An analytical technique called EBIT-EPS analysis can be used to help determine when debt financing is advantageous and when equity financing is advantageous.
Consider the Yuma Corporation with a present capital structure consisting only of common stock (35 million shares). Assume that Yuma is considering an expansion and evaluating two alternative financing plans. Plan 1, equity financing, would involve the sale of an additional 15 million shares of common stock at $20 each. Plan 2, debt financing, would involve the sale of $300 million of 10 percent long-term debt.
If the firm adopts Plan 1, it remains totally equity financed. If, however, the firm adopts Plan 2, it becomes partially debt financed. Because Plan 2 involves the use of financial leverage, this financing issue is basically one of whether it is in the best interests of the firm’s existing stockholders to employ financial leverage. Table illustrates the calculation of EPS at two different assumed levels of EBIT for both financing plans. Because the relationship between EBIT and EPS is linear, the two points calculated in Table can be used to graph the relationship for each financing plan, as shown in figure.
In this example, earnings per share at EBIT levels less than $100 million are higher using the equity financing alternative. Correspondingly, at EBIT levels greater than $100 million, earnings per share are higher with debt financing. The $100 million figure is called the EBIT-EPS indifference point. By definition, the earnings per share for the debt and equity financing alternatives are equal at the EBIT-EPS indifference point:EPS (debt financing) = EPS (equity financing)
Probability Distribution of EBIT,Travco Manufacturing Company
EBIT-EPS indifference point[(EBIT – Id)(1 – T) – Dp]/Nd = [EBIT – Ie)(1 – T) – Dp]/Ne
where EBIT is earnings before interest and taxes; Id is the firm’s total interest payments if the debt alternative is chosen; Ie is the firm’s total interest payments if the equity alternative is chosen; and Nd and Ne represent the number of common shares outstanding for the debt and equity alternatives, respectively. The firm’s effective tax rate is indicated as T, and Dp is the amount of preferred dividends for the firm. This equation may be used to calculate directly the EBIT level at which earnings per share for the two alternatives are equal. The data from the example shown in Table yield the EBIT-EPS indifference point:
EBIT-EPS Analysis,Yuma Corporation (All Dollar Figures
Except Per-Share Amounts Are in Millions of Dollars)*
Note that in the equity financing alternative, a 66.67 percent increase in EBIT (from $75 million to $125 million) results in a 66.67 percent increase in earnings per share (from $0.90 to $1.50), or, by Equation , a degree of financial leverage ofDFL = 66.67%/66.67% = 1.00
Similarly, in the debt financing alternative, a 66.67 percent increase in EBIT results in a 111.69 percent increase in earnings per share, or a degree of financial leverage ofDFL = 111.69%/66.67% = 1.68
Figure EBIT-EPS Analysis,Yuma Corporation
A comparable magnification of earnings per share will occur if EBIT declines. This wider variation in earnings per share, which occurs with the debt financing alternative, is an illustration of financial risk, because financial risk is defined as the increased variability in earnings per share due to the firm’s use of debt. All other things being equal, an increase in the proportion of debt financing is said to increase the financial risk of the firm.
EBIT-EPS Analysis and Capital Structure Decisions
The tools of EBIT-EPS analysis and the theory of an optimal capital structure can help a firm choose an appropriate capital structure. This section uses an example to develop a 5- step procedure designed to assist financial managers in making capital structure decisions.
Balboa Department Stores has been 100 percent financed with equity funds since the firm was founded. While analyzing a major expansion program, the firm has decided to consider alternative capital structures. In particular, it has been suggested that the firm should use this expansion program as an opportunity to increase the long-term debt ratio from the current level of 0 percent to a new level of 30 percent. Interest on the proposed new debt will amount to $100,000 per year.
