Capital Structure

EBIT – EPS Analysis

 EBIT – EPS Analysis
• EBIT-EPS analysis is a very strong and important tool in
the hands of the finance manager. 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.
 Relationship between EBIT – EPS
There are two ways to analyse the relationship
of EBIT and EPS
Two ways to analyse EBIT
and EPS

1. Constant EBIT with 2. Varying EBIT with

changing Financing pattern changing Financing pattern
 1. Constant EBIT with changing
Financing pattern
• Assuming EBIT constant analysis will be done to
see the impact of various financing patterns on
the return available to equity shareholders. 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:-
• Interest
• Tax
• Preference Dividend
• Residual Profit (Equity Dividend)
• Suppose ABC, Ltd which is expecting a EBIT of Rs. 1,50,000 per
annum on an investment of Rs. 5,00,000 is considering a
finalization of the capital structure or the financial plan. The
company has access to raise funds of varying amount 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. 50% funds by equity share capital, 25% by preference shares
and 25% by issue of 10% debentures.
4. 25% funds by equity share capital, 25% by preference shares
and 50% by the issue of 10% debentures.
Assuming tax @ 30% calculate EPS
OPTION 1 OPTION 2 OPTION 3 OPTION 4
What happens if the return on investment is
reduced from 30% TO 18 %?

OPTION 1 OPTION 2 OPTION 3 OPTION 4

• EBIT 90,000 90,000 90,000 90,000

• 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.
2. Varying EBIT with different financing
patterns
• The assumption of constant EBIT is not
possible and realistic.
• A firm may not be able to estimate the EBIT
level accurately and it may be different from
expected one.
• Therefore, effect of financial leverage on EPS
must be analysed.
• Suppose there are three firms X Ltd, Y Ltd and
Z Ltd. Their financial positions is as follows:-
• EBIT – 10,000; 16,000 and 22,000
• TAX @ 30%

X LTD Y LTD Z LTD

SHARE CAPITAL 2,00,000 1,00,000 50,000

(OF RS 100 EACH)

6% DEBENTURES 0 1,00,000 1,50,000

TOTAL FUNDS 2,00,000 2,00,000 2,00,000

 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.
• Financial break even level is such a level of EBIT at
which only the fixed financial charges of the firm
are covered and consequently the EPS is zero.
• If EBIT reduces below the financial break even
level, the EPS will be negative.
 Financial break even level of EBIT can
be calculated as:
1. If the firm has employed debt only and no
preference shares:-
F. Break even EBIT = Interest Charge

2. If the firm has employed debt and preference

share capital, then
F. Break even EBIT = Int. Charge + pref divi/ (1-t)
 Indifference Point/Level
• The indifference level of EBIT is one at which
the EPS under two or more capital structures
are same.
• Out of several financial plans available, the
firm may have two or more structures at
which EPS is same for a given EBIT.
• Such level of EBIT at which EPS is same is
known as Indifference level of EBIT.
• PQR Ltd is expecting an EBIT of Rs. 55,00,000
after implementing the plan of expansion for
50,00,000. the funds can be further raised by
issue of equity shares of 5,000 each or by
issue of 10% debenture. Find out the EPS
under these two alternatives plans if capital
structure stands at 10,000 shares.