EBIT-EPS Analysis

We have studied about Financial Leverage. A co is said to have has financial leverage when it has some
If debt/equity ratio is high, it is called high financial leverage
Generally speaking, some amount of debt helps in enhancing EPS
But if debt is TOO HIGH, EPS decreases and at some stage it can even become negative
Indifference EBIT is that amount of EBIT, at which, the EPS remains same irrespective of amount of fin
In other words, at some particular value of EBIT, even if you change the financial leverage, the EPS re

Illustration ABC Co wants to invest in a project: And expected EBIT is given below:

Investment required (Rs lac) 400 EBIT Probability

Interest rate on debt 10% Worst case: 30 10%
Face value of shares, Rs 10 Most likely 60 70%
Tax rate 30% Best case: 90 20%

Co is considering three options: High financial Leverage of 1:1, low financial leverage of 0.33:1, or no le
Which option is better for the co? i.e. which option maximizes the EPS?

Let us work out the eps for each different leverage, and for the three different EBIT scenarios…..

Option 1: High leverage: D/E ratio = 1:1 Option 2: Low leverage: D/E ratio =
Debt 200 Debt
Equity 200 Equity
No of shares, lacs 20 No of shares, lacs
EBIT 30.00 40.00 90.00 EBIT
Interest cost 20.00 20.00 20.00 Interest cost
EBT 10.00 20.00 70.00 EBT
Tax 3.00 6.00 21.00 Tax
PAT 7.00 14.00 49.00 PAT
EPS 0.35 0.70 2.45 EPS

If EBIT is high, then EPS is HIGHER for a co with higher financial leverage
If EBIT is low, then EPS is LOWER for a co with higher financial leverage
However, there will be some level of EBIT, at which, EPS will be the same regardless of leverage
This level of EBIT is called INDIFFERENCE EBIT
Indifference EBIT is that amount of EBIT, at which, the EPS remains same irrespective of amount of fin

(EBIT* - I1)(1-T)/n1 is equal to: (EBIT* - I2)(1-T)/n2

(x-20)/20 = (x-0)/40 If you expect EBIT to be HIGH

2x-40=x If you expect EBIT to be LOWE
x=40
Indifference EBIT = Rs 40 lacs
EBIT 30.00 40.00 90.00
EPS1 (high leverage) 0.35 0.70 2.45
EPS2 (low leverage) 0.47 0.70 1.87
EPS3 (No leverage) 0.53 0.70 1.58

EPS = (EBIT-I)(1-T)/n
where I = Interest cost
n = no. of shares

Let Indifference EBIT be called EBIT *

At Indifference EBIT, EPS is the same regardless of level of financial leverage

So therefore,
Leverage 1 Leverage 2
(EBIT* - I1)(1-T)/n1 is equal to: (EBIT* - I2)(1-T)/n2

By substituting values of I1, I2, n1 and n2 for different leverage level, we can calculate EBIT*

EXP(EBIT)=
Indifference EBIT=
verage when it has some debt on its Bal sheet

spective of amount of financial leverage

ncial leverage, the EPS remains the same. That level of EBIT is called the Indifference EBIT.

Expected EBIT= 63
Expected EBIT 63 is > Indifference EBIT 40
GO for HIGHER leverage

verage of 0.33:1, or no leverage at all (i.e. zero debt)

EBIT scenarios…..

ow leverage: D/E ratio = 0.33:1 Option 3: No leverage

100 Debt 0
300 Equity 400
30 No of shares, lacs 40
30 40 90 EBIT 30 40 90
10.00 10.00 10.00 Interest cost 0.00 0.00 0.00
20.00 30.00 80.00 EBT 30.00 40.00 90.00
6.00 9.00 24.00 Tax 9.00 12.00 27.00
14.00 21.00 56.00 PAT 21.00 28.00 63.00
0.47 0.70 1.87 EPS 0.53 0.70 1.58

ardless of leverage

spective of amount of financial leverage

pect EBIT to be HIGHER than Indifference EBIT, then go for HIGHER leverage
pect EBIT to be LOWER than Indifference EBIT, then go for LOWER leverage
culate EBIT*

