EBIT-EPS ANALYSIS
Q1) The following capital structure is available for ABC Ltd.:
Equity Share Capital ( Face Value= Rs.100) = Rs.5,00,000
Retained Earnings = Rs.2,00,000
General reserve = Rs.2,00,000
8% Preference Share Capital = Rs. 50,000
12% Debentures = Rs.50,000
Following sources have been identified for raising finance for meeting its expansion program:
Equity Share Capital = Rs.4,00,000
14% Debentures = Rs.1,00,000
Return on Investment is 15%. Calculate EBIT and proposed EBIT.
Sol.) Existing Capital Structure:
Equity Share Capital =Rs.5,00,000
Retained Earnings=Rs.2,00,000-
General Reserve = Rs.2,00,000
8% Preference Shares=Rs.50,000
12% Debentures= Rs.50,000
Total= Rs.10,00,000
Present EBIT =15% on ROI of Rs.10,00,000 = Rs.1,50,000
Additional Capital Structure:
Equity Share Capital =Rs.4,00,000
14% Debentures = Rs.1,00,000
Total = Rs.5,00,000
1
Proposed EBIT= 15% on ROI of Rs. 5,00,000= Rs75,000
Total EBIT=1,50,000 + 75,000 = Rs.2,25,000
Therefore, after expansion EBIT of the firm would be Rs.2,25,000
Q2) A firm has an all equity capital structure consisting of 1,00,000 equity shares of Rs.10
per share. The firm wants to raise Rs.2,50,000 to finance its investments and is considering
three alternative methods of financing:
a) To issue 25,000 equity shares at Rs.10 each.
b) To borrow Rs.2,50,000 at 8% interest rate.
c) To issue 2,500 preference shares of Rs.100 each at 8% dividend rate.
1) If the firm’s EBIT after additional investment is Rs.3,12,500 and the tax rate is
50%, which choice is to be made?
2) Explain the effect on EPS, if EBIT decreases to Rs.75,000.
3) Draw conclusion in respect to the relationship between EBIT and EPS.
Sol.) 1) EPS under Different Forms of Financing
Particulars Equity Financing Debt Financing (Rs.) Preference
(Rs.) Financing (Rs.)
EBIT 3,12,500 3,12,500 3,12,500
(-) Interest [8% of - 20,000 -
2,50,000]
EBT
3,12,500 2,92,500 3,12,500
(-) Tax @50%
1,56,250 1,46,250 1,56,250
PAT
1,56,250 1,46,250 1,56,250
(-) Preference
- - 20,000
Dividend [8%]
Earnings available to
equity shareholders 1,56,250 1,46,250 1,36,250
2
[1]
O/S Eq. shares [2]
EPS [1/2] 1,25,000 1,00,000 1,00,000
1.25 1.46 1.36
Change of form of financing has increased EPS. Higher the ratio of debt to equity, the greater
would be the return to the equity shareholders.
2) EPS under Different Forms of Financing (Reduced EBIT)
Particulars Equity Financing Debt Financing (Rs.) Preference
(Rs.) Financing (Rs.)
EBIT 75,000 75,000 75,000
(-) Interest - 20,000 -
EBT 75,000 55,000 75,000
(-) Tax @50% 37,500 27,500 37,500
PAT 37,500 27,500 37,500
(-) Preference - - 20,000
Dividend
Earnings available to
37,500 27,500 17,500
equity shareholders
O/S Eq. shares
1,25,000 1,00,000 1,00,000
EPS
0.30 0.28 0.18
3) If the level of EBIT is greater and its probability in the downward fluctuation is lower,
it is beneficial to employ debt in the firm’s capital structure.
3
Q3) X Ltd. Plans to raise a total capital of Rs.4,00,000. Company has 3 options:
Plan A: No debt, all equity shares
Plan B: 40% debt (10%), 40% preference shares (12%) and 20% equity shares
Plan C: 70% Debt (10%) and 30% equity Shares
Face Value of Equity Shares and Preference Shares is Rs.10 in all plans. Rates in brackets
indicate a fixed return on debt and preference shares. The firm estimates its EBIT to be
Rs.80,000. Tax rate is 50%. Which plan is profitable to implement?
