EBIT-EPS Indifference Point
For simplicity, we will assume there are no preferred shares to consider.
Let's work through an example. With this information we can use the formula to calculate the company's current EBIT. That's a great growth rate, but with the new interest expense and shares outstanding, it isn't obvious how this growth will translate to earnings per share. The resulting EPS will tell us if this capital structure is the best way to fund the growth plan and also improve EPS.
This analysis tells the company's management and investors that this plan is far from optimal.
Indifference Point Debt Funding
While it may increase EBIT, the cost of the new debt and the new shares outstanding are too great to support the company's earnings per share. In order to pursue this growth plan, the company must either change the balance of debt and equity financing, find cheaper sources of funding, or find a new plan that can generate a higher growth rate to support the costs of interest and equity. If you're reading this because you want to learn more about stocks and how to invest, check out The Motley Fool's Broker Center and get started today.
Similarly financial breakeven point is the level of EBIT at which after paying interest, tax and preference dividend, nothing remains for the equity shareholders.
In other words, financial breakeven point refers to that level of EBIT at which the firm can satisfy all fixed financial charges. Thus financial breakeven point refers to the level of EBIT at which financial profit is nil. A company has formulated the following financing plans to finance Rs 15, 00, which is required for financing a new project.
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Calculation of Point of Indifference | Capital Structure
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Name required. Post to Cancel. Post was not sent - check your email addresses! This is equivalent on the standard normal curve to the following:.
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The probability that EBIT will be less than 1. 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. On the standard normal curve, this corresponds to the following:. The probability that EBIT will be less than 2.
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.
Financial leverage is a double -edged sword: It enhances expected returns, but it also increases risk. It is important to note that a firm need not feel constrained by industry standards in setting its own capital structure. The final choice of a capital structure involves a careful analysis of expected future returns and risks relative to other firms in the industry. Specifically, which financing alternative results in the higher stock price? 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.
In summary, the firm potentially can show increased earnings to its stockholders by increasing its level of financial risk. Evaluation Of Financial Performance.
How Do You Find the Level of EBIT Where EPS Doesn't Change?
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- The EBIT EPS indifference point a identifies the EBIT level at which the EPS | Course Hero!
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