Scribd
Upload
5 views

EBIT

The EBIT-EPS approach analyzes the impact of debt on shareholders' returns and risks, focusing on the relationship between earnings before interest and taxes and earnings per share. While it aids in evaluating short-term financial plans, it has limitations such as neglecting long-term value maximization and the variability of EPS. Ultimately, the approach should be used for initial evaluations, with a preference for long-term shareholder value in decision-making.

Uploaded by

sandy28ster5377
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
5 views

EBIT

The EBIT-EPS approach analyzes the impact of debt on shareholders' returns and risks, focusing on the relationship between earnings before interest and taxes and earnings per share. While it aids in evaluating short-term financial plans, it has limitations such as neglecting long-term value maximization and the variability of EPS. Ultimately, the approach should be used for initial evaluations, with a preference for long-term shareholder value in decision-making.

Uploaded by

sandy28ster5377
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 2

EBIT-EPS APPROACH

The three most common approaches to determining a firm's capital structure are as
follows:

1) EBIT-EPS approach: for analyzing the impact of debt on shareholders’ return and
risk
2) Valuation approach: for determining the impact of debt on the shareholders’ value
3) Cash flow approach: for analyzing the firm’s ability to service debt and avoid
financial distress

Introduction to EBIT-EPS Analysis

Definition: The EBIT-EPS (Earnings Before Interest and Taxes—Earnings Per Share)
analysis examines the impact of alternative financial plans on shareholders' income and its
variability.

Purpose: To decide on the optimal capital structure by analyzing the effect of debt on EPS
(and ROE).

EPS Variability and Financial Risk

 Leverage and Risk: Debt creates EPS variability, leading to financial risk. Extreme
fluctuations can threaten solvency.
 Trade-off: Debt can increase EPS, but shareholders face higher risk (demanding
higher compensation).
 Potential Value Decrease: Despite higher EPS, high debt can decrease firm value
due to increased financial distress risk.
 Long-Term vs. Short-Term: The EPS criterion frequently prioritizes short-term
gains over long-term value maximization, where the risk-return trade-off plays a
crucial role.

Shortcomings of EPS as a Financing Decision Criterion

 The short-term focus ignores the long-term perspectives of financing decisions.


 The failure to address the risk-return trade-off contrasts with the wealth maximization
principle.
 Important Performance Measure but Not a Decision Criterion: The criterion is useful
for evaluation purposes, not for making financing decisions.
Practical Application of EPS in Financing Decisions
 Initial Evaluation: Use EPS to compare alternative financial plans' short-term
impact.
 Ultimate Decision: Prioritize long-term share value maximization, considering
shareholders' best interests.
 Communication: If chosen plans negatively impact short-term EPS, clearly
communicate the rationale to investors.

Limitations of EBIT-EPS Analysis

1. Arbitrary Accounting Assumptions do not accurately reflect economic profits.


2. It ignores the Time Value of Money by not taking into account the timing of cash
flows.
3. Ignores Risk (Variability of EPS): Concentrate solely on the expected EPS, rather
than its variability

You might also like