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).
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,
For example, let's assume that the company:
To raise the $50,000, you are considering three alternatives:
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.
|Price per share||$50.00||$40.00||N/A|
|+ Additional Funds||+ 50,000||+ 50,000||+ 50,000|
|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.
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.
Notice the following points:
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:
- 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
- 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.
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:
less than $6,000, we would tend to use common stock financing. Our EPS will be higher than the other two alternatives as long as sales are weak enough to keep us below the $6,000 EBIT level. As sales and EBIT fall, the fact that we don't have to pay a fixed interest or dividend payment is a big advantage and offers the company a great deal of flexibility.
above $6,000, we would use tend to use debt financing. The EPS level is maximized by using debt as long as sales are high enough to keep us above the $6,000 EBIT level. As sales increase, the higher financial leverage causes EPS to rise at a much faster rate than common stock financing would do.
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.