EBIT-EPS (or Indifference) Analysis:
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
EPS1  EPS2
( EBIT *  I 1 )(1  T )  D p1
N1

( EBIT *  I 2 )(1  T )  D p 2
N2
where
EBIT* =the indifference EBIT
I = the interests
T= tax rate
DP = the dividends for the preferred shares
N = the number of shares outstanding
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
Other Capital Structure Analysis Tools:
(1) Coverage ratios.
(2) Lender requirements or debt covenants
(3) Bond ratings
(4) Industry norms
(5) Detailed cash flow analysis including sensitivity and scenario analysis
Example 1 (An EBIT-EPS Indifference Analysis)
The NBA Corporation is comparing two different capital structures, an all-equity plan
(Plan I) and a levered plan (Plan II). Under Plan I, NBA would have 200 shares of stock
outstanding. Under Plan II, NBA would have 100 shares of stock and $5,000 in debt
outstanding. The interest rate is 12 percent and there are no taxes.
(a)
If EBIT is $1,000, which plan results in the higher EPS?
(b)
If EBIT is $2,000, which plan results in the higher EPS?
(c)
What is the break-even EBIT; that is, what EBIT generates exactly the same EPS
under both plans?
Solutions
(a)
If EBIT is $1,000, which plan results in the higher EPS?
Plan I
EPS I 
Plan II
EPS II 
EBIT 1000

 $5
N
200
EBIT  I 1000  5000(012
. ) 1000  600


 $4
N
100
100
The plan I has a higher EPS given EBIT = $1000.
(b)
If EBIT is $2,000, which plan results in the higher EPS?
Plan I
EPS I 
Plan II
EPS II 
EBIT 2000

 $10
N
200
EBIT  I 2000  5000(012
. ) 2000  600


 $14
N
100
100
The plan II has a higher EPS given EBIT = $2000.
(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
For financial leverage to be beneficial, operations must be reasonably profitable.
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:
EPS(1) 
EPS( 2 ) 
( EBIT  I (1) )(1  T )  Dp
n(1)
( EBIT  I ( 2 ) )(1  T )  Dp
n( 2 )

( EBIT  100,000)(0.60)  0 .6 EBIT  60,000

110,000
110,000

( EBIT  160,000)(0.60)  0 .6 EBIT  96,000

100,000
100,000
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))
($1m)(.60)  60,000)
will be preferred. I.e., EPS(1) 
 $4.90 , and
110,000
($1m)(.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.