Unit 9: EBIT-EPS Analysis - Subjective Questions

Leverage refers to the use of fixed costs in a company's cost and capital structure to magnify the effect of changes in sales on operating profit and earnings per share.

The main forms of leverage are:

• Operating leverage: Arises from fixed operating costs such as rent, depreciation, and salaries.
• Financial leverage: Arises from fixed financial charges such as interest on debt and preference dividends.
• Combined leverage: Represents the joint effect of operating and financial leverage.

Significance of leverage:

• It can increase shareholders' returns when business conditions are favorable.
• It magnifies losses when sales or operating profit declines.
• It helps management evaluate business and financial risk.
• It assists in selecting an appropriate cost structure and financing mix.

Thus, leverage acts as a double-edged sword because it can increase both expected return and risk.

A company's operating costs can be divided into fixed costs and variable costs.

• Fixed costs remain constant within a relevant range of activity, irrespective of changes in output. Examples include rent, depreciation, and managerial salaries.
• Variable costs change directly with production or sales volume. Examples include direct materials and sales commissions.

The contribution and operating profit are calculated as:

A company with a high proportion of fixed operating costs has high operating leverage. A small change in sales then produces a larger change in EBIT. In contrast, a company relying mainly on variable costs generally has lower operating leverage and lower operating risk.

Operating leverage measures the sensitivity of earnings before interest and tax, or EBIT, to a change in sales. It arises because a company incurs fixed operating costs.

It is expressed as:

Causes:

• High depreciation due to capital-intensive production
• Fixed rent and lease expenses
• Fixed administrative and employee costs
• Automation and large production capacity

Implications:

• A high degree of operating leverage magnifies increases in EBIT when sales rise.
• It also magnifies decreases in EBIT when sales fall.
• High operating leverage therefore indicates high business risk.
• Operating leverage declines as sales move farther above the break-even point.

Operating leverage is useful for evaluating the effect of sales fluctuations on operating profitability.

The degree of operating leverage is defined as:

Let:

• = units sold
• = selling price per unit
• = variable cost per unit
• = fixed operating cost

Then:

For a small change in quantity, the change in EBIT is:

Therefore:

Substituting the relevant values:

Hence:

Since is contribution and is EBIT:

Step 1: Calculate contribution

Step 2: Calculate EBIT

Step 3: Calculate the degree of operating leverage

Step 4: Estimate the change in EBIT

The new EBIT will be:

Therefore, the degree of operating leverage is 2, and a increase in sales is expected to increase EBIT by , from to .

Operating leverage, break-even point, and business risk are closely related.

The break-even point is the level at which total contribution equals fixed operating costs:

At the break-even point, EBIT is zero. Since:

operating leverage becomes extremely high when EBIT is close to zero. As sales rise above the break-even point, EBIT increases and DOL generally declines.

Risk implications:

• High fixed operating costs produce a high break-even point.
• A high break-even point increases the possibility of operating losses during weak demand.
• High operating leverage makes EBIT more sensitive to sales fluctuations.
• This sensitivity is known as business risk.

Therefore, firms with high operating leverage must maintain sufficient sales volume to cover their fixed operating costs.

Financial leverage refers to the use of funds carrying fixed financial charges, especially debt and preference share capital, to increase the potential return available to equity shareholders.

Where only interest-bearing debt is present:

or:

Effect on shareholders:

• If the return earned on borrowed funds exceeds the after-tax cost of debt, debt can increase EPS.
• Interest is generally tax-deductible, creating a tax advantage.
• When EBIT falls, interest must still be paid, causing EPS to decline more sharply.
• Excessive debt increases the possibility of default and financial distress.

Thus, financial leverage can improve equity shareholders' returns but also increases financial risk.

The degree of financial leverage measures the responsiveness of EPS to a change in EBIT:

Assume that the company has interest expense , tax rate , and equity shares. Then:

Since and remain constant, the proportional sensitivity of EPS to EBIT gives:

Since :

If preference dividend is also payable, it must be converted into its pre-tax equivalent because preference dividends are paid from after-tax profit:

A larger fixed interest or preference dividend obligation results in a higher DFL and greater financial risk.

Step 1: Calculate earnings before tax

Step 2: Calculate the degree of financial leverage

Step 3: Estimate the change in EPS

Therefore, the degree of financial leverage is 1.25, and an increase in EBIT is expected to produce a increase in EPS, assuming the tax rate, number of shares, and other factors remain constant.

The effect of financial leverage depends on the relationship between the return earned on assets and the cost of borrowed funds.

• Favorable financial leverage: It exists when the return earned on borrowed funds exceeds their cost. The surplus accrues to equity shareholders, increasing EPS and return on equity.
• Unfavorable financial leverage: It exists when the return earned on borrowed funds is lower than the cost of debt. Interest absorbs more than the earnings generated by debt, reducing EPS.
• Neutral financial leverage: It exists when the return earned on borrowed funds equals their cost. Debt financing then has no material effect on equity shareholders' returns.

Financial leverage should not be evaluated solely by its potential to increase EPS. Management must also consider cash-flow stability, interest coverage, default risk, and the company's capacity to withstand a decline in EBIT.

