EBIT/EPS Analysis
The tax benefit of debt
Trade-off theory
Practical considerations in the
determination of capital structure
CAPITAL STRUCTURE
Lecture 2
EBIT/EPS Analysis
The tax benefit of debt
Trade-off theory
Practical considerations in the
determination of capital structure
CAPITAL STRUCTURE
Lecture 2
Kevin Campbell, University of Stirling, October 2006
2
2
Capital structure
Issues:
EBIT-EPS analysis
The tax shield benefit of debt
The trade-off theory of capital structure
Practical considerations that affect the
capital structure decision
Kevin Campbell, University of Stirling, October 2006
3
3
Business Risk vs Financial
Risk
Business risk is the variability of a
firm’s Earnings Before Interest and
Taxes (EBIT)
Financial risk arises from the use of
debt, which imposes a fixed cost in
the form of interest payments =
financial leverage
.
Kevin Campbell, University of Stirling, October 2006
4
4
EBIT/EPS analysis
Examines how different capital
structures affect earnings available to
shareholders (EPS) and risk
Question: for different levels of
EBIT
,
how does financial leverage affect
EPS
?
Kevin Campbell, University of Stirling, October 2006
5
5
Risk and the Income
Statement
Sales
Business – Variable costs
Risk – Fixed costs
EBIT
– Interest expense
Financial Earnings before taxes
Risk – Taxes
Net Income
EPS
= Net Income / no. of shares
Kevin Campbell, University of Stirling, October 2006
6
6
Current and Proposed Capital
Structures
CURRENT
PROPOSED
Total assets
$100 million $100 million
Debt
0 million
50 million
Equity
100 million
50 million
Share price
$25
$25
No. of shares
4,000,000 2,000,000
Interest rate
10%
10%
Note: for the purpose of simplicity we ignore taxes in this
example
Kevin Campbell, University of Stirling, October 2006
7
7
CURRENT CAPITAL STRUCTURE
No Debt, 4 Million Shares (millions
omitted)
EBIT 50%
EBIT 50%
EBIT 50%
EBIT 50%
BELOW
BELOW
ABOVE
ABOVE
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EBIT
$6.00
$12.00 $18.00
– Int 0.00
0.00 0.00
NI
$6.00
$12.00 $18.00
EPS
$ 1.50
$ 3.00
$ 4.50
Kevin Campbell, University of Stirling, October 2006
8
8
EBIT 50%
EBIT 50%
EBIT 50%
EBIT 50%
BELOW
BELOW
ABOVE
ABOVE
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EBIT
$6.00
$12.00 $18.00
– Int 5.00
5.00 5.00
NI
$1.00
$ 7.00
$13.00
EPS
$ 0.50
$ 3.50
$ 6.50
PROPOSED CAPITAL STRUCTURE
50% Debt (10% Coupon), 2 million
Shares
(millions
omitted)
Kevin Campbell, University of Stirling, October 2006
9
9
EBIT/EPS analysis
Current versus Proposed
Current
(no debt)
Proposed
(with
debt)
EPS
8
6
4
2
0
-2
-4
3
6
9 10
12
15
18
EBIT
For EBIT up to £10m,
equity financing is
best
For EBIT greater than
£10m, debt financing is
best
Kevin Campbell, University of Stirling, October 2006
10
10
The impact of financial
leverage
If EBIT is > 10, the levered capital
structure is preferable, ie EPS is higher
If EBIT is < 10, the unlevered capital
structure is preferable
Conclusion: whether or not debt is
beneficial is dependent upon the
capacity of firms to generate EBIT
Kevin Campbell, University of Stirling, October 2006
11
11
Indifference Level
The break-even EBIT occurs where the
lines cross
At that level of EBIT both capital
structures have the same EPS
Kevin Campbell, University of Stirling, October 2006
12
12
Set the two EPS values equal to each other
and solve for EBIT:
Current (unlevered) Proposed (levered)
(EBIT-Int)(1-T) = (EBIT-Int)(1-T)
S S
Since we assume T=0
(EBIT-Int)
=
(EBIT-Int)
S S
Breakeven Point
Kevin Campbell, University of Stirling, October 2006
13
13
Break-even EBIT
(millions
omitted)
10
$
20
$
2
)
5
($
4
4
2
2
)
1
.
