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Indifference EBIT
Indifference EBIT
Different financing decisions will have differing impacts on EPS. We can examine the
effects of various financing alternatives through an EPS-EBIT analysis, which involves
determining the crossover or 'indifference' EBIT at which the EPS is the same between
two financing alternatives. Suppose that the firm is comparing the two possible capital
structures, 1 and 2. Then, EBIT*, the indifference EBIT, is such that
EPS 1 = EPS 2
In the absence of tax and preferred shares in the capital structure of the firm, the above
expression becomes
EBIT * − I 1 EBIT * − I 2
=
N1 N2
Plan I
EBIT 1000
EPS I = = = $5
N 200
Plan II
EBIT − I 1000 − 5000 ( 0.12 ) 1000 − 600
EPS II = = = = $4
N 100 100
Plan I
EBIT 2000
EPS I = = = $10
N 200
Plan II
EBIT − I 2000 − 5000 (0.12 ) 2000 − 600
EPS II = = = = $14
N 100 100
(c) What is the break-even EBIT; that is, what EBIT generates exactly the same EPS
under both plans?
EPS I = EPS II
EBIT *
EBIT * − I
=
NI N II
EBIT * EBIT * − 600
=
200 100
EBIT = $1200
*
EPS * = $6
Example 2
A firm presently has 100,000 common shares outstanding and currently has $1M of
bonds outstanding with annual interest of 10%. Their effective tax rate is 40%. They
need to raise $500,000. The following options are available.
(1) Issue common shares at $50 each (i.e. n2 = $500,000/$50 = 10,000 new shares).
(2) Issue new debt at 12% annually.
Which should they choose if they expect EBIT to be $1 million for the upcoming year?
Solution
The EPS equations for the financing alternatives are given below:
Setting EPS (1 )
= EPS ( 2) and solving for EBIT*, we obtain EBIT * =$760,000
Therefore, since expected EBIT >$760,000, then the plan with more debt (i.e., plan (2))
($1 m )(. 60 ) − 60 ,000 )
will be preferred. I.e., EPS (1) = = $4.90 , and
110 ,000
($1 m)(. 60 ) − 96 ,000 )
EPS ( 2 ) = = $5.04
100 ,000
If expected EBIT <$760,000, then the plan with less debt (i.e., plan (1)) will be preferred.