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Coursework Question9 Material

This document discusses the impact of earnings per share (EPS) on share price and describes EPS-EBIT analysis, a technique for examining the effects of different capital structures on a firm's EPS. It states that EPS can indirectly impact share price through dividends and directly through price-earnings ratios. The document then presents an equation for determining the break-even EBIT level that would produce the same EPS under two financing alternatives, taking into account interest, taxes, shares outstanding, and preferred dividends. It concludes that if the probability of achieving the break-even EBIT is higher than 70% and existing gearing is not high, debt financing is recommended over equity financing.

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12 views

Coursework Question9 Material

This document discusses the impact of earnings per share (EPS) on share price and describes EPS-EBIT analysis, a technique for examining the effects of different capital structures on a firm's EPS. It states that EPS can indirectly impact share price through dividends and directly through price-earnings ratios. The document then presents an equation for determining the break-even EBIT level that would produce the same EPS under two financing alternatives, taking into account interest, taxes, shares outstanding, and preferred dividends. It concludes that if the probability of achieving the break-even EBIT is higher than 70% and existing gearing is not high, debt financing is recommended over equity financing.

Uploaded by

hoang
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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Applied Chemicals

There are direct and indirect ways EPS affects the share price. The indirect impact is through
dividend payments. If an increase in the EPS leads to higher growth in dividends in future,
this will be reflected in higher price provided increase in the EPS is not achieved through
high risk investments. The direct way is through its impact on price earnings ratio. The
increase in the EPS lead to increase in price earnings ratio provided the higher EPS is not
based on high risk investments which in turn is due to relatively larger increase in the share
price compared to increase in the EPS.

EPS-EBIT analysis is a technique used for examining the effect of alternative capital
structure on a firm's EPS. In other words, EPS-EBIT analysis considers what happens to EPS
at various levels of EBIT for a given change in debt equity ratio. The EBIT level that causes
two financing alternatives to produce same EPS is determined from the equation below:

EBIT *

 I1 1  t   d ps1

EBIT *

 I 2 1  t   d ps2
n1 n2

where
EBIT* is the unknown crossover (break-even) point in EBIT.
I1 and I2 are the annual interest charges under the two financing plans respectively
t is the firm's marginal tax rate
n1 and n2 are the number of shares outstanding under the two plans respectively
dps1 and dps2 are the annual preferred dividend payments under the two plans respectively
If dps1 and dps2 are assumed to be zero, then the above equation becomes:
I n  I n 
EBIT*  1 2 2 1
n 2  n1

Once the break-even EBIT is calculated, then if the probability of achieving the break-even
EBIT in future is higher (about 70%) and if the existing gearing ratio is not high, then debt
financing is used.
Otherwise equity financing is recommended.

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