EBIT EPS Analysis

EBIT-EPS
analysis
RISK AND UNCERTAINTY

There are two types of expectations individuals may have
about the future-
Certainty, and
uncertainty
Risk describes a situation where there is not just one
possible outcome, but an array of potential returns. Also
there are various probabilities for each of the probable
returns.
.
2
Risk refers to the variability in the actual returns vis--vis

the estimated returns, in terms of cash flows
Risk may be defined as the chance of future loss that can
be foreseen
Risk exists because of the inability of the decision-maker to
make perfect forecasts
Risk refers to a set of unique outcomes for a given event
which can be assigned probabilities while uncertainty refers
to the outcomes of a given event which are too unsecure to
be assigned probabilities
Types of Risk
Risk
Systematic Risk
Unsystematic Risk
1.
1.
2.
3.
4.
Interest Rate Risk

Market Risk
Purchasing Power Risk
Exchange Rate Risk
2.
Business Risk
a) Internal
Business
Risk
b) External
Business
Risk
Financial Risk
Unsystematic Risk
1. Business Risk is the variability in operating income due
operating conditions of the company. This can be divided
into two types
a. Internal Business Risk
Factors affecting Internal Business Risk are:
Fluctuation in Sale
Research and development
Personnel management
Fixed cost
Single product
b. External Business Risk

Result of operating conditions imposed on the firm
circumstances beyond its control.
Social and regulatory factors
Political Risk
Business cycle
2. Financial Risk
It refers to the variability in return due to capital structure.
Factors affecting capital structure decisions

Financial Leverage or Trading on Equity
Growth and Stability of Sales
Cost of Capital
Risk
Cash flows
Nature and Size of a Firm
Control
Flexibility
Capital market conditions
Legal Considerations
EBIT-EPS analysis: involves a comparison of alternative methods of

financing at various levels of EBIT.
Case: Suppose a firm has a capital structure of exclusively comprising
of ordinary shares amounting to Rs. 10,00,000. The firm now wishes to
raise additional Rs. 10,00,000 for expansion. The firm has four
alternative financial plans:
(a) It can raise the entire amount in the form of equity capital.
(b) It can raise 50% as equity capital and 50% as 5% debentures.
(c) It can raise entire amount as 6% debentures.
(d) It can raise 50% as equity capital and 50% as 5% preference
capital.
Further assume that existing EBIT are Rs. 1,20,000, tax

rate 35%, outstanding ordinary shares 10,000 and the
market price per share is Rs. 100 under all four
alternatives.
Which financing plan should the firm select.
If EBIT is (80,000, 1,00,000, 1,30,000, 1,60,000 and
2,00,000) calculate EPS.
Indifference point: is the EBIT level at which the EPS is the same for
two alternative financial plans.
The financial manager of a company has formulated various financial
plans to finance Rs. 30,00,000 requires to implement various capital
budgeting projects:
(i) Either equity capital of Rs. 30,00,000 or Rs. 15,00,000, 10%
debentures and Rs. 15,00,000 equity.
(ii) Either equity capital of Rs. 30,00,000 or 13% preference shares of
Rs. 10,00,000 and Rs. 20,00,000 equity.
(iii) Either equity capital of Rs. 30,00,000 or 13% preference capital of

Rs. 10,00,000 (subject to dividend tax of 10%), Rs. 10,00,000, 10%
debentures and Rs. 10,00,000 equity and
(iv) Either equity share capital of Rs. 20,00,000 and 10% debentures
of Rs. 10,00,000 or 13% preference share capital of Rs. 10,00,000,
10% debentures of Rs. 8,00,000 and Rs. 12,00,000 equity.
You are required to determine the indifference point for each financial
plan assuming 35% tax rate and the face value of equity share is Rs.
100.
ROI-ROE Analysis
Relationship between the Return on Investment (ROI)
& Return on Equity (ROE) for different level of financial leverage.
The influence of ROI & Financial Leverage on ROE is
mathematically as follows,
ROI = (EBIT/Total Assets)

ROE = [ROI+(ROI-r)D/E](1-t)
Where,
r = Cost of Debt
D/E = Debt-Equity Ratio
t = Tax rate
ROI-ROE Analysis
Problem
Korex Limited, requires an investment outlay of Rs. 100 million, is
Considering two capital structures:
Capital Structure A
Capital Structure B
Equity
100 Million
50 Million
Debt
0 Million
50 Million
Average cost of capital is fixed at 10%, the ROI(EBIT/Total Assets) may

vary widely. The Tax rate is 50%.
ROI-ROE Analysis
Capital Structure A
Capital Structure B
5% 10% 15% 20% 25%
5% 10% 15% 20% 25%
10
15
20
25
10
15
20
25
10
15
20
25
10
15
20
2.5 5
7.5
10
12.5
0 2.5
7.5
10
Tax
Profit after Tax 2.5 5
7.5
10
12.5
0 2.5
7.5
10
RIO
EBIT
Interest
Profit before
Tax
Return on
Equity
2.5% 5% 7.5% 10% 12.5%
0% 5% 10% 15% 20%
ROI-ROE Analysis
Looking at the relationship between ROI & ROE we find that,
The ROE under capital structure A is higher than the ROE under
capital structure B, when ROI is less than the cost of Debt.
The