Solved Examples Based On Ebit-Eps Analysis Part 1 E...

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Solved Examples Based On Ebit-Eps Analysis Part 1 E...

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Solved Examples Based On Ebit-Eps Analysis Part 1 Example

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Solved Examples Based On Ebit-Eps Analysis Part 1 Example

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.

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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

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 A EBIT $ Less interest Taxes Earning after taxes Earnings available to ordinary shareholders Number of shares Earnings per share 3.9 4.1 3.9 20,000 15,000 10,000 15,000 (EPS) 3.5
exp: 10 years

Jeremy Slick
B 25,000 42,000 78,000 78,000 C 60,000 95,000 33,250 61,750 __ __ 61,750 60,000 21,000 39,000 __ 1,20,000 42,000 78,000 25,000 53,000 39,000
exp: 7 Year

D $ 1,20,000
exp: 7 Year

1,20,000 $ 1,20,000 $ 1,20,000

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Earnings before taxes 1,20,000

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Less preference dividend

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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. 2. 3. Financing Plan B Financing Plan C Financing Plan D $ 25,00 60,000 38,462

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SUMMARY Of Operating, Financial And Combined Leverage Indifference Point Solved Examples Based On Ebit-Eps Analysis Part 1 Example Indifference Point For A New Company Types Of Leverage Calculate Operating Leverage, Financial Leverage And Combined Leverage 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 Solved Examples Based On Ebit-Eps Analysis Part 2 EBIT-EPS Analysis Calculate All Three Types Of Leverages Determine Which Plan Would You Recommend To Finance The New Project Determine Degree Of Operating, Financial And Combined Leverages Calculate Number Of Equity Shares, Indifference Point, Expected Market Price Of The Shares

Financing plan A involves no cost as there is no fixed financial charge. That the financing plan involves a specific amount of cost, is another way of saying that an equal amount of earnings before interest and taxes is necessary to cover the fixed financial charges. Since preference dividend is not tax-deductible, we must divide the total dividends by one, minus the tax rate, in order to obtain the EBIT necessary to cover these dividends as a financial charge. Assuming a 35 per cent tax 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 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 breakeven level of earnings before interest and taxes because it represents the level of EBIT necessary for the firm to break even 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. 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 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. Beyond the financial break-even point, increase in EPS is more than the proportionate increase in EBIT. This is illustrated in Table 10.8, which presents the EBIT-EPS relationship for the data in Example under the various EBIT assumptions given in the box: (i) $ 80,000 (4 per cent return on total assets) (ii) 1,00,000 (5 per cent return on total assets) (iii) 1,30,000 (6.5 per cent return on total assets) (iv) 1,60,000 (8 per cent return on total assets) (v) 2,00,000 (10 per cent return on total assets) (10.5)

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