A business can be funded by debt or equity, and each funding mechanism has an associated cost. One method of optimizing your capital funding is to understand the relationship between earnings per share (EPS) and earnings before interest and taxes (EBIT) under different scenarios. EPS-EBIT analysis is often used to decide between funding a project with a fixed source of funds or using the leverage afforded by increased external debt. By comparing the EBIT value at which both alternatives are equal, you can decide whether your expected returns will favor one plan or the other.
Calculate values for EPS based on a range of expected EBIT. The relationship between EPS and EBIT is:
EPS = (EBIT - i) (1 - t) / n
The "i" parameter is the interest rate of the debt, the "t" parameter is the tax rate, and "n" is the number of equity shares.
Graph the EPS-EBIT curves for alternative financing plans on the same set of axes, with EBIT being the independent variable, plotted on the x axis, and EPS being the dependent variable, plotted on the y axis.
Solve for the point at which the curves intersect. This is called the indifference point and it is the minimum expected EBIT for the financial leverage afforded by debt to be beneficial.
(EBIT - i1) (1 - t1) / n1 = (EBIT - i2) (1 - t2) / n2
- Many different factors determine the most appropriate financial scenario. Graphing EPS-EBIT curves only allows you to determine the break-even point where financing alternatives are equivalent.
- Comstock Images/Comstock/Getty Images