Sol.) EPS under Different Plans
Particulars Plan A Plan B Plan C
Capital Structure 4,00,000 4,00,000 4,00,000
Equity share Capital Rs.4,00,000 [40,000 Rs.80,000 [8,000 eq. Rs.1,20,000 [ 12,000
eq. sh @ Rs.10 each] sh @ Rs.10 each] eq. sh. @ Rs.10
(Face Value of
each]
Rs.10)
-
Preference Share - Rs.1,60,000 [ 16,000
Capital (face value pref. sh.@ Rs.10
of Rs.10) each]
Debentures Rs.1,60,000 [ 16,000
Rs.2,80,000 [ 28,000
- deb. @ Rs.10 each]
(Face Value of deb. @ rs.10 each]
Rs.10)
4
EBIT 80,000 80,000 80,000
(-) Interest - 16,000 28,000
EBT 80,000 64,000 52,000
(-) Tax @ 50% 40,000 32,000 26,000
PAT 40,000 32,000 26,000
(-) Pref. Dividend - 19,200 -
(12% on pref, sh,cap
of Rs.1,60,000)
Profit available for
equity shareholders 40,000 12,800 26,000
No. of eq. shares
EPS 40,000 8,000 12,000
1 1.60 2.16
Q4) The existing capital structure of P Ltd. Is as follows:
Equity share Capital (face value of Rs.10) = Rs.6,00,000 = 60,000 shares
Retained Earnings = Rs.2,00,000
10% Preference Shares = Rs.3,00,000
8% Debentures = Rs.2,00,000
The company requires a sum of Rs.5,00,000 to finance its expansion program. It is
considering the following 3 options:
a) Issue of 40,000 equity shares (face value of Rs.10) at a premium of Rs.2.50
b) Issue of 10% Preference Shares at par
c) Issue of 8% Debentures
EBIT , after expansion would be Rs.8,00,000. Tax Rate is 50%. It is estimated that P/E ratio
of equity share in the above 3 options of financing would be 12,8 and 6 respectively. Which
of the alternative plan would you consider to best amongst the 3 options?
5
Sol) Estimated Market Price Per Share
Particulars Plan 1 Plan 2 Plan 3
EBIT 8,00,000 8,00,000 8,00,000
(-) Interest 16,000 16,000 [16,000+ 40,000]
EBT 7,84,000 7,84,000 7,44,000
(-) Tax @50% 3,92,000 3,92,000 3,72,000
PAT 3,92,000 3,92,000 3,72,000
(-) Pref. Dividend 30,000 [30,000 +50,000]= 30,000
80,000
3,12,000
Profit available for 3,62,000 3,42,000
eq. shareholders
No. of [Link] 60,000
1,00,000 60,000
EPS 5.2
3.62 5.7
P/E ratio= [Market 8
12 6
Price per share/EPS]
Market Price per Eq.
Rs.41.6
Sh.[EPS * P/E ratio Rs.43.44 Rs.34.2
6
Q5) ABC Ltd. Plans to expand their existing business with a new factory. Its existing equity
share capital (Face Value= Rs.10) is Rs.5 lakhs. 10% Debentures outstanding are Rs.3 lakhs.
Funds requirement of new factory is Rs.20 lakhs. Company has 3 alternative plans to raise
debt requirements of Rs.8 lakhs, Rs.12 Lakhs and Rs.20 lakhs. Balanced amount would be
raised by equity. Cost of borrowing for additional funds is as under:
Up to Rs.5,00,000 = 10%
Up to Rs.12,00,000 = 12%
Up to Rs.25,00,000 = 14%
Existing EBIT is Rs.10 lakhs. New factory would yield an EBIT of Rs.30 lakhs. Additionally,
company’s policy is to maintain a debt-equity ratio not exceeding 3:1 and is prepared to take
minimum advantage of debt.
Assume tax rate of 50%. Work out EPS and recommend the scheme selected.
