Capital Structure Decisions

EBIT-EPS Analysis
EBIT- earnings before interest and taxes
EPS earnings per share
-

a tool that is used to analyze and determine the best financing

option among different financing alternatives available to the firm
in the hope of achieving the best possible capital structure (higher
EPS, the better)

Steps:
1. Calculate the EPS of each financing alternative based on a certain
value of EBIT. (Value of EBIT is represented by X, a general
variable, thus EPS will also be an expression in terms of X).
EBIT
Less:
Interest (due to debt
financing)
EBT or NIBT
Less: Taxes
EAT or NIAT
Less: P/S Dividend (due to P/S
financing)
EAC or Earnings Available to
C/S
EPS = EAC / (No. of C/S shares outstanding after taking financing
alternative)
2. Construct the EBIT-EPS chart.
(X-axis: EBIT, y-axis: EPS) EPS(y) is in terms of EBIT(x) to the 1 st
degree meaning chart will compose of line and one would need two
points to draw a line.
1st Point: Assume any X-value (any hypothetical EBIT level)
2nd Point: The EBIT value that will give 0 EPS. (or EBIT necessary to
cover all fixed financial costs for a particular financing plan)
3. Identify the indifference point for each pair of alternative.
( EBIT * I )(1 t ) P ( EBIT * I )(1 t ) P

S1
S2

where: EBIT*= EBIT indifference point

I = interest expense
t= tax rate

P = preferred stock dividends

S1, S2 = # of C/S shares outstanding after taking financing
alternative 1 and 2, resp.
4. Analyze which alternative is best at different levels of EBIT.

EBIT-EPS Problems:
1. Dorsey Porridge Company presently has $3.6 million in debt
outstanding bearing an interest rate of 10%. It wishes to finance a
$4 million expansion program and is considering three
alternatives: additional debt at 12%, preferred stock with an 11%
dividend, and the sale of common stock at $16 per share. The
company presently has 800,000 shares of common stock
outstanding and is in a 40% tax bracket.
a. If earnings before interest and taxes are presently $1.5 million,
what would be earnings per share for the three alternatives,
assuming no immediate increase in profitability?
b. Develop a break-even, or indifference, chart for these
alternatives. What are the approximate indifference points?
c. Which alternative do you prefer? How much would EBIT need to
increase before the next alternative would be best?
2. The Lemaster Company is a new firm that wishes to determine an
appropriate capital structure. It can issue 16% debt or 15%
preferred stock. Moreover, common can be sold at $20 per share.
In all cases, total capitalization of the company will be $5 million,
and it is expected to have a 30% tax rate. The possible capital
structures are:
Plan
1
2
3
4

Debt
0%
30
50
50

Preferred
0%
0
0
20

Equity
100%
70
50
30

a. Construct an EBIT-EPS chart for the 4 plans.

b. Determine the relevant indifference points.
c. Which plan is the best for different levels of EBIT?
3. Hi Grade Regulator Company currently has 100,000 shares of
common stock outstanding with a market price of $60 per share. It
also has $2 million in 6% debt. The company is considering a $3
million expansion program that it can finance with (1) all common
stock at $60 a share, (2) straight bonds at 8% interest, (3)

preferred stock at 7%, or (4) half common stock at $60 per share
and half 8% bonds.
a. For a hypothetical EBIT level of $1 million after the expansion
program, calculate the earnings per share for each of the
alternative methods of financing. Assume a corporate tax rate of
50%.
b. Construct an EBIT-EPS chart. What are the indifference points
between alternatives? What is your interpretation of them?
What is the best financing alternative under different levels of
EBIT?
4. The Power Corporation currently has 2 million shares outstanding
at a price of $20 each and needs to raise an additional $5 million.
These funds could be raised with stock or 10% debentures. Expected
EBIT after the new funds are raised will be normally distributed with
a mean of $4 million per year and a standard deviation of $2 million.
Power Corporation has a 50% tax rate. What is the probability that the
debt alternative is superior with respect to earnings per share.