EBIT-EPS ANALYSIS
EBIT-EPS ANALYSIS
PRESENTED BY: KIMBEARLY CHENG, MBA
An approach for selecting the To analyze the effects of a firm’s capital
capital structure that maximizes structure on the owners’ returns, we consider
earnings per share (EPS) over the relationship between earnings before
the expected range of earnings interest and taxes (EBIT) and earnings per
before interest and taxes (EBIT). share (EPS). A constant level of EBIT—
constant business risk—is assumed, to isolate
the effect on returns of the financing costs
associated with alternative capital structures.
EPS is used to measure the owners’ returns,
which are expected to be closely related to
share price.2
EBIT-EPS Approach to
Capital Structure
We can plot coordinates on the EBIT–EPS graph
by assuming specific EBIT values and calculating
the EPS associated with them.
Such calculations for three capital structures—
debt ratios of 0%, 30%, and 60%—for Cooke
Company were presented in Table 12.12.
For EBIT values of $100,000 and $200,000, the
associated EPS values calculated there are
summarized in the table below the graph in
Figure 12.6.
EBIT-EPS Approach to Capital Structure
When interpreting EBIT–EPS analysis, it is important to consider the risk of each capital
structure alternative.
Graphically, the risk of each capital structure can be viewed in light of two measures:
the financial breakeven point (EBIT-axis intercept)
the degree of financial leverage reflected in the slope of the capital structure line: The
higher the financial breakeven point and the steeper the slope of the capital structure line,
the greater the financial risk.
NOTE: PD = Preferred Share Dividend
INDIFFERENCE POINT
NOTE: Indifference Point = Financial Break-even Point
Considering Risk in EBIT–EPS Analysis
When interpreting EBIT–EPS analysis, it is Reviewing the three capital structures plotted for Cooke
important to consider the risk of each capital Company in Figure 12.6, we can see that as the debt ratio
increases, so does the financial risk of each alternative.
structure alternative. Graphically, the risk of each
Both the financial breakeven point and the slope of the
capital structure can be viewed in light of two
capital structure lines increase with increasing debt
measures: (1) the financial breakeven point (EBIT- ratios. If we use the $100,000 EBIT value, for example,
axis intercept) and (2) the degree of financial the times interest earned ratio (EBITinterest) for the
leverage reflected in the slope of the capital zero-leverage capital structure is infinity ($100,000$0);
structure line: The higher the financial breakeven for the 30% debt case, it is 6.67 ($100,000$15,000); and
point and the steeper the slope of the capital for the 60% debt case, it is 2.02 ($100,000 $49,500).
Because lower times interest earned ratios reflect higher
structure line, the greater the financial risk
risk, these ratios support the conclusion that the risk of
the capital structures increases with increasing financial
leverage. The capital structure for a debt ratio of 60% is
riskier than that for a debt ratio of 30%, which in turn is
riskier than the capital structure for a debt ratio of 0%.
The Basic Shortcoming of EBIT–EPS Analysis
The most important point to recognize when using EBIT–EPS analysis
is that this technique tends to concentrate on maximizing earnings
rather than maximizing owner wealth. The use of an EPS-maximizing
approach generally ignores risk. If investors did not require risk
premiums (additional returns) as the firm increased the proportion of
debt in its capital structure, a strategy involving maximizing EPS
would also maximize owner wealth. But because risk premiums
increase with increases in financial leverage, the maximization of EPS
does not ensure owner wealth maximization. To select the best
capital structure, both return (EPS) and risk (via the required return,
ks) must be integrated into a valuation framework consistent with the
capital structure theory presented earlier.
OPTIMAL CAPITAL STRUCTURE
To determine the firm’s value under alternative capital structures, the firm
must find the level of return that must be earned to compensate owners
for the risk being incurred.
Here it involves estimating the required return associated with each level
of financial risk, as measured by a statistic such as the coefficient of
variation of EPS.
CHOOSING THE OPTIMAL CAPITAL STRUCTURE
To determine the firm’s value under alternative capital structures, the firm
must find the level of return that it must earn to compensate owners for
the risk being incurred.
The required return associated with a given level of financial risk can be
estimated in a number of ways.
Theoretically, the preferred approach would be first to estimate the
beta associated with each alternative capital structure and then to use
the CAPM framework to calculate the required return, rs.
A more operational approach involves linking the financial risk
associated with each capital structure alternative directly to the
required return.
Although there is some
relationship between
expected profit and value, there is
no reason to believe that profit-
maximizing strategies necessarily
result in wealth maximization. It
is therefore the wealth of the
owners as reflected in the
estimated share value that should
serve as the criterion for selecting
the best capital structure.
ENDE