Sol.) Existing Capital Structure:
Equity Share Capital=Rs.5,00,000
10% Debentures=Rs.3,00,000
New Capital Structure=Rs.20,00,000
Total Long-term Sources= Rs.28,00,000
Maximum permitted debt-equity ratio= 3:1
So, Maximum debt can be Rs.21,00,000 = 3/4th of Rs.28,00,000
Statement Showing EPS Under Different Schemes
Particulars Scheme 1 Scheme 2 Scheme 3
Additional Debt 8,00,000 12,00,000 18,00,000
EBIT 40,00,000 40,00,000 40,00,000
[30,000 +96,000]= [30,000 + 1,44,000] [30,000 + 2,52,000]
7
(-) Interest 1,26,000 = 1,74,000 = 2,82,000
38,74,000 38,26,000 37,18,000
EBT 19,37,000 19,13,000 18,59,000
(-) Tax @50% 19,37,000 19,13,000 18,59,000
PAT 20,00,000 20,00,000 20,00,000
Funds requirement
of new factory(A)
8,00,000 12,00,000 18,00,000
Debt Component of
new factory (B)
12,00,000 8,00,000 2,00,000
Additional equity
share capital of new
factory(A-B)
Existing eq. [Link]. 5,00,000 5,00,000 5,00,000
Total [Link]. 17,00,000 13,00,000 7,00,000
No. of eq. shares 1,70,000 1,30,000 70,000
EPS 11.39 14.71 26.55
Q6) Y Ltd. With net operating earnings of Rs.3,00,000, is attempting to evaluate a number of
possible capital structures as given below. Which capital structure will you recommend and
why?
Capital Structure Debt in Capital Cost of Debt (%) Cost of Equity (%)
Structure (Rs.)
1 3,00,000 10 12
2 4,00,000 10 12.5
3 5,00,000 11 13.5
8
4 6,00,000 12 15
5 7,00,000 14 18
Sol.)
Particulars CS 1 CS 2 CS 3 CS 4 CS 5
EBIT 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
(-) Interest 30,000 40,000 55,000 72,000 98,000
Net Income 2,70,000 2,60,000 2,45,000 2,28,000 2,02,000
for Eq. sh.
Ke
0.12 0.125 0.135 0.15 0.18
E (market
22,50,000 20,80,000 18,14,815 15,20,000 11,22,222
value of
equity=
NI/Ke)
D (market
value of
3,00,000 4,00,000 5,00,000 6,00,000 7,00,000
debt)
Total Market
Value= V=
E+D
25,50,000 24,80,000 23,14,815 21,20,000 18,22,222
Overall Cost
of Capital
[EBIT/V]
0.117= 0.120= 12% 0.129= 0.141= 0.164 =
11.7% 12.9% 14.1% 16.4%
9
CAPITAL GEARING RATIO
It analyzes the capital structure of the company. This is the ratio between fixed charge
bearing securities and non-fixed charge bearing securities.
Capital Gearing Ratio=
[Pref sh. Cap.+ Debentures + Long-term debts bearing fixed interest]/[Eq. [Link].+ Reserves]
A higher capital gearing is an indication that it is burdened with more debt and preference
shares that result in a fixed commitment/payment, irrespective of profits. This would turn
risky in case of a reduction in profits, in particular during recession times. Therefore, lenders
need to be very careful while dealing with a highly geared firm.
Trade Cycles:
a) Inflation/Boom Period- adopt the policy of high gear to magnify EPS.
b) Deflation/Depression Period: adopt the policy of low gear and raise considerable
amounts of equity funds as there is no commitment to pay fixed rate of dividends.
Q1) Calculate capital gearing from the following. Comment on the ratio, if the firm is passing
through the period of inflation and planning for expansion.
Equity Share Capital = Rs.7,00,000
7% Preference Share Capital = Rs.2,00,000
11% Debentures = Rs.4,00,000
Long Term Loan = Rs.3,00,000
Reserves and Surplus = Rs.4,00,000
Current Liabilities= Rs.10,00,000
Sol.) Capital Gearing Ratio=
[Pref sh. Cap.+ Debentures + Long-term debts bearing fixed interest]/[Eq. [Link].+ Reserves]
= [2,00,000 + 3,00,000 + 4,00,000]/[7,00,000 +4,00,000]
= 9,00,000/11,00,000
10
= 0.82
As the capital gearing ratio is less than 1, the firm is low geared. During the inflation period,
profits of the firm remain high and so company does not experience difficulty to meet the
fixed interest/dividend obligations. Firm can use more debt to improve EPS. In case of
expansion, more debt should be employed to improve ROI.
