EBIT - Earnings Before Interest and Taxes.

Accountants like to use the term Net

Operating Income for this income statement item, but finance people usually
refer to it as EBIT. Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales
(hence the term net operating income). Another way of looking at it is that this is
the income that the company has before subtracting interest and taxes (hence,
EBIT).

EAT - Earnings After Taxes. Accountants call this Net Income or Net Profit After
Taxes, but finance people usually refer to it as EAT.

EPS - Earnings Per Share. This is the amount of income that the common
stockholders are entitled to receive (per share of stock owned). This income may
be paid out in the form of dividends, retained and reinvested by the company, or
a combination of both.

The Analysis

I need to raise additional money by issuing either debt, preferred stock, or

common stock. Which alternative will allow me to have the highest earnings per
share?

This question calls for an EBIT/EPS analysis. Simply put, this simply means that
we will calculate what our earnings per share will be at various levels of sales
(and EBIT).

Actually, it isn't necessary to start with sales. Since a company's EBIT, or net
operating income, isn't affected by how the company is financed, we can skip
down the income statement to the EBIT line and begin there. In other words, we
assume a certain level of sales, calculate our estimated EBIT at that level, and
then calculate what our EPS will be for each alternative form of financing (debt,
preferred stock, and common stock).

An Illustration

For example, let's assume that the company:

1. is currently financed entirely with common stock (i.e., no debt and no
preferred stock). The firm has 2,000 shares of common stock
outstanding.
2. currently pays no common stock dividend; all earnings are retained and
reinvested into the company.
3. needs to raise $50,000 in new money. As financial manager, you want to
know which financing alternative should be used.
4. is in the 35% tax bracket.
To raise the $50,000, you are considering three alternatives:

1. common stock - The company can sell additional shares at the current
price of $50 per share. This means that 1,000 new shares of common
stock will need be to be sold ($50,000/$50 per share).
2. preferred stock - The dividend yield on preferred stock will have to be
7.3% of the amount of money raised. (The preferred can be sold for $40
per share.) The number of shares of common stock will remain
unchanged.
3. debt - The interest rate on any new debt will be 4% per year. The number
of shares of common stock will remain unchanged.

Let's pick a beginning level for EBIT of $10,000. We can then calculate what the
earnings per share will be for each financing alternative.

Common Preferred
Debt
Stock Stock
Price per share $50.00 $40.00 N/A
Annual Rate N/A 7.3% 4.0%

Common Stock $100,000 $100,000 $100,000

+ Additional Funds + 50,000 + 50,000 + 50,000
Total Funds $150,000 $150,000 $150,000

EBIT (Net Operating

$10,000 $10,000 $10,000
Income)
- Interest Expense (@4%) -0 -0 - 2,000
Earnings Before Taxes 10,000 10,000 8,000
- Taxes (@35%) - 3,500 - 3,500 - 2,800
EAT (Net Income) 6,500 6,500 5,200
- Preferred Dividends
-0 - 3,650 -0
(@7.3%)
Earnings Available to
6,500 2,850 5,200
Common (EATC)
No. of Common Shares 3,000 2,000 2,000
Earnings Per Share (EATC/#
$2.17 $1.43 $2.60
of shares).)

The above table shows us the earnings per share at an EBIT level of $10,000. If
sales are sufficiently high to give us an EBIT level of $10,000, then our EPS will
be highest by issuing debt, common stock yields the next highest EPS, and the
preferred stock alternative results in the lowest level of EPS.

However, we would eventually like to draw a graph of the EPS over a range of
sales and EBIT. This will allow us to understand the relationship between sales
and EPS more fully. As sales (and EBIT) increase, what will happen to earnings
per share?

This is easily answered - we just repeat the above table for a different level of
EBIT. Let's assume that we don't think that our company's EBIT will fall below
2,000, so we can reproduce the table for that level of EBIT. If we think that the
highest that EBIT will be for the next few years is $30,000, then we might choose
that level also. While we're at it, let's throw in an EBIT of $20,000 also. In other
words, we will construct the table for four values of EBIT: $2,000, $10,000,
$20,000 and $30,000.

The EBIT/EPS Graph

Once the tables have been constructed, we can draw the graph below. We
simply plot the earnings per share under each alternative for each of our EBIT
levels and connect the dots to draw the lines.
Relationships

Notice the following points:

1. The preferred stock line is parallel to the debt line and lies below the debt
line. This will always be the case because debt has two distinct
advantages over preferred stock:

a. interest on the debt is tax-deductible and preferred stock dividends are not
tax-deductible, and
b. debt is the cheaper form of financing (i.e., the interest rate is less than the
preferred dividend yield) because it enjoys greater protection in the event
of default).

This means that the EPS will always be higher under debt financing than under
preferred stock financing. Since both options pay a fixed rate (e.g., 4% and
7.3%), they offer similar effects of leverage - leading to the parallel lines above.
Preferred stock may offset this quantitative advantage with some qualitative ones
(less restrictive provisions, etc.), but debt financing will always offer the higher
earnings per share - a big advantage.

2. Since common stock financing offers a smaller degree of leverage, the

slope of the common stock line is lower than the other two lines. This
leads to two "crossover points" where the common stock line crosses the
other two lines. These are indifference points.

• At an EBIT level of $6,000, you would be indifferent between common

stock financing and debt financing. Both will give you the same EPS (of
$1.30 per share).

• At an EBIT level of $16,800, you would be indifferent between common

stock financing and preferred stock financing. Both will give you the same
EPS (of $3.64 per share).

Summary

So which of the three financing alternatives should we use to raise the $50,000?
It all depends on our sales forecast. We estimate the future level of sales and
calculate our expected level of EBIT for this sales level.

If the expected level of EBIT is:

• less than $6,000, we would tend to use common stock financing. Our
EPS will be higher than the other two alternatives as long as sales are
weak enough to keep us below the $6,000 EBIT level. As sales and EBIT
fall, the fact that we don't have to pay a fixed interest or dividend payment
is a big advantage and offers the company a great deal of flexibility.
• above $6,000, we would use tend to use debt financing. The EPS level is
maximized by using debt as long as sales are high enough to keep us
above the $6,000 EBIT level. As sales increase, the higher financial
leverage causes EPS to rise at a much faster rate than common stock
financing would do.

What if the forecasted sales level is equal to (or very close to) the
indifference point of $6,000? Then you would not make the decision based on
the basis of EPS. There are a number of qualitative factors that will increase in
importance and you would tend to weigh these factors closely in making the debt
vs. equity decision.

We would not consider using preferred stock financing at all unless there is some
compelling reason to do so. There may be reasons for doing this - to avoid
restrictive debt covenants, to gain greater flexibility, to avoid using up all of your
debt capacity at the present time, etc. However, from a quantitative standpoint,
EPS under debt financing will always be higher than the preferred stock
alternative.