Question

A company with EBIT of $6,000,000 is considering two financing alternatives. The first alternative would have interest expense of $2,000,000 and 1,000,000 common shares outstanding, whereas the second would have interest expense of $3,800,000 but only 750,000 shares outstanding.

Particulars		Alternative 1	Alternative 2
EBIT		6000000	6000000
Interest		2000000	3800000
EBT		4000000	2200000
Tax @ 35%		1400000	770000
Net Profit		2600000	1430000
No. of shares		1000000	750000
EPS		2.60	1.91
EBIT increases by 20% =			7200000
Particulars		Alternative 1	Alternative 2
EBIT		7200000	7200000
Interest		2000000	3800000
EBT		5200000	3400000
Tax @ 35%		1820000	1190000
Net Profit		3380000	2210000
No. of shares		1000000	750000
EPS		3.38	2.95
EBIT decreases by 20% =			4800000
Particulars		Alternative 1	Alternative 2
EBIT		4800000	4800000
Interest		2000000	3800000
EBT		2800000	1000000
Tax @ 35%		980000	350000
Net Profit		1820000	650000
No. of shares		1000000	750000
EPS		1.82	0.87

EBIT/EPS indefference point is $9,200,000

1) Need to provide comments on EBIT/EPS results. What principle does this problem demonstrate?

Answer 1

EBIT/ EPS INDIFFERENCE POINT SUGGESTS THAT AT $92,00,000, BOTH PLANS WILL BE EQUAL.

THIS ANALYSIS HAS VERY GREAT IMPLICATION FOR INVESTMENT ANALYSTS

THE TWO PLANS HAS MAJOR DIFFERENCE IN FINANCING.

The first alternative would have interest expense of $2,000,000 and 1,000,000 common shares outstanding, whereas the second would have interest expense of $3,800,000 but only 750,000 shares outstanding.

IMPLICATION:

NOW WHEN THE EBIT WILL BE BELOW $92,00,000, WE WILL GO FOR PLAN WITH HIGHER EQUITY (THAT IS FIRST ALTERNATIVE)

AND

WHEN THE EBIT WILL BE HIGHER THAN $92,00,000, WE WILL GO FOR PLAN WITH HIGHER DEBT (THAT IS SECOND ALTERNATIVE)

AND SEE THE ABOVE THE TABLE

ALL THE EBITs ARE LESS THAN $92,00,000

AND EVERY TIME, FIRST ALTERNATIVE IS SHOWING BETTER EPS.

Go through it, Any doubts, please feel free to ask, Give positive feedback, Thank you