields the maximum EPS to equity shareholders under
assumed EBIT level, is regarded as the best mix or the optimum capital structure.
There are two ways to analyse the relationship of EBIT and EPS. These two ways are:
Figure 9: Relationship between EBIT and EPS

(1)
(2)

Constant EBIT with Changing Financing Pattern


Varying EBIT with Changing Financing Pattern

Constant EBIT with Changing Financing Pattern:


In this section, we will try to analyse the impact of various financing patterns on the return
available to equity shareholders assuming constant level of EBIT. The return available to equity
shareholders is the residue part of the profit. The total operating profit is divided into various
claimants. These are four claimants of EBIT as shown below:
Figure 10: Claimants of EBIT

After payment to the first three claimants, the remaining portion is distributed as equity dividend
by dividing the amount available to equity shareholders by the total number of equity shares. The
statement of calculation of EPS can be prepared as follows:

Particulars

Amount (Rs.)

EBIT
Less: Interest

XXX
XXX
-----------------

EBT
Less: Tax

XXX
XXX
-------------------

EAT
XXX
Less: Preference Dividend
XXX
--------------Earnings Available to Equity Shareholders
XXX
Number of Equity Shares
XXX
EPS (Earnings to ESH/ No of Equity Shares)
XXX
The EPS will be different for different financing patterns assuming constant level of EBIT. It is
because the interest paid is tax deductible which resulted in tax benefits to equity share holders.
Thus, interest on debt capital can be used to increase the return to equity shareholders.
However it should be remembered that interest is a liability i.e. fixed financial charge on the
earning of the company. It increases the risk perception of the investor. So, its not possible to
keep increasing the level of debt content in the capital structure of the company. The ratio of debt
in capital structure will depend on various factors like nature of business, market conditions,

economic conditions, earning pattern of the company and cost of the debt. But the two important
factors which determine the level of debt content in the capital structure are rate of interest on
debt capital and rate of return on overall capital. If the rate of interest is higher than the rate of
return to the firm, it is better to use less amount of debt content in the capital structure. In such a
case, equity shareholders will bear a part of cost of debt and EPS will decline.
Similarly, when rate of return on capital exceeds rate of interest on debt, higher amount of debt
can be used in the capital structure which will result in disproportionate increase in the earnings
available to equity shareholders (ESH) and EPS will increase.
Illustration 3:
A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs. 10,00,000.
Company is in need of Rs. 8,00,000 for its expansion activities. Company can raise this amount
by either equity shares capital or 12% preference share capital or 10% debentures. The company
is considering the following financing patterns:
1. 10,00,000 through issue of Equity Shares at par;
2. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue of
Debentures;
3. 5,00,000 through Equity Shares and 2,50,000 through 12% Preference Share Capital and
remaining 2,50,000 through 10% Debentures.;
4. 5,00,000 through Debt and 2,50,000 through Equity Shares and remaining 2,50,000
through 12% Preference Share Capital.
Find out the best financing mix assuming 50% tax rate.
Solution 3:
Capital Structure
Plan I
Plan II
Plan III
Plan IV
Equity Share of 100
each
10,00,000
5,00,000
5,00,000
2,50,000
12% Preference Share
--------2,50,000
2,50,000
10% Debt
-----5,00,000
2,50,000
5,00,000
Total Capital Employed 10,00,000
10,00,000
10,00,000
10,00,000
Particulars
EBIT (ROI 25%)
Less: Interest

Plan I
Plan II
Plan III
Plan IV
5,00,000
5,00,000
5,00,000
5,00,000
-------50,000
25,000
50,000
________________________________________________
EBT
5,00,000
4,50,000
4,75,000
4,50,000
Less: Tax (50%)
2,50,000
2,25,000
2,37,500
2,25,000
_______________________________________________
EAT
2,50,000
2,25,000
2,37,500
2,25,000
Less: Preference Dividend -----------------50,000
30,000
Earnings to Equity
Shareholder
2,50,000
2,25,000
1,87,500
1,95,000
Number of shares
10,000
5,000
5,000
2,500

