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Solved Examples Based On Ebit-Eps Analysis – Part 1 E...
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Leverage
Solved Examples Based On Ebit-Eps Analysis – Part 1 Example
Solved Examples Based On Ebit-Eps Analysis – Part 1 Example
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Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to $ 10,00,000. The firm now wishes to raise additional $ 10,00,000 for expansion. The firm has four alternative financial plans: (A) It can raise the entire amount in the form of equity capital. (B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures. (C) It can raise the entire amount as 6% debentures. (D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital. Further assume that the existing EBIT are $ 1,20,000, the tax rate is 35 per cent, outstanding ordinary shares 10,000 and the market price per share is $ 100 under all the four alternatives. Which financing plan should the firm select? Solution
TABLE 10.7 EPS under Various Financial Plans Financing plans
Jeremy Slick A
EBIT $
B
C
1,20,000 $ 1,20,000 $ 1,20,000
Less interest
—
25,000
Earnings before taxes 1,20,000
exp: 7 Year
95,000
42,000
33,250
Earning after taxes
78,000
61,750
Earnings available to
$ 1,20,000
60,000
Taxes
Less preference dividend
(3 reviews) Master in Business Administratio...
D
1,20,000
__ 61,750
Marc Karver
42,000
39,000
__ 78,000
60,000 21,000
(0 reviews) Bachelors in Business Informatio...
78,000 __
25,000
39,000
53,000
exp: 7 Year
Connect
Erin Kimmerle
ordinary shareholders Number of shares
Connect
(0 reviews) Bachelor in Commerce, Bachelor i... 20,000
15,000
10,000
Earnings per share
15,000 (EPS)
3.9
4.1
3.9
exp: 10 years
Connect
Matthew Griswold
3.5
(3 reviews) Master's degree in Business/Mark...
The calculations in Table 10.7 reveal that given a level of EBIT of $ 1,20,000, the financing alternative B, which involves 75 per cent ordinary shares and 25 per cent debt, is the most favourable with respect to EPS. Another disclosure of the table is that although the proportion of ordinary shares in the total capitalization under the financing plan D is also 75 per cent, that is, equal to plan B, EPS is considerably different (lowest). The difference in the plans B and D is due to the fact that interest on debt is tax-deductible while the dividend on preference shares is not. With 35 per cent income tax, the explicit cost of preference shares would be higher than the cost of debt. Table 10.7 also indicates that the annual before-tax costs of the various financing plans are: 1.
Financing Plan B
$ 25,00
2.
Financing Plan C
60,000
3.
Financing Plan D
38,462
Combined Leverage Indifference Point
another way of saying that an equal amount of earnings before interest and taxes is necessary to cover the fixed financial charges.
Solved Examples Based On Ebit-Eps Analysis –
EBIT necessary to c over these dividends as a financial charge. Assuming a 35 per cent t ax rate, preference dividend of $ 25,000 can be paid on EBIT of $ 38,462. The fixed financial charge would, therefore, be higher. Earnings per share would be zero for plans
Part 1 Example Indifference Point For A New Company
B, C and D for the EBIT level of $ 25,000, $ 60,000 and $ 38,462 respectively. This level of EBIT may be termed as financial
Types Of Leverage
breakeven level of earnings before interest and taxes because it represents the level of EBIT necessary for the firm to break even
Calculate Operating Leverage, Financial
on its fixed financial charge." In other words, it is the level of EBIT at which the firm can satisfy all fixed financial charges (i.e.
Leverage And Combined Leverage
interest and preference dividend). EBIT less than this level. Will result in negative EPS. The financial break-even point can be determined by Eq. (10.5). Financial break-even point = I + PD / 1 - I where
(10.5)
I = Annual interest charges
PD = Preference dividend t = Tax rate Equation 10.5 gives before-tax earnings necessary to cover the firm's fixed financial obligations. As fixed financial charges are added, the break-even point for zero EPS is increased by the amount of the additional fixed cost.
Solved Examples Based On Operating Leverage Indifference Point For An Existing Company Financing Alternative –Sample Problem Financial Leverage Determination Of EPS And MPS Under Alternative Financial Plans
Beyond the financial break-even point, increase in EPS is more than the proportionate increase in EBIT. This is illustrated in Table
Solved Examples Based On Ebit-Eps Analysis –
10.8, which presents the EBIT-EPS relationship for the data in Example under the various EBIT assumptions given in the box:
Part 2
(i) $ 80,000 (4 per cent return on total assets)
EBIT-EPS Analysis
(ii)
1,00,000 (5 per cent return on total assets)
(iii) 1,30,000 (6.5 per cent return on total assets)
Calculate All Three Types Of Leverages
(iv) 1,60,000 (8 per cent return on total assets)
Determine Which Plan Would You Recommend
(v) 2,00,000 (10 per cent return on total assets)
To Finance The New P roject
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Determine Degree Of Operating, Financial And
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SUMMARY Of Operating, Financial And
Financing plan A involves no cost as there is no fixed financial charge. That the financing plan involves a specific amount of cost, is Since preference dividend is not tax-deductible, we must divide the total dividends by one, minus the tax rate, in order to obtain the
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