Earnings Before Interest and Tax (EBIT) – Earnings per Share (EPS) Analysis
Keeping in view the primary objective of financial management of maximizing the market value of the firm, the F.BIT-EPS analysis should be considered logically as the first step in the direction of designing a firm’s capital structure. As discussed in detail, the EBIT-EPS analysis hows the impact of various financing alternatives on EPS at various levels of EBIT. This analysis is useful for two reasons: (i) the EPS is a measure of a firm’s performance given the P/E ratio, the larger the EPS, the larger would be the value of a firm’s shares; and (ii) given the importance of EPS and the function of the EBIT-EPS Analysis to show the value of EPS under various financial alternatives at different levels of EBIT, the EBIT-EPS analysis information on be extremely useful to the finance manager in arriving at an appropriate financing decision. EPS analysis is illustrated (based on Example) that we see EPS is Rs 6.5 per share at the point of intersection of two financial alternatives: (i) 100 per cent equity financing, and (ii) 50 per cent equity financing and 50 per cent debt financing. At that point, EPS is equal under both the plans. At the point of intersection, the EBIT level is Its 3 lakh. Beyond the point of intersection, the EPS is under alternative (ii) which uses 50 per cent deb! than alternative (i) Below the point of intersection, the EPS is higher under alternative (i) which exclusively uses equity rather than the half debt-mixed alternative (ii) which financial plan should be adopted, to be determined with reference to the likely level of EBIT. If the company’s likely level of EBIT is Rs 4.5 lakh, the debt-mixed alternative should be preferred as the EPS is Rs 13 under this alternative while it is Rs 9.75 under the equity alternative. Thus, the finance manager can compare the point of intersection with the most likely level of EBIT and can decide the financing mix. The manager should determine the probabilities of critical levels of EBIT. If the probability of EBIT going below Rs 3 lakh is negligible or the debt-mix alternative should be recommended by the finance manager. On the other hand, if the probability of EBIT falling below the indifference point is high, the equity-alternative should be preferred. In general, the higher the level of EBIT and the lower the probability of downward fluctuation, the greater is the amount of debt that on be employed. While taking a decision in this respect, it should be remembered that P/E ratio is less for a levered financial plan due to increased financial risk. Therefore, increase in EPS should be greater so that its advantage is not completely offset or more than set by using debt in the capital structure. Moreover, if the debt alternative entails a provision for creating a sinking fund, the finance manager should keep in mind that earnings available for payment of dividends and reinvestment to further expand facilities would be reduced by the amount of the sinking fund payment. The indifference point would then be computed using Eq. 16.1.
Let us suppose in our example, the sinking fund payment is Rs 1,40,000 for 8 years. The indifference point would have to be escalated to Rs 5,00,000. The earlier decision of going for debt at the most likely level of EBIT of Rs 4.5 lakh will be reversed. Likewise, in calculating the indifference level of EBIT, he should take cognizance of fixed interest or sinking fund liability on the other debts already outstanding. If preference shares are outstanding, its dividend (and sinking fund, if any, in the case of redeemable preference shares) requirements should also be provided for.