Operating leverage and financial leverage differ as follows:

A company may have high operating leverage, high financial leverage, or both. Management should assess their joint effect because excessive use of both can create substantial total risk.

Combined leverage measures the effect of a change in sales on earnings per share. It captures the joint impact of fixed operating costs and fixed financial charges.

It is expressed as:

It can also be calculated as:

Where only interest-bearing debt exists:

Importance:

• It measures the company's total exposure to sales fluctuations.
• It combines business risk and financial risk.
• It helps management forecast the effect of sales changes on EPS.
• It assists in coordinating operating-cost and capital-structure decisions.
• A high DCL indicates that a small decline in sales can cause a large decline in EPS.

Therefore, combined leverage is a useful measure of the company's overall risk.

The degree of operating leverage is:

The degree of financial leverage is:

Multiplying the two measures gives:

The percentage change in EBIT cancels out, leaving:

Hence:

Using the component formulas:

After cancelling EBIT:

If EBT equals , then:

Step 1: Calculate variable costs and contribution

Step 2: Calculate EBIT and EBT

Step 3: Calculate leverage measures

Alternatively:

Step 4: Estimate the change in EPS

Therefore, DOL is 1.6, DFL is 1.25, DCL is 2, and EPS is expected to increase by .

A company's total risk depends on the interaction between operating and financial leverage.

• High operating leverage and high financial leverage: This is the riskiest combination. Sales volatility strongly affects EBIT, and changes in EBIT are further magnified into EPS changes.
• High operating leverage and low financial leverage: The company has substantial business risk but limits additional financial risk by using less debt.
• Low operating leverage and high financial leverage: Stable operating profits may permit the company to assume more debt, although fixed interest obligations still create financial risk.
• Low operating leverage and low financial leverage: This combination produces relatively low total risk but may provide lower opportunities to magnify shareholders' returns.

A company with high operating leverage should generally be cautious about assuming high financial leverage. The appropriate combination depends on sales stability, industry conditions, cash flows, asset structure, and management's risk tolerance.

EBIT-EPS analysis examines the relationship between earnings before interest and tax and earnings per share under alternative financing plans.

EPS is calculated as:

where is interest, is the tax rate, is preference dividend, and is the number of equity shares.

Objectives:

• Compare debt, preference share, and equity financing plans
• Identify the financing plan that maximizes EPS at an expected EBIT
• Determine the EBIT indifference point
• Evaluate the effect of financial leverage on shareholders' earnings

Procedure:

1. Identify the interest, preference dividend, tax rate, and equity shares under each plan.
2. Estimate EBIT for the relevant period.
3. Calculate EPS under every financing alternative.
4. Determine the indifference point between plans.
5. Compare EPS together with financial risk and coverage capacity.

The plan producing the highest EPS is not automatically optimal because risk and financial distress must also be considered.

The EBIT indifference point is the level of EBIT at which two financing plans produce the same EPS.

For Plan 1:

For Plan 2:

At the indifference point:

Therefore:

This equation is solved for , the indifference EBIT.

If there are no preference dividends, the equation becomes:

Since the same tax factor appears on both sides, it may be cancelled. Above or below the indifference point, the preferred financing plan depends on which plan produces the higher EPS. A debt-heavy plan often produces higher EPS above the indifference point and lower EPS below it.

Let the indifference EBIT be .

EPS under the equity plan:

EPS under the debt plan:

At the indifference point:

Cancelling and cross-multiplying:

EPS at the indifference point is:

Therefore, the EBIT indifference point is , and EPS under either plan is per share. Above this EBIT, the debt plan produces higher EPS; below it, the equity plan produces higher EPS.

Major assumptions:

• EBIT can be estimated with reasonable accuracy.
• Interest rates and tax rates remain constant.
• All earnings available to equity shareholders are reflected in EPS.
• The number of shares under each plan is known.
• Business risk remains unchanged across financing plans.
• Financing decisions do not materially affect operating performance.

Limitations:

• It emphasizes EPS maximization rather than shareholder wealth maximization.
• It does not directly consider market value, share price, or cost of capital.
• It may ignore default risk, financial distress, and debt-covenant restrictions.
• Expected EBIT is uncertain and may fluctuate significantly.
• Accounting EPS does not necessarily represent cash flow available to shareholders.
• The analysis may overlook financing flexibility and future borrowing capacity.
• Two plans producing the same EPS may involve substantially different levels of risk.

Therefore, EBIT-EPS analysis should be used with cash-flow analysis, coverage ratios, valuation methods, and risk assessment.

Leverage measures provide a sequential analysis of how sales changes affect EBIT and EPS.

Given:

A change in sales is expected to cause a change in EBIT in the same direction.

Given:

A change in EBIT is expected to cause a change in EPS in the same direction.

The combined leverage is:

Thus, a change in sales is expected to cause a change in EPS. For example, if sales decline by :

Interpretation:

• DOL indicates the company's business risk.
• DFL indicates its financial risk.
• DCL indicates total risk to equity earnings.

Management can reduce excessive total risk by lowering fixed operating costs, reducing debt, or maintaining a suitable balance between the two forms of leverage.