EPS(Rs.)
25
45
41.5
78
In the above example, alternative IV seems to be best alternative with EPS of Rs. 78. The EPS is
Rs. 25 when no debt is used in the capital structure. The EBIT of Rs. 5,00,000 on investment of
RS 10,00,000 turn out to be 50%. After tax ROI will be 25%. But the use of cheaper source of
finance such as debt at 10% cost and preference share at 12% cost will increase earnings per
share. Thus, use of more and more debt or fixed payment capital will lead to increase in EPS to
the shareholders.
Thus, we can conclude the followings:
1. Financial leverage (use of debt) has a favourable impact on the EPS only when ROI is
more than cost of debt (net of tax).
2. The EPS keeps increasing with the use of debt content in the capital structure till ROI is
more than cost of debt.
3. Financial leverage will have unfavourable impact on EPS if ROI is less than cost of debt
at any point of time.

Varying EBIT with Different Financing Patterns:


In the previous section, we got an insight into the impact of financing pattern on constant EBIT
levels. But in reality, it is impossible to have constant EBIT in all economic conditions.
Therefore, varying levels of EBIT will be more practical approach to consider and analyse the
impact of different financing patterns. The following example will explain:
Illustration 4:
A company having equity share capital of Rs. 4,00,000 divided into shares of Rs. 100 each. The
company wants to raise additional fund of Rs. 2,00,000 for its diversification programme. The
company has following alternatives for raising the fund:
Plan I: Issue of 20,000 Equity Shares of 100 each
Plan II: Issue of 20,000 Preference Shares of 100 each
Plan III: Issue of 10% Debentures of Rs. 100 each
The expected current EBIT level of the company in present scenario is Rs. 1,00,000. The EBIT
will change according to general economic conditions as given below:
Good Conditions: EBIT Rs. 1,20,000
Bad Conditions: EBIT Rs. 80,000
Calculate EPS in all the cases and analyse the results.
Assume tax rate of 50%.
Solution 4:
Capital Structure of the Company
Particulars

Present CS

Proposed Capital Structure


Plan I
Plan II
Plan III

Equity Shares
4,00,000
12% PSC
-----10% Debntrure -----Total Capital
4,00,000

6,00,000
4,00,000
5,00,000
----------2,00,000
--------------------------2,00,000
6,00,000
6,00,000
6,00,000

Case A: When EBIT is Rs. 1,00,000 (Present Scenario)


Particulars
Present CS
Proposed Capital Structure
Plan I
Plan II
Plan III
EBIT
1,00,000
1,00,000
1,00,000
1,00,000
Less: Interest --------------------20,000
EBT
1,00,000
1,00,000
1,00,000
80,000
Less: Tax
50,000
50,000
50,000
40,000
EAT
50,000
50,000
50,000
40,000
Less:
Pref. Dividend
--------------24,000
---------Earnings to ESH 50,000
50,000
26,000
40,000
Number of Shares 4,000
6,000
4,000
4,000
EPS
12.5
8.33
6.5
10

Case B: When EBIT is Rs. 1,20,000 (Good Conditions)


Particulars
Present CS
Proposed Capital Structure
Plan I
Plan II
Plan III

EBIT
1,00,000
Less: Interest
-------EBT
1,00,000
Less: Tax
50,000
EAT
50,000
Less:
Pref. Dividend ---------Earnings to ESH 50,000
Number of Shares 4,000
EPS
12.5

1,20,000
-----1,20,000
60,000
60,000
---------60,000
6,000
10

1,20,000
1,20,000
--------20,000
1,20,000
1,00,000
60,000
50,000
60,000
50,000
24,000
36,000
4,000
9

-------50,000
4,000
12.5

Case B: When EBIT is Rs. 80,000 (Bad Conditions)


Particulars
Present CS
Proposed Capital Structure
Plan I
Plan II
Plan III
EBIT
1,00,000
80,000
80,000
80,000

Less: Interest -------EBT


1,00,000
Less: Tax
50,000
EAT
50,000
Less:
Preference Dividend---------Earnings to ESH 50,000
Number of Shares
4,000
EPS
12.5