50
($
4
EBIT
EBIT
EBIT
EBIT
EBIT
EBIT
EPS
EPS
L
U
Kevin Campbell, University of Stirling, October 2006
14
14
EPS
U
1.5 3.0 4.5
EPS
L
0.5 3.5 6.5
Spread
U
3.0
Spread
L
6.0 … that’s RISK
The impact of financial
leverage
EBIT 50%
EBIT 50%
EBIT 50%
EBIT 50%
BELOW
BELOW
ABOVE
ABOVE
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EXPECTED
EXPECTED
Kevin Campbell, University of Stirling, October 2006
15
15
The impact of financial
leverage
Leverage increases EPS if EBIT is high
enough.
At very low levels of EBIT, EPS can be
negative – as interest on debt has
priority over payments to shareholders.
Financial leverage produces a broader
spread of EPS values, ie shareholders’
returns are less predictable. This
represents added RISK.
Kevin Campbell, University of Stirling, October 2006
16
16
Summary: EBIT/EPS analysis
Indicates EBIT values when one capital
structure may be preferred over
another
Analysis of expected EBIT can focus on
the likelihood of actual EBIT exceeding
the indifference point
Kevin Campbell, University of Stirling, October 2006
17
17
Because interest on debt is
deducted from EBIT before the
amount of tax paid is calculated,
there is a benefit to debt … in the
form of lower corporate taxes
Consider an example …
The tax benefit of debt
Kevin Campbell, University of Stirling, October 2006
18
18
Firm
U
nlevered Firm
L
evered
No debt
$10,000 of 12% Debt
$20,000 Equity $10,000 in Equity
40% tax rate 40% tax rate
The tax benefit of debt
Both firms have same business risk and
EBIT of $3,000.
They differ only with respect to use of
debt.
U
has $20K in Equity &
L
has $10K in
Equity
Kevin Campbell, University of Stirling, October 2006
19
19
EBIT
$3,000
$3,000
Interest
0
1,200
EBT
$3,000
$1,800
Taxes (40%) 1 ,200 720
NI
$1,800
$1,080
ROE
9.0
%
10.8
%
Firm U Firm L
U; 1.8/20K =
9
% L; 1.08 / 10K =
10.8
%
The tax benefit of debt
Kevin Campbell, University of Stirling, October 2006
20
20
Why does financial leverage
increase the overall return to
investors?
Investors include both:
Debtholders (banks & bondholders)
Shareholders
Total return to investors:
U: NI = $1,800.
L: NI + Interest = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200
L: $720 Difference = $480
More EBIT goes to investors in Firm L
Kevin Campbell, University of Stirling, October 2006
21
21
Because the Government subsidizes debt,
and the tax savings go to the investors.
The tax savings are called the “
tax shield
”
and grows proportionally with the increase of
debt.
Why does financial leverage
increase the overall return to
investors?
Kevin Campbell, University of Stirling, October 2006
22
22
Debt versus Equity
Basic point. A firm’s
cost of debt
is always
less than its
cost of equity
.
Why?
debt has seniority over equity
debt has a fixed return
the interest paid on debt is tax-deductible.
It may appear a firm should use as much
debt and as little equity as possible due to
the cost difference … but this ignores the
potential problems associated with debt.
A Basic Capital Structure
Theory
Kevin Campbell, University of Stirling, October 2006
23
23
A Basic Capital Structure
Theory
There is a
trade-off
between the
benefits
of using debt and the
costs
of
using debt.
The use of debt creates a
tax shield
benefit
from the interest on debt.
The costs of using debt, besides the obvious
interest cost, are the additional
financial
distress costs
and
agency costs
arising from
the use of debt financing.
Kevin Campbell, University of Stirling, October 2006
24
24
The costs of
financial distress
associated with debt
Bankruptcy costs
including legal and
accounting fees and a likely decline in the
value of the firm’s assets
Financial distress may also cause
customers, suppliers, and management to
take actions harmful to firm value.
A Basic Capital Structure
Theory
Kevin Campbell, University of Stirling, October 2006
25
25
Agency costs
arise from conflicts between
shareholders and bondholders
When you lend money to a business, you are
allowing the shareholders to use that money in
the course of running that business.
