Finance managers often evaluate financing plans based on how the plan affects earnings per share, or EPS. Financing plans produce different levels of EPS at different levels of earnings before interest and taxes, or EBIT. The EBIT-EPS indifference point is the EBIT level at which the earnings per share is equal under two different financing plans.
Calculate the EBIT-EPS Indifference Point
Calculate the total amount of any interest expense associated with each financing plan. To do so, multiply the interest rate by face value of the instruments and the number of periods you'll pay interest. For example, say that one of the finance plans is to issue bonds with a face value of $1,000 that pay 5 percent interest annually for ten years. The interest expense is 1,000 multiplied by 10 and 0.05, or $500.
Set the EBIT level as the independent variable, or x variable, for the equation. Subtract any interest expenses associated with the financing plan from x and multiply by the tax rate. For example, say that issuing bonds will create interest expense of $500 and the effective income tax rate for the business is 35 percent. The formula thus far should read (x-500)*(0.35).
Divide the EBIT expression by the the number of equity shares that will be outstanding after adopting the plan to calculate EPS, the dependent (y) variable. For example, say that the company currently has 1,000,000 shares outstanding. Issuing bonds will not increase the number of equity shares outstanding, so the number of shares stays constant. The formula should read y=(x-500)*(0.35)/1,000,000
Repeat the process for the second finance project in question and plot each equation on the same graph. Plot EBIT on the x-axis and EPS on the y-axis. Identify the point at which two of the lines intersect. The corresponding x and y values represent the level of EBIT at which both plans provide the same EPS. For example, say that the two lines intersect at an x value of 6,000 and a y value of 3. That means that when the firm's EBIT is at $6,000, both plans generate an EPS of $3 per share and the company is indifferent between plans.
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