EBIT-EPS Approach

Approach
The EBIT-EPS Approach is a method of selecting the firm's capital structure by determining the combination of funding sources that maximizes earnings per share (EPS) over the firm's expected range of earnings before interest and taxes (EBIT) Focuses on finding a capital structure with the highest EPS (earning per share) over the expected range of EBIT (earnings before interest and taxes). In short, it shows the sensitivity of the EPS with respect to the changes in EBIT.

Example
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?

Relation Between EBIT and EPS

EPS=[(EBIT-I) (1-t)] / n
EPS=earning per share, EBIT=earning before interest and tax, I=interest, t=tax rate, n=no. of equity shares

Solution
Financial Plans EBIT Less Interest Earnings before taxes (EBT) Taxes Earnings after taxes (EAT) Less preference dividend Earning available to shareholders A 1,20,000 1,20,000 42000 78000 78000 B 1,20,000 25000 95000 33250 61750 61750 C 1,20,000 60000 60000 21000 39000 39000 D 1,20,000 1,20,000 42000 53000 25000 53000

Number of shares
Earning per Share (EPS)

20000
3.9

15000
4.1

10000
3.9

15000
3.5

Inference from the Example

The financing alternative B is the most favorable with respect to EPS.
Although the proportion of ordinary shares in the total capitalization under the financing plan D is equal to plan B. But 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.

Contd..
Thus we can say that, generally the cost of debt is lower than the cost of equity. Therefore raising debt (trading on equity) increases EPS and it gives benefit to the shareholders.

However, excess of debt will create more risk and therefore it is not advisable. A firm should identify an ideal level of quantum of debt and equity so that it is within proportion.

EBIT-EPS Analysis
The EBIT-EPS analysis is a first step in deciding about a firms capital structure.
But it suffers from certain limitations and does not provide unambiguous guide in determining the level of debt in practice.

The major shortcomings of the EPS as a financing-decision criterion are:

Drawbacks
1. It is based on arbitrary accounting assumptions and does not reflect the economic profits.
2. It does not consider the time value of money. 3. It ignores the variability about the expected value of the EPS, and hence, ignores risk.