APPROACHES OF CAPITAL STRUCTURE
a) Net Income Approach
b) Net Operating Income Approach
c) MM Approach
d) Traditional Approach
NET INCOME APPROACH- Relevance Concept
Value of the firm = Value of Debt + Value of Equity
Q1) The expected EBIT of a firm is Rs.2,00,000. It has issued equity share capital with Ke @
10% and 6% debt of Rs.5,00,000. Find out the value of the firm and overall cost of capital.
What will be the impact on the financial position of the firm if it issues 6% Debt of
Rs.7,00,000?
Sol.) When Debt = Rs.5,00,000
Particulars Amount (Rs.)
EBIT 2,00,000
(-) Interest @ 6% 30,000
Net Profit 1,70,000
Ke 0.10
Value of Equity (E) = NP/Ke 17,00,000
11
Value of Debt (D) 5,00,000
Total Value of Firm (E+D) 22,00,000
WACC (Ko) = EBIT/V 0.090 = 9%
When Debt = Rs.7,00,000
Particulars Amount (Rs.)
EBIT 2,00,000
(-) Interest @6% 42,000
Net Profit 1,58,000
Ke 0.10
Value of Equity (E) 15,80,000
Value of Debt (D) 7,00,000
Total Value of Firm (V+D) 22,80,000
WACC (Ko) = EBIT/V 0.877 = 8.77%
NET OPERATING INCOME APPROACH- Irrelevance Concept
Value of Equity = EBIT/Ko
E=V–D
Cost of Equity (Ke) = [EBIT – Interest]/[V-D]
Q1) The firm has an EBIT of Rs.2,00,000 and belongs to a risk class of 10%. What is the
value of cost of equity capital if it employs 6% debt to the extent of 30%,40% or 50% of
the total capital fund of Rs.10,00,000?
Sol.) Total Capital = Rs.10,00,000
Ko= 10% V=E+D
12
Particulars 30% Debt 40% Debt 50% Debt
(3,00,000) (4,00,000) (5,00,000)
EBIT 2,00,000 2,00,000 2,00,000
(-) Interest (6%) 18,000 24,000 30,000
Net Profit 1,82,000 1,76,000 1,70,000
Ko 0.10 0.10 0.10
Value of Firm (V) = 20,00,000 20,00,000 20,00,000
[EBIT/Ko]
Value of 6% debt
3,00,000 4,00,000 5,00,000
(D)
Value of Equity [V-
D] 17,00,000 16,00,000 15,00,000
Ke = Net profit/E
0.107 = 10.7% 0.11= 11% 0.113 = 11.3%
Q2) The expected annual income of the firm is Rs.10,00,000. The firm has Rs.50,00,000,
10% debentures. The overall cost of capital is 12.5%. Calculate the value of the firm and cost
of equity according to NOI Approach.
If the company increases debt from Rs.50,00,000 to Rs.60,00,000, what would be the value
of the firm?
Sol.)
Particulars Case 1 – Debt = Case 2 – Debt =
Rs.50,00,000 Rs.60,00,000
EBIT 10,00,000 10,00,000
(-) Interest @10% 5,00,000 6,00,000
Net Operating Profit 5,00,000 4,00,000
13
WACC (Ko) 0.125 0.125
Value of the Firm (V)= 80,00,000 80,00,000
EBIT/Ko
Value of Debt (D)
50,00,000 60,00,000
Value of Equity (E)
30,00,000 20,00,000
Ke= NOP/E
0.166 = 16.6% 0.2 = 20%
TRADITIONAL APPROACH
Q1) ABC Ltd. having an EBIT of Rs.1,50,000 is contemplating to redeem a part of the capital
by introducing debt financing. Presently it is 100% equity firm with equity capitalization rate,
Ke, of 16%. The firm is to redeem the capital by introducing debt financing upto Rs.3,00,000,
i.e. 30% of total funds or up to Rs.5,00,000, i.e. 50% of total funds. It is expected that for the
debt financing up to 30% the rate of interest will be 10% and the Ke will increase to 17%.