After considerable discussion, it has been decided that the firm is willing to accept a 25 percent chance that operating earnings in any year will be below the indifference point and a 5 percent chance that the firm will have to report a loss in any year. To complete this analysis, it is necessary to compute the probability that operating earnings will be below the indifference point, that is, the probability that EBIT will be less than $300,000. This is equivalent on the standard normal curve to the following:Z = $300,000 – $500,000/$200,000 = –1.0
or 1.0 standard deviation below the mean. The probability that EBIT will be less than 1.0 standard deviation below the mean is 15.87 percent; this is determined from Table V at the end of the book. Therefore, on the basis of the indifference point criterion, the proposed new capital structure appears acceptable. The probability of incurring losses must now be analyzed. This is the probability that EBIT will be less than the required interest payments of $100,000. On the standard normal curve, this corresponds to the following:z = $100,000 – $500,000/$200,000 = –2.0
or 2.0 standard deviations below the mean. The probability that EBIT will be less than 2.0 standard deviations below the mean is 2.28 percent, as shown in Table V. According to this criterion, the proposed capital structure also seems acceptable.
If either or both of these tests had shown the proposed capital structure to have an unacceptable level of risk, the analysis would have been repeated for lower levels of debt than the proposed 30 percent rate. Similarly, because the proposed capital structure has exceeded the standards set by the firm, management might want to consider even higher levels of debt than the proposed 30 percent.
This step is undertaken only after a proposed capital structure has met the “internal” tests for acceptability. Financial leverage is a double -edged sword: It enhances expected returns, but it also increases risk. If the increase in perceived risk is greater than the increase in expected returns, the firm’s weighted cost of capital may rise instead of fall, and the firm’s stock price and market value will decline.
It is important to note that a firm need not feel constrained by industry standards in setting its own capital structure. If, for example, a firm has traditionally been more profitable than the average firm in the industry, or if a firm’s operating income is more stable than the operating income of the average firm, a higher level of financial leverage can probably be tolerated. The final choice of a capital structure involves a careful analysis of expected future returns and risks relative to other firms in the industry.
EBIT-EPS Analysis and Stock Prices
An important question arising from EBIT-EPS analysis is the impact of financial leverage on the firm’s common stock price. Specifically, which financing alternative results in the higher stock price? Returning to the Yuma Corporation example discussed earlier, suppose the company is able to operate at the $125 million EBIT level. Then, if the company chooses the debt financing alternative, its EPS will equal $1.63, and if it chooses the equity alternative, its EPS will be $1.50.
But the stock price depends on the price–earnings (P/E) ratio that the stock market assigns to each alternative. Suppose the stock market assigns a P/E ratio of 16.0 to the company’s common stock if the equity alternative is chosen and a P/E ratio of 15.4 if the debt alternative is chosen. Recalling from Chapter that the P/E ratio (Equation) was defined as the market price per share of common stock (P0) divided by the current earnings per share (EPS), the common stock price can be calculated for both alternatives as follows:
These calculations show that in this case the stock market places a higher value on the company’s stock if the debt alternative is chosen rather than the equity alternative. Note that the stock market assigned a slightly lower P/E ratio to the debt alternative. The stock market recognized the increased financial risk associated with the debt alternative, but this increased risk was more than offset by the increased EPS possible with the use of debt.
To carry the Yuma Corporation example one important step further, suppose the company, while operating at the $125 million EBIT level, chooses an even higher level of debt in its capital structure significantly increases the company’s financial risk—to the point where bankruptcy could occur if EBIT levels turned downward in a recession. If the stock market assigns a P/E ratio of 10.0, for example, the stock price would be $22.50 (= $2.25 _ 10.0), and it would be clear that this change in capital structure is not desirable.
It is important to emphasize that the P/E ratios in the preceding example are simply assumptions. As an analytical technique, EBIT-EPS analysis does not provide a complete solution to the optimal capital structure question.
In summary, the firm potentially can show increased earnings to its stockholders by increasing its level of financial risk. However, because increases in risk tend to increase the cost of capital (which is analogous to a decrease in the P/E ratio), the firm’s management has to assess the trade -off between the higher earnings per share for its stockholders and the higher costs of capital.
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