Introductory Corporate Finance: Leverage - EBITEPS Analysis, Indifference Point Optimal Capital Structure in relation to EBIT levels

What This Is

EBIT-EPS analysis is a crucial concept in corporate finance that helps investors and analysts understand the relationship between a company's earnings before interest and taxes (EBIT), its capital structure, and its earnings per share (EPS). By analyzing this relationship, we can determine the indifference point, which is the optimal capital structure that maximizes EPS. For example, consider a company like Apple, with an EBIT of $50 billion and a capital structure consisting of 20% debt and 80% equity. If we assume a tax rate of 25% and a cost of debt of 5%, we can calculate the indifference point and determine the optimal capital structure.

Key Formulas & Models

• EBIT = Sales - (VC + FC): Earnings before interest and taxes; measures a company's profitability before considering its capital structure.
  • EBIT: Earnings before interest and taxes
  • Sales: Total revenue
  • VC: Variable costs
  • FC: Fixed costs
• EPS = EBIT / (Shares Outstanding): Earnings per share; measures a company's profitability per share.
  • EPS: Earnings per share
  • EBIT: Earnings before interest and taxes
  • Shares Outstanding: Total number of shares outstanding
• WACC = wd × rd(1-T) + wps × rps + we × re: Weighted average cost of capital; used as a discount rate.
  • WACC: Weighted average cost of capital
  • wd: Proportion of debt in capital structure
  • rd: Cost of debt
  • T: Tax rate
  • wps: Proportion of preferred stock in capital structure
  • rps: Cost of preferred stock
  • we: Proportion of equity in capital structure
  • re: Cost of equity
• DFL = EBIT - (Interest × (1 - T)): Debt-free leverage; measures a company's EBIT sensitivity to sales.
  • DFL: Debt-free leverage
  • EBIT: Earnings before interest and taxes
  • Interest: Interest expense
  • T: Tax rate
• DOL = Q(P-V) / (Q(P-V)-F): Degree of operating leverage; measures a company's EBIT sensitivity to sales.
  • DOL: Degree of operating leverage
  • Q: Sales
  • P: Price per unit
  • V: Variable costs per unit
  • F: Fixed costs
• Sustainable Growth Rate = ROE × (1 - Retention Ratio): Sustainable growth rate; measures a company's long-term growth rate.
  • Sustainable Growth Rate: Long-term growth rate
  • ROE: Return on equity
  • Retention Ratio: Proportion of earnings retained in the business

Step-by-Step Calculation

1. Calculate EBIT: Sales - (VC + FC)
2. Calculate EPS: EBIT / (Shares Outstanding)
3. Calculate WACC: wd × rd(1-T) + wps × rps + we × re
4. Calculate DFL: EBIT - (Interest × (1 - T))
5. Calculate DOL: Q(P-V) / (Q(P-V)-F)
6. Calculate Sustainable Growth Rate: ROE × (1 - Retention Ratio)

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC, as it reflects the current market price of the company's securities.
  • Counterexample: A company with a book value of $100 million and a market value of $200 million should use the market value of $200 million for WACC.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the calculation of WACC, as they represent the cost of issuing new securities.
  • Counterexample: A company with a flotation cost of 5% should include this cost in the calculation of WACC.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs represent the potential benefits of alternative uses of resources.
  • Counterexample: A company that has already invested $100 million in a project should not include this cost as an opportunity cost when evaluating future projects.

Exam / CFA Tips

• Tip: When evaluating a company's capital structure, consider the trade-off between debt and equity.
• Tip: Use the indifference point to determine the optimal capital structure that maximizes EPS.
• Tip: Be careful when using the sustainable growth rate formula, as it assumes a constant retention ratio and return on equity.
• Tip: When evaluating a company's financial statements, consider the impact of taxes on the company's profitability.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and a tax rate of 25%. Calculate the debt-free leverage (DFL).

Answer: DFL = $10 million - ($2 million × (1 - 0.25)) = $10 million - $1.5 million = $8.5 million

Last-Minute Cram Sheet

• EBIT = Sales - (VC + FC): Measures a company's profitability before considering its capital structure.
• EPS = EBIT / (Shares Outstanding): Measures a company's profitability per share.
• WACC = wd × rd(1-T) + wps × rps + we × re: Used as a discount rate to evaluate a company's capital structure.
• DFL = EBIT - (Interest × (1 - T)): Measures a company's EBIT sensitivity to sales.
• DOL = Q(P-V) / (Q(P-V)-F): Measures a company's EBIT sensitivity to sales.
• Sustainable Growth Rate = ROE × (1 - Retention Ratio): Measures a company's long-term growth rate.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• The sustainable growth rate formula assumes a constant retention ratio and return on equity.
• The indifference point is the optimal capital structure that maximizes EPS.
• WACC should be calculated using market value, not book value.