EBIT/EPS Analysis

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Glossary

EBIT - Earnings Before Interest and Taxes.  Accountants like to use the term Net Operating Income for this income statement item, but finance people usually refer to it as EBIT (pronounced as it is spelled - E, B, I, T).  Either way, on an income statement, it is the amount of income that a company has after subtracting operating expenses from sales (hence the term net operating income).  Another way of looking at it is that this is the income that the company has before subtracting interest and taxes (hence, EBIT).

EAT - Earnings After Taxes.  Accountants call this Net Income or Net Profit After Taxes, but finance people usually refer to it as EAT (pronounced E, A, T).

EPS - Earnings Per Share.  This is the amount of income that the common stockholders are entitled to receive (per share of stock owned).  This income may be paid out in the form of dividends, retained and reinvested by the company, or a combination of both. (It is pronounced E, P, S).


The Analysis

I need to raise additional money by issuing either debt, preferred stock, or common stock.   Which alternative will allow me to have the highest earnings per share?

This question calls for an EBIT/EPS analysis.  Simply put, this simply means that we will calculate what our earnings per share will be at various levels of sales (and EBIT).

Actually, it isn't necessary to start with sales.  Since a company's EBIT, or net operating income, isn't affected by how the company is financed, we can skip down the income statement to the EBIT line and begin there.  In other words,

  1. we assume a certain level of sales,
  2. calculate our estimated EBIT at that level, and
  3. then calculate what our EPS will be for each alternative form of financing (debt, preferred stock, and common stock).

An Illustration

For example, let's assume that the company:

  1. is currently financed entirely with common stock (i.e., no debt and no preferred stock).  The firm has 2,000 shares of common stock outstanding.
  2. currently pays no common stock dividend; all earnings are retained and reinvested into the company.
  3. needs to raise $50,000 in new money.  As financial manager, you want to know which financing alternative should be used.
  4. is in the 35% tax bracket.

To raise the $50,000, you are considering three alternatives:

  1. common stock - The company can sell additional shares at the current price of $50 per share.  This means that 1,000 new shares of common stock will need be to be sold ($50,000/$50 per share).
  2. preferred stock - The dividend yield on preferred stock will have to be 7.3% of the amount of money raised.  (The preferred can be sold for $40 per share.) The number of shares of common stock will remain unchanged.
  3. debt - The interest rate on any new debt will be 4% per year.  The number of shares of common stock will remain unchanged.

Let's pick a beginning level for EBIT of $10,000.  We can then calculate what the earnings per share will be for each financing alternative.

Common
Stock  
Preferred
Stock  

Debt 
   Price per share $50.00 $40.00 N/A
   Annual Rate N/A 7.3% 4.0%
   Common Stock $100,000 $100,000 $100,000
+ Additional Funds + 50,000 + 50,000 + 50,000
   Total Funds $150,000 $150,000 $150,000
 
  EBIT (Net Operating Income) $10,000 $10,000 $10,000
- Interest Expense (@4%) - 0 - 0 - 2,000
  Earnings Before Taxes 10,000 10,000 8,000
- Taxes (@35%) - 3,500 - 3,500 - 2,800
  EAT (Net Income) 6,500 6,500 5,200
- Preferred Dividends (@7.3%) - 0 - 3,650 - 0
  Earnings Available to Common (EATC) 6,500 2,850 5,200
  No. of Common Shares 3,000 2,000 2,000
  Earnings Per Share (EATC/# of shares).) $2.17 $1.43 $2.60

The above table shows us the earnings per share at an EBIT level of $10,000.  If sales are sufficiently high to give us an EBIT level of $10,000, then our EPS will be highest by issuing debt, next highest by issuing common stock, and lowest by issuing preferred stock.

However, we would eventually like to draw a graph of the EPS over a range of sales and EBIT.  This will allow us to understand the relationship between sales and EPS more fully.  As sales (and EBIT) increase, what will happen to earnings per share?

This is easily answered - we just repeat the above table for a different level of EBIT.  Let's assume that we don't think that our company's EBIT will fall below 2,000, so we can reproduce the table for that level of EBIT.  If we think that the highest value for EBIT during the next few years will be $30,000, then we might choose that level also.  While we're at it, let's throw in an EBIT of $20,000 also.  In other words, we will construct the above table for four values of EBIT:  $2,000, $10,000, $20,000 and $30,000.

The EBIT/EPS Graph

Once the tables have been constructed, we can draw the graph below. We simply plot the earnings per share under each alternative for each of our EBIT levels and connect the dots to draw the lines.

Relationships

Notice the following points:

  1. The preferred stock line is parallel to the debt line and lies below the debt line.  This will always be the case because debt has two distinct advantages over preferred stock:

  1. debt is the cheaper form of financing (i.e., the interest rate is less than the preferred dividend yield) because it enjoys greater protection in the event of bankruptcy or default), and
  2. interest on the debt is tax-deductible and preferred stock dividends are not tax-deductible.

This means that the EPS will always be higher under debt financing than under preferred stock financing.  Since both options pay a fixed rate (e.g., 4% and 7.3%), they offer similar effects of leverage - leading to the parallel lines above.  Preferred stock may offset this quantitative advantage with some qualitative ones (less restrictive provisions, etc.), but debt financing will always offer the higher earnings per share - a big advantage.

Since common stock financing offers a smaller degree of leverage, the slope of the common stock line is less than the other two lines. This leads to two "crossover points" where the common stock line crosses the other two lines.  These are indifference points.

  1. At an EBIT level of $6,000, you would be indifferent between common stock financing and debt financing.  Both will give you the same EPS (of $1.30 per share).
  2. At an EBIT level of $16,800, you would be indifferent between common stock financing and preferred stock financing.  Both will give you the same EPS (of $3.64 per share). However, this point is relatively unimportant since preferred stock won't likely be used by the company (since using debt always yields a higher EPS than preferred stock).

Summary

So which of the three financing alternatives should we use to raise the $50,000?  It all depends on our sales forecast.  We estimate the future level of sales and calculate our expected level of EBIT for this sales level.

If the expected level of EBIT is:

What if the forecasted sales level is equal to (or very close to) the indifference point of $6,000?  Then you would not make the decision based on the basis of EPS.  There are a number of qualitative factors that will increase in importance and you would tend to weigh these factors closely in making the debt vs. equity decision.

We would not consider using preferred stock financing at all unless there is some compelling reason to do so.  There may be reasons for doing this - to avoid restrictive debt covenants, to gain greater flexibility, to avoid using up all of your debt capacity at the present time, etc.  However, from a quantitative standpoint, EPS under debt financing will always be higher than the preferred stock alternative.