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Ch.6 Point of Indifference

The document discusses using the earnings per share (EPS) approach to determine the optimal capital structure for a company by analyzing how different financing mixes impact EPS across a range of expected earnings before interest and taxes (EBIT) levels. It provides examples of calculating EPS under different capital structures and developing EBIT-EPS charts to identify the point of indifference where EPS is equal between alternatives. The analysis helps companies select the financing plan that maximizes shareholder returns through EPS.

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Mark Kaiser
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124 views15 pages

Ch.6 Point of Indifference

The document discusses using the earnings per share (EPS) approach to determine the optimal capital structure for a company by analyzing how different financing mixes impact EPS across a range of expected earnings before interest and taxes (EBIT) levels. It provides examples of calculating EPS under different capital structures and developing EBIT-EPS charts to identify the point of indifference where EPS is equal between alternatives. The analysis helps companies select the financing plan that maximizes shareholder returns through EPS.

Uploaded by

Mark Kaiser
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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POINT OF INDIFFERENCE

 Previous sections analyze the impact of alternative


investment in fixed assets & financing alternatives,
particularly with debt on the firm’s EPS
 Due to that, it is important for afirm to adopt sound
financial decisions, such as optimal financing
mixes to maximize the firm’s value (EPS)
 Proper fianancing mixes is important because:
 Increase in interest charges
 Reduce the EAT
 Results in higher EPS
EPS-EBIT Approach to Capital Structure

 This approach involves selecting the


capital structure that maximizes EPS over
the expected range of EBIT.
 The emphasis is on maximizing the
owner’s returns (EPS)
 Disadvantage: earnings are only one of
the determinants of shareholder wealth
maximization
 Does not consider the impact of risk
Cont’d
 E.g The capital structure for Best Soya, a
manufacturer of soy base products is shown
below. Currently the company uses only equity
in its capital structure. Assume the company is in
the 40% tax bracket.
Best Soya Current Capital Structure
Long term debt
Common stock (25,000 shares@RM20) RM 500,000
Total Capital (assets) RM 500,000
Cont’d

 Given an EBIT level of 100,000 & 200,000, the


following is the EPS for the company

EBIT 100,000 200,000


Interest - -
EBT 100,000 200,000
Tax (40%) 40,000 80,000
EAT 60,000 120,000
EPS 2.40 4.80
Cont’d
EPS = (EBIT –I)(1-Tax rate) – PS Div
# of common stock o/standing
EPS = (100,000-0)(1-0.4) -0
25,000
= RM2.40
EPS = (200,000-0)(1-0.4) -0
25,000
= RM4.80
EBIT-EPS Chart

 The chart can be developed using the given


EBIT level and the EPS at that EBIT level
 X-axis: represent EBIT
 Y-axis: represent EPS
Cont’d
 The company is considering altering its capital
structure while maintaining its original
RM500,000 capital base as shown below:

Plan 1 Plan 2
30% debt at 10% 60% debt at 16.5%
interest rate interest rate
70% common stock 40% common stock
issued at RM20 each issued at RM20 each
Cont’d
 Given an EBIT level of 100,000 & 200,000
which plan should be chosen?

Plan A
i) EPS = (100,000-15,000)(1-0.4) -0
17,500
= RM2.91

ii) EPS = (200,000-15,000)(1-0.4) -0


17,500
= RM6.34
Cont’d

Plan B
i) EPS = (100,000-49,500)(1-0.4) -0
10,000
= RM3.03

ii) EPS = (200,000-49,500)(1-0.4) -0


10,000
= RM9.03
EBIT-EPS Chart
Point Of Indifference
 The EBIT level that cause the EPS of two plans to be
the same
 Using chart: the POI is when the EPS lines for each
plan cross each other
 Mathematically
(EBIT1- I1)(1-tax)-Ps Div = (EBIT2- I2)(1-tax)-Ps Div
# of Common o/standing1 # of Common o/standing2
Cont’d

(EBIT1- 15000)(1-0.4)-0 = (EBIT2- 49500)(1-0.4)-0


17500 10000
(0.6EBIT-9000)10000 = ( 0.6EBIT-29700)17500
6000EBIT-90000000 = 10500EBIT- 519750000
4500EBIT = 429750000
EBIT = RM95,500
E.g 2
 Kulim Tech. Bhd. currently has 3 million shares
of common stock outstanding, along with RM 1
million in 10% bonds. The company is
considering a RM10 million expansion program,
which will be financed with either all common
stock issue at market price of RM50/share OR all
bonds at a 12% interest rate. The company’s tax
rate is 40%.
i) Calculate the indifference level for EBIT and EPS
for the company.
Plan A Bond(interest) Preferred Common
Stock stock
Existing 100,000 0 3 million
New - - 200,000
Total 100,000 0 3,200,00

Plan B Bond(interest) Preferre Common


d Stock stock
EXisting 100,000 0 3 million
New 1,200,000 - 0
Total 1,300,000 0 3,000,00
Cont’d
Jelutong Furniture is analyzing two financing plans. Plan A
requires the firm to sell bonds with interest rate of 14%. 1
million ringgit would be raised in this manner. In addition under
plan a RM 5 million would be raised by selling common stocks
at RM 50/share. Plan B also involved raising RM 6 million.
These would be accomplished by selling RM 3 million of bonds
at an interest rate of 16%. The other three million would come
from selling common stocks at RM 50/share. The firm is in a
35% tax bracket.

a) Find the EBIT indifference level associated with the two


financing proposals.
b) Prepare an analytical income statements that proves EPS will
be the same regardless of the plan chosen at the EBIT level
found in part (a).
c) Prepare an EBIT-EPS analysis chart for this situation.
d) If a detailed financial analysis projects that long term EBIT will
always be close to RM1,800,000 annually, which plan will
provide for the higher EPS.

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