Page 203 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 8.11.1 EBIT-EPS (Approach) Analysis

Here we shall try to understand how sensitive are Earnings Per Share (EPS) to the changes in
Earnings Before Interest and Tax (EBIT) under different financial plans/capital structures/
alternatives. It is known as EBIT-EPS analysis. Use of fixed cost sources of finance in capital
structure of a firm is known as financial leverages/trading on equity. In other words, use of less
cost source of finance to maximise Earnings Per Share (EPS), but the benefits are more when a
firm uses debt as a source of finance, due to cheap and interest is tax deductible source. Use of
debt can be used to maximise shareholder wealth only when a firm has a high level of operating
profit (EBIT). EBIT-EPS analyses is one way to study the relation between Earnings Per Share
(EPS) and various possible levels of operating profit (EBIT), under various financial plans.
Illustration 6: XYZ Co. Ltd. has a share capital of 1,00,000 face value of 10 each. It requires
50,000 to finance expansion programme and is considering three alternative financial plans.

1. Issue of 5000 ordinary shares of 10 each
2. Issue of 500 preference shares of 100 each at 10 per cent and
3. Issue of 10 per cent debentures of 50,000

The company’s operating profit (EBIT) after additional investment is 40,000 per annum. Tax
rate is 50 per cent. Show the effect of use of debt in financial plan.
Solution:
Calculation of EPS

Financial Plan
Particulars
I (Equity) ( ) II (Preference) ( ) III Debt – Equity ( )
EBIT 40,000 40,000 40,000
Less: Interest --- --- 5,000
EBT/or PBT 40,000 40,000 35,000
Less: Tax at 50% 20,000 20,000 17,500
PAT or EAT
20,000 20,000 17,500
Less: Preference dividend --- 5,000 ---
Earnings available to share holders. 20,000 15,000 17,500
No. of shares outstanding 15,000 10,000 10,000
Earnings available to shareholder
EPS = 1.333 1.5 1.75
No. of equity shares

Illustration 7: VS International Ltd., has a capital structure (all equity) comprising of 5,00,000
each share of 10. The firm wants to raise an additional 2,50,000 for expansion project. The firm
has the following four alternative financial plans I, II, III and IV. The firm is able to earn an
operating profit at 80,000 after additional investment and 50 per cent tax rate. Calculate EPS for
all four alternatives and select the preferable financial plan.
1. Raise the entire amount in the form of equity capital.
2. Raise 50 per cent as equity capital and 50 per cent as 10 per cent debt capital.
3. Raise the entire amount as 12 per cent debentures.

4. Raise 50 per cent equity capital and 50 per cent preference share capital at 10 per cent.

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