-----80,000
40,000
40,000

------20,000
80,000
60,000
40,000
30,000
40,000
30,000

---------24,000
---------40,000
16,000
30,000
6,000
4,000
4,000
6.67
4
7.5

The above results can be summarized as follows:


Capital Structure Present
Plan I
Plan II
Plan III
EPS : When
Case A:
When EBIT is 1,00,000
12.5
8.33
Case B:
When EBIT is 1,20,000
12.5
10
Case C:
When EBIT is 80,000
12.5
6.67

Proposed

6.5

10

12.5

7.5

Plan I: It can be seen from the table above that in alternative plan I the percentage increase or
decrease in EPS is same as percentage increase or decrease in EBIT. For instance, When EBIT
increases form 1,00,000 to Rs. 1,20,000 i.e. 20% increase, EPS also increase in the same ratio
from Rs. 8.33 to Rs. 10 i.e. 20% increase. Similarly, when EBIT decrease from 100,000 to Rs.
80,000 ie. 20% decline, EPS also decline by the same percentage from Rs. 8.33 to Rs. 6.67 i.e.
20% decline.
Plan II: Similarly in alternative plan II, the increase in EPS is 38.46% as compare to the increase
of 20% in the EBIT level. The magnifying effect of cheap source of fund i.e. preference share
capital resulted in more than proportionate increase in EPS.
Plan III: In alternative plan III, the percentage increase in EPS is 25% while EBIT increases
from 1,00,000 to 1,20,000. Thus percentage increase in EPS is more than the percentage increase
in EBIT. It is because of leverage or using cheaper source of finance i.e. debt in the capital
structure of the company. The after tax cost of debt is 5% (10% (1-t)). Thus the use of cheaper
source of finance leads to magnifying effect on the earnings available to equity shareholders.
Thus from the above discussions, we conclude:
1. When there is fixed financial charge or debt content in the capital structure of the firm,
the percentage change in the EPS is equal to percentage change in EBIT as seen in the
alternative Plan I.

2. Use of fixed payment capital like preference shares and debentures results in magnifying
effect on the EPS. It means us e of cheap source of finance will lead to more than
proportionate increase in the EPS as seen in the alternative (b) and (c) both.
3. Us e of leverage (debt and preference shares) in the capital structure will have
unfavorable impact on the EPS if return on investment is less than cost of debt.

Financial Break -Even Level:


The EBIT level at which, firm is able to cover its fixed financial charge (interest and preference
dividend) is called financial break -even level. The earnings available to equity shareholders will
be zero at financial break -even level. Thus financial break- even level means that level of EBIT
which lead to zero EPS. The EPS will be positive above the financial break- even level of EBIT
while EPS will go down if EBIT falls below the break -even level.
Financial break-even level can be obtained as follows:
(i) When debt and preference shares are used in capital structure
EBIT= Interest +PD
(1-t)
Where I= interest payment
PD= preference dividend (preference dividend will be adjusted for corporate dividend tax if
information is given)
T= rate of income tax
(ii) When only debt is used in the capital structure
EBIT= Interest
Illustration 5:
A firm has 5,00,000, 10% debentures in their capital structure . The company also pay preference
dividend of RS. 50,000. The income tax rate is 40%. Company also pays corporate dividend tax
@20%.
Find out financial break-even level of EBIT.
Solution 5:
Financial break-even level when dent and preference shares are used
EBIT = I+ PD(including (CDT)/(1-t)
= 50,000 + 60,000(50,000+10,000)/ (1-.4)
= 50,000+ 60,000/.6
= 1,50,000Rs.
Verification:
EBIT
1,50,000
Less: Interest
50,000
-------------------------EBT
1,00,000

Less: Tax (40%)


