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Example:: Online Live Tutor Indifferent Point - Debt, Equity Funding

The indifferent point is the level of Earnings Before Interest and Taxes (EBIT) at which the Earnings Per Share (EPS) is the same for alternative financial plans using different combinations of debt and equity financing. The formula to calculate the indifferent point compares the EPS using different levels of interest costs, tax rates, number of shares, and EBIT. In the example, the indifferent point is calculated to be $1,800,000 EBIT for a project with a capital cost of $15 million that is considering financing $10 million with equity and $5 million with debt.

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55 views1 page

Example:: Online Live Tutor Indifferent Point - Debt, Equity Funding

The indifferent point is the level of Earnings Before Interest and Taxes (EBIT) at which the Earnings Per Share (EPS) is the same for alternative financial plans using different combinations of debt and equity financing. The formula to calculate the indifferent point compares the EPS using different levels of interest costs, tax rates, number of shares, and EBIT. In the example, the indifferent point is calculated to be $1,800,000 EBIT for a project with a capital cost of $15 million that is considering financing $10 million with equity and $5 million with debt.

Uploaded by

Ivy Baguindoc
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the same for two

alternative financial plans. The indifferent point can be defined as "the level of EBIT beyond which the benefits of financial leverage begin to operate with respect to Earnings Per share (EPS)". If the EBIT exceeds the indifference point level of EBIT, the use of fixed-cost source of funds would be beneficial from the EPS viewpoint. In this case, financial leverage would be favorable. In the reverse scenario, if the expected level of EBIT is less than the indifference point, the advantage of EPS would be available from the use of equity capital and not debt capital. The point of indifference can be calculated using the following formula:

Where: X = EBIT indifference level I1 = Fixed interest costs under alternative 1. I2 = Fixed interest costs under alternative 2. PD = Preference dividend, if any. T = Tax rate S1 = Number of equity shares outstanding under alternative 1. S2 = Number of equity shares outstanding under alternative 2. Example: A new project is under consideration by a company which involves a capital investment of $15,000,000. Fixed interest on debt capital is 12% and tax rate is 50%. If the debt-equity ratio insisted by the financing agencies is 2:1, calculate the point of indifference. The new equity shares can be issued for $100 par value. There are no preference shares. Solution: The 2 alternatives available are: Raising the entire amount by equity shares and Raising $10,000,000 by equity and $5,000,000 by debt to maintain a debt-equity ratio of 2:1. Alternative 1: Interest = $0 (as no debt) Number of equity shares = $15,000,000/$100 par 150,000 shares. Alternative 2: Interest = $5,000,000 x 12% $600,000 Number of equity shares = $10,000,000/$100 par 100,000 shares. Preference dividend in both alternatives is zero. Calculation of Indifference point:

X (.50) 150,000 = (.50X - 300,000) 100,000 Solving for the above equation, we get X = $1,800,000. X = Indifference EBIT level = $1,800,000. If the EBIT crosses the above indifference level EBIT, the use of fixed-cost source of funds would be beneficial from the EPS viewpoint and the financial leverage would be favorable. Online Live Tutor Indifferent Point - Debt, Equity Funding: We have the best tutors in Finance in the industry. Our tutors can break down a complex Indifferent Point - Debt, Equity Funding problem into its sub parts and explain to you in detail how each step is performed. This approach of breaking down a problem has been appreciated by majority of our students for learning Indifferent Point - Debt, Equity Funding concepts. You will get one-to-one personalized attention through our online tutoring which will make learning fun and easy. Our tutors are highly qualified and hold advanced degrees.

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