Basic features of EBIT EPS analysis and Point of indifference and Financial break even point PDF

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Summary

EBIT – EPS Analysis is an important tool used to optimize the capital structure for
highest earning for shareholders. Helps in understanding the sensitivity of EPS at a given level of EBIT under different
sources of financing. EBIT level at which EPS remain the same irrespective of dif...

Description

EBIT- EPS ANALYSIS ➢ EBIT – EPS Analysis is an important tool used to optimize the capital structure for highest earning for shareholders. ➢ It designs various alternatives of debt, equity and preference shares in order to maximize EPS at a given level of EBIT. ➢ Helps in understanding the sensitivity of EPS at a given level of EBIT under different sources of financing. ➢ It helps in analyzing how capital structure decision is important to raise the value of firm. ➢ Optimal capital structure minimizes the cost of capital and maximizes the earnings. BASIC FEATURES OF EBIT – EPS ANALYSIS 1. If companies opting debt financing, return is greater than the cost of capital, EPS increases with out an increase in owners’ equity. 2. If company increases its debt beyond at a point, the EPS will continue to rise but the value of the shares will fall because of greater exposure of shareholders to financial risk. 3. Variability of EPS depends on the growth and stability of sales. EPS fluctuates with the fluctuations in sales. 4. Rate of return on total asset less that Kd , EPS will fall with the degree of leverage.

SALES

****

LESS VARIABLE COST

**** -------

CONTRIBUTION

****

LESS FIXED COST

**** -------

EBIT

****

LESS INTEREST ON DEBT **** -----EBT

****

LESS TAX

**** ------

EAT

****

LESS PREF DIVIDENT

**** ------

EQUITY EARNINGS

**** -------

EPS = EARNINGS AVAILABLE TO EQUITY SHARE HOLDER ------------------------------------------------------------------------NUMBERS OF SHARES OUTSTANDING

POINT OF INDIFFERENCE

❖ EBIT level at which EPS remain the same irrespective of different alternatives of debt- equity mix. ❖ At this level of EBIT, rate of return on capital employed is equal to the cost of debt. known as break even level of EBIT. ❖ Point of indifference can be calculated algebraically, as below: (X-I 1) (1-T) – PD ------------------------------

=

S1

(X-I 2) (1-T) -PD --------------------------S2

Where X= Equivalency point or point of indifference or Break-even EBIT level I 1 = Interest under alternative financial plan 1 I 2 = Interest under alternative financial plan 2 T = Tax Rate PD = Preference Dividend S 1 = Amount of equity share capital under alternative 1 S 2 = Amount of equity share capital under alternative 2

Illustration 1: A project under consideration by your company requires a capital investment of Rs 60 lakhs. Interest on term loan is 10% p.a . and tax rate is 50% calculate the point of indifference for the project. If the debt equity ratio instead by the financing agency is 2:1 As the debt equity ratio by financing agencies is 2:1, the company has two alternative financial plans 1. Raising the entire amount of Rs 60 lakhs by the issue of equity shares, there by using no debt 2. Raising Rs 40 lakhs by way of debt and Rs 20 lakh by issue of equity share capital.

Calculation of Point of indifference: (X-I 1) (1-T) – PD ------------------------------

=

S1

(X-I 2) (1-T) -PD --------------------------S2

I1 =0 I 2 = 4 (10/100*40) T = 50% PD = O ( No preference shares ) S 1= 60 S 2 = 20 Substituting the values, (X-0) (1-0.5) – 0 = ------------------------------

=

60

20

= 0.5 X

=

60 = 20(0.5X) = 10 X

(X-4) (1-0.5) -0 ---------------------------

0.5 X – 2 20

=

60 (0.5X – 2) =

30 X -120

X= 6

Thus, EBIT at point of indifference is 6 lakhs. At this level 6 lakh of EBIT, the earning on equity after tax will be 5% p.a. irrespective of alternative debt – equity mix when the rate of interest on debt is 10% p.a.

FINANCIAL BREAK-EVEN POINT

❖ It is a point at which the level before EBIT at which EPS of the company is equal to Zero. ❖ it is a level of EBIT that equal to the fixed financial cost for the company such as Interest on debt, preference dividend etc.

Objective Type Questions (KPSC Previous years)

1. EBIT means……. a. accounting profit b. profit after depreciation c. profit after tax d operating profit 2. Trading on equity magnifies the profit when, … a. rate of return equal to cost of capital b. rate of return greater than cost of capital c. rate of return less than cost of capital d. cost of capital equal to interest 3. combination of debt and equity that leads to maximization of the value of the firm is known as…. a. Wealth maximization b. financial leverage c. Investment decision d. optimum capital structure 4. Two alternative financial plan give the same EPS such a situation is known as… A. indifference point b. trading on equity c. margin of safety d. none of the above...