However, if the firm opts for 50% debt financing, then interest will be payable @ 12% and
the Ke will be 20%. Find out the value of the firm and its WACC under different levels of
debt financing.
Sol.) Total Funds = Rs.10,00,000
Particulars 0% Debt 30% Debt 50% Debt
Total Debt - 3,00,000 5,00,000
Rate of interest (Kd) - 10% 12%
EBIT 1,50,000 1,50,000 1,50,000
(-) Interest - 30,000 60,000
EBT 1,50,000 1,20,000 90,000
Ke 0.16 0.17 0.20
Value of Equity (E) 9,37,500 7,05,882 4,50,000
Value of Debt (D) - 3,00,000 5,00,000
14
Total Value [E+D] 9,37,500 10,05,882 9,50,000
Ko= EBIT/V 0.16 = 16% 0.149 = 14.9% 0.157 = 15.7%
Q2) XYZ Ltd. has EBIT of Rs.4,00,000. The firm currently has outstanding debts of
Rs.15,00,000 at an average cost, Kd of 10%. Its cost of equity capital Ke is estimated to be
16%.
a) Determine the current valuation of the firm using the Traditional Valuation approach.
b) Determine the firm’s overall capitalization rate, Ko.
c) The firm is considering to issue capital of Rs.5,00,000 in order to redeem Rs.5,00,000
debts. The cost of debt is expected to be unaffected. However, the firm’s cost of
equity capital is to be reduced to 14% as a result of decrease in leverage. Would you
recommend the proposed action?
Sol.) a) Value of the firm as per Traditional Approach
Particulars Amount (Rs.)
EBIT 4,00,000
(-) Interest (10% on Rs.15,00,000) 1,50,000
Net Income for Equity Shareholders 2,50,000
Ke 0.16
Market Value of Equity (E) 15,62,500
Market Value of Debt (D) 15,00,000
Total Market Value [E+D] 30,62,500
Overall Capitalization rate:
Ko = EBIT/V = 4,00,000/30,62,500 = 13.1%
Effect of Proposed redemption of Debt:
15
Particulars Amount (Rs.)
EBIT 4,00,000
(-) Interest (10% on Rs.10,00,000) 1,00,000
Net Income 3,00,000
Ke 0.14
Market Value of Equity 21,42,857
Market Value of Debt 10,00,000
Total Market Value 31,42,857
Ko 12.73%
The proposal should be accepted as it would increase the value of the firm from Rs.30,62,500
to Rs.31,42,857. The cost of capital will also be reduced from 13.1% to 12.73%.
MODIGLIANI-MILLER APPROACH
Q1) Companies U and L are identical in every aspect except that the former does not use
debt in its capital structure, while the latter employs Rs.6,00,000 of 15% debt. Assuming that
all the MM assumptions are met, corporate tax rate is 50%, EBIT is Rs.2,00,000 and equity
capitalization of unlevered company is 20%, what will be the value of the firms U and L?
Also determine the WACC for both the firms.
Sol.) Under MM Approach:
Value of Unlevered Firm (Vu) = [EBIT(1-t)]/Ke= [2,00,000 (1-0.50)]/0.20 = Rs.5,00,000
Value of Levered Firm (Vl) = Vu + debt (t)=5,00,000 + 6,00,000(0.50) = Rs.8,00,000
Ko of Unlevered Firm = 20% = Ke
Ko of levered Firm =
EBIT = 2,00,000
(-) Interest@15% = 90,000
16
EBT= 1,10,000
(-) Tax @50% = 55,000
PAT= 55,000
Total Market Value (V) = 8,00,000
(-) Market Value of Debt (D)= 6,00,000
Market Value of Equity (E)= 2,00,000
Ke= PAT/E = 55,000/2,00,000 = 0.275 = 27.5%
Ko = [Kd(t) * proportion of Debt in CS] + [ Ke * Proportion of Equity in CS]
= [15%(0.50) * 6,00,000/8,00,000] + [27.5% * 2,00,000/8,00,000]
= [7.5% * 0.75] + [27.5% *0.25]
= 0.0563 + 0.0688 = 0.125 = 12.5%
Q2) P Ltd. and Q Ltd. are engaged in the same nature of business and are identical in all
respects in terms of EBIT with Rs.2,00,000, except the former has 12% debentures of
Rs.4,00,000. Equity capitalization rate of P ltd. is 12% and for Q ltd. Is 10%. Calculate the
total value and overall capitalization rate of P Ltd. and Q Ltd.