Shareholders interests are different from your
interests, because
You (as lender) are interested in getting your
money back
Shareholders are interested in maximizing their
wealth
A Basic Capital Structure
Theory
Kevin Campbell, University of Stirling, October 2006
26
26
Agency costs
associated with debt:
Restrictive covenants meant to protect
creditors can reduce firm efficiency.
Monitoring costs may be expended to insure
the firm abides by the restrictive covenants.
As the level of debt financing increases, the
contractual and monitoring costs are
expected to increase.
A Basic Capital Structure
Theory
Kevin Campbell, University of Stirling, October 2006
27
27
Capital structure:
practical considerations
In addition to the variables described by
the trade-off theory of capital structure, a
variety of practical considerations also
affect a firm’s capital structure decisions:
Industry standards
Creditor and rating agency requirements
Maintaining excess borrowing capacity
Profitability and the need for funds
Managerial risk aversion
Corporate control
Kevin Campbell, University of Stirling, October 2006
28
28
Industry standards
It is natural to compare a firm’s capital
structure to other firms in the same
industry.
Business risk is a significant factor
impacting a firm’s capital structure and is
heavily influenced by a firm’s industry.
Evidence indicate firms’ capital structures
tend toward an industry average.
Practical considerations
Kevin Campbell, University of Stirling, October 2006
29
29
Creditor and Rating Agency Requirements
Firms need to abide by restrictive covenants,
which may include restrictions on the amount
of future debt.
Firms typically desire to appear financially
strong to potential creditors in order to
maintain borrowing capacity and low interest
rates.
Using less debt in capital structure helps to
maintain this appearance.
Practical considerations
Kevin Campbell, University of Stirling, October 2006
30
30
Maintaining Excess Borrowing
Capacity
Successful firms typically maintain
excess borrowing capacity.
This provides financial flexibility to react
to investment opportunities.
The maintenance of excess borrowing
capacity causes firms to use less debt
in their capital structure than otherwise.
Practical considerations
Kevin Campbell, University of Stirling, October 2006
31
31
Profitability and the Need for Funds
Profits can be paid out as dividends to
shareholders or reinvested in the firm.
If a firm generates high profits and
reinvests a large proportion back into
the firm, then it has a continuous
source of internal funding.
This will reduce the use of debt in the
firm’s capital structure.
Practical considerations
Kevin Campbell, University of Stirling, October 2006
32
32
Practical considerations
Managerial Risk Aversion
Well-diversified shareholders are likely to
welcome the use of financial leverage.
Management wealth is typically much
more dependent upon the success of the
company acting as their employer.
To the extent management can act on their
own desires, the firm is likely to have less
debt in its capital structure than is desired
by shareholders.
Kevin Campbell, University of Stirling, October 2006
33
33
Practical considerations
Corporate Control
Controlling owners may desire to issue
debt instead of ordinary shares since debt
does not grant ownership rights.
Firms with little financial leverage are
often considered excellent takeover
targets.
Issuing more debt may help to avoid a
corporate takeover.
Kevin Campbell, University of Stirling, October 2006
34
34
Summary
EBIT/EPS analysis
may be used to help
determine whether it would be better to
finance a project with debt or equity.
Firms must trade-off the
tax advantage
to
debt financing against the effect of debt on
firm risk
.
Because of the
tradeoff
between the tax
advantage to debt financing and risk, each
firm has an
optimal
capital structure.
Kevin Campbell, University of Stirling, October 2006
35
35
KONIEC
DZIĘKUJĘ ZA UWAGĘ
Kevin Campbell, University of Stirling, October 2006
36
36
Homework…
EBIT/EPS Analysis
A company is considering the following two capital structures:
Plan A:
sell 1,200,000 shares at £10 per share (£12 million total)
Plan B:
issue £3.5 million in debt (9% coupon) and sell 850,000
shares at £10 per share (£12 million total)
Assume a corporate tax rate of 50%
REQUIRED:
(a) What is the break-even value of EBIT?
(b) At this break-even value, what is the income statement for each
capital structure plan and the EPS?
(c) Draw a diagram to illustrate the trade-off between EBIT and EPS