40,000
---------------------------EAT
60,000
Less:
PD (Including CDT) 60,000
___________________
EPS
NIL
___________________
Indifference Level of EBIT:
Indifference level of EBIT is that level of EBIT where two or more different capital structure
leads to same EPS. It means an attempt is made to find out EBIT which will result in equal
earning per share for two different financing patterns. Calculation of indifference level of EBIT
plays an important role in capital designing decisions. If expected EBIT is more than the
indifference level of EBIT, a firm can go for higher debt content in the capital structure as it will
lead to increase in the earning per share of the firm. But if expected EBIT is less than
indifference level of EBIT, any increase of debt content will lead to decrease in the EPS for
shareholders. Thus in later case it is advisable to use more of equity than the debt in capital
structure. In this analysis EBIT is taken as dependent variable while EPS is taken as independent
variable. Thus students are required to ascertain the indifference level of EBIT in different
financing patterns.
Calculation of indifference level of EBIT require two steps
STEP 1: Calculate EPS in equation form for different financing pattern assuming EBIT as X
STEP 2: Compare two financing pattern to calculate EBIT
Following are possible financing pattern available to the firm.
a. When only equity shares are used for financing
EPS
= EBIT (1-t)
(Equation 1)
N1
Where N1 = Number of Shares
b. When debt and equity are used for financing:
EPS
= (EBIT- I)(1-t)
N2

(Equation 2)

Where N1= Number of Shares (N2 will be different than N1 because of different equity capital
in these two different financing pattern)

c. When debt, equity and preference shares are used for financing:

EPS

= (EBIT-I)(1-t)- PD
N3
Where PD= Preference Dividend
N3= Number of Shares

(Equation 3)

d. When equity and preference share capital is used for financing:


EPS
= EBIT (1-t)- PD
N4
(Equation 4)
Where N4= Number of Shares
Note: N1, N2, N3, N4 will depend upon the amount of equity capital used in particular financing
mix.
Illustration 6:
A company is considering a capital structure of RS. 10,00,000 for which following options are
available. Calculate indifference level of EBIT in each case;
1. Equity share capital of RS. 10,00,000 or 10% debentures of RS. 5,00,000 and remaining
amount from equity share capital.
2. Equity share capital of Rs. 8,00,000 plus 10% debentures of Rs. 200,000 Or equity share
capital of Rs. 7,00,000 plus 12% preference share of Rs. 3,00,000.
3. Equity share capital of Rs. 10,00,000 Or equity share capital of Rs. 5,00,000 plus 10%
debenture of Rs. 2,50,000 plus 12% preference share of Rs. 2,50,000.
Solution 6:
Calculation of Indifference Level of EBIT
1. The this case all equity financing is compared with debt and equity financing , therefore
equation number 1 and 2 will be compared to find out indifference level of EBIT
All Equity

=
EBIT (1-t)
N1

Equity + Debt
=

(EBIT- I)(1-t)
N2

EBIT (1-.5)
10,000

= (EBIT-50,000)(1-.5)
5,000

On solving, we get
EBIT= Rs. 1,00,000.

Thus, indifference level of EBIT is RS. 1,00,000.


Verification:

Particulars

Plan I

Plan II

All Equity
EBIT
Less: Interest

Debt + Equity
1,00,000
1,00,000
50,000
-----------------------------------------------EBT
1,00,000
50,000
Less: Tax(40%)
50,000
25,000
-----------------------------------------------EAT
50,000
25,000
Less: Preference dividend
------------------------------------------------Earnings available to Equity Shareholders 50,000
25,000
-------------------------------------------------Number of Equity Shares
10,000
5,000
EPS
Rs. 5
Rs.5
Thus at Rs. 100,000 EBIT, both financing plan will lead to equal EPS.
1. In this case, equity and debenture financing is compared with equity and preference share
capital. Thus equation no 2 and 4 will be compared to find out indifference level of EBIT.
(EBIT-I) (1-t)
=
EBIT(1-t) PD
N2
N4
EBIT (1-.5)/ 10,000
=
EBIT (1-.5)- 60,000/ 5,000
On solving, we get
EBIT= Rs. 3,24,000
(Verification may be done as given above)
1. This case, all equity financing is compared with equity, debt and preference share capital.
Thus equation no 1 and 3 will be compare to find out indifference level of EBIT.

EBIT(1-t)
N1

EBIT(1-.5)
10,000

On solving, we get
EBIT = Rs. 1,70,000
(Verification may be done)

(EBIT-I)(1-t)- PD
N3
(EBIT-25,000)(1-.5)- 30,000
5,000

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