Show the arbitration process by which an investor having shares worth Rs.5,00,000 in Q Ltd.
will be benefitted by switching over to P Ltd.
Sol.)
Particulars P Ltd. [D+E] Q Ltd. [E]
EBIT 2,00,000 2,00,000
(-) Interest @12% 48,000 -
Earnings available to eq. sh. 1,52,000 2,00,000
Ke 0.12 0.10
17
Value of Equity[E]= 12,66,667 20,00,000
Earnings/Ke
Value of Debt[D]
4,00,000 -
Total Value of Firm
16,66,667 20,00,000
[V=E+D]
Overall capitalization Rate
[Ko] = EBIT/V
11.9% 10%
Arbitrage Process:
Investors having shares worth Rs.5,00,000 out of the total worth of equity of Rs.20,00,000 is
holding 25% shares in Q ltd.
Investor’s current position in Q Ltd.:
Dividend Income [25% of Rs.2,00,000] = Rs.50,000
Total Income from Q Ltd. = Rs.50,000
Market value of Investment in Q Ltd.=Rs.5,00,000
He sells the investment in Q Ltd. for Rs.5,00,000 and buys 25% of equity shares and
debentures in P Ltd.
In P Ltd., 25% of Equity shares [25% of 12,66,667] = Rs.3,16,667
25% of Debentures [ 25% of 4,00,000]= Rs.1,00,000
Dividend Income [ 25% of 1,52,000]= 38,000
12% interest on Rs.1,00,000 = 12,000
Total Income of P Ltd.= Rs.50,000
Market Value of Investment in P ltd:
Equity Shares= 3,16,667
Debentures =1,00,000
18
Total Investment=Rs.4,16,667
Investor is able to maintain the same amount of income of Rs.50,000. However, he has saved
his investment by Rs.83,333 [ 5,00,000 – 3,16,667 – 1,00,000].
Q3) A Ltd. and B Ltd. are engaged in the same nature of business and are identical in all
respects in terms of EBIT with Rs.4,00,000, except the former has 10% debentures of
Rs.6,00,000. Equity capitalization rate of A ltd. is 14% and for B ltd. Is 12%. Calculate the
total value and overall capitalization rate of A Ltd. and B Ltd.
Show the arbitration process by which an investor having shares worth Rs.6,00,000 in B Ltd.
will be benefitted by switching over to A Ltd.
Sol.)
Particulars P Ltd. Q Ltd.
EBIT
(-) Interest @10%
Earnings available to eq. sh.
Ke
Value of Equity[E]=
Earnings/Ke
Value of Debt[D]
Total Value of Firm
[V=E+D]
Overall capitalization Rate
[Ko] = EBIT/V
Arbitrage Process:
19
Investors having shares worth Rs.6,00,000 out of the total worth of equity of Rs……is
holding ..% shares in B ltd.
Investor’s current position in Q Ltd.:
Dividend Income [] = Rs.
Total Income from B Ltd. = Rs.
Market value of Investment in B Ltd.=
He sells the investment in B Ltd. for Rs.6,00,000 and buys ..% of equity shares and
debentures in A Ltd.
In A Ltd., ..% of Equity shares [% of] = Rs.
% of Debentures [ % of]= Rs.
Dividend Income [ % of]=
% interest on Rs. =
Total Income of A Ltd.= Rs.
Market Value of Investment in A ltd:
Equity Shares=
Debentures =
Total Investment=
Investor is able to maintain the same amount of income of Rs.. However, he has saved his
investment by Rs.
20
21
22
23
24
25