63
ndifference EBIT= 40
Cost of flat 80 1st case:no debt

Bank loan avlbl 70

Interest rate 7%

Within 1 year: 2nd case: you take the loan

Price of flat appreciates by 10%

ROI
ROE
 Own Investment 80
Appreciation 8
ROE 10%

ou take the loan

Own inv 10
Loan 70
Appreciation 8
Value of asset at end of 1 yr 88
Interest payable 4.9
Residual 83.1
Your gain 3.1
Return on equity 31%
Existing capital structure
No. of equity shares 100,000
Present equity, Rs 1,000,000
Face value of shares, Rs 10
Co needs to invest additional Rs 20 lacs for expansion 2,000,000
Interest rate on loan 12%
Tax rate 30%
Option 1: New investment is Entirely equity financed
Option 2: New investment is financed through 50% equity, 50% debt
Option 3: New investment is Entirely debt financed
Q1. Carry out the EBIT-EPS analysis Exp EBIT is > Indiffe
Q2. Determine the Indifference EBIT level Therefore higher leverag

Option1 Option 2
Final Debt - 1,000,000
Final Equity 3,000,000 2,000,000
No of shares 300,000 200,000
EBIT 200,000 360,000 600,000 200,000
Int - - - 120,000
EBT 200,000 360,000 600,000 80,000
PAT 140,000 252,000 420,000 56,000
EPS 0.47 0.84 1.40 0.28

Indifference EBIT (EBIT* - I1)(1-T)/n1 is equal to: (EBIT* - I2)(1-T)/n2

Indifference EBIT = EBIT* = x

(x-0)/3=(x-1.2)/2
Indifference EBIT = 3,60,000
 Profitability scenario is given below:
Scenario Probability EBIT
Boom 0.2 600,000
Normal 0.7 450,000
Recession 0.1 200,000

Expected EBIT = 455,000

Exp EBIT is > Indifference EBIT
efore higher leverage will be beneficial

Option 3
2,000,000
1,000,000
100,000
360,000 600,000 200,000 360,000 600,000
120,000 120,000 240,000 240,000 240,000
240,000 480,000 (40,000) 120,000 360,000
168,000 336,000 (40,000) 84,000 252,000
0.84 1.68 (0.40) 0.84 2.52

BIT* - I2)(1-T)/n2
 ROI-ROE analysis
Capital structure A Capital structure B
(Unlevered) (Leveraged)
Rs million Rs million
Equity 500 Equity 250
Debt 0 Debt 250
Total investment 500 Total investme 500
Cost of debt 0 Cost of debt 12%
Tax rate 30% Tax rate 30%

ROI = EBIT/Total assets = EBIT/(Capital + Liabilities) Note: correct formula for ROI = EBIT/Capital employed, where capital emp
ROE = PAT / E However, just for illustration here we are taking an approximation,

Capital structure A Capital structure B

ROI 5% 12% 15% 20% 25% ROI 5%
EBIT 25 60 75 100 125 EBIT 25
Interest 0 0 0 0 0 Interest 30
EBT 25 60 75 100 125 EBT -5
Tax 7.5 18 22.5 30 37.5 Tax 0
PAT 17.5 42 52.5 70 87.5 PAT -5
RoE 3.5% 8.4% 10.5% 14.0% 17.5% RoE -2.0%

1 When ROI is lower than cost of debt, then lower financial leverage leads to higher ROE
2 When ROI = cost of debt, ROE is equal for both higher as well as lower leveraged case
3 When ROI > cost of debt, then ROE is higher for higher leveraged co

EBIT-EPS analysis, ROI-ROE analysis are useful inputs while deciding the Capital Structure of the
Capital Structure is essentially the mix of equity and debt used to finance the company
 Financing Decision
Capital Structure
Risks

apital employed, where capital employed = Total assets - Current liabilities

we are taking an approximation, ignoring current liabilities.

Capital structure B
12% 15% 20% 25%
60 75 100 125
30 30 30 30
30 45 70 95
9 13.5 21 28.5
21 31.5 49 66.5
8.4% 12.6% 19.6% 26.6%

ds to higher ROE
leveraged case

e Capital Structure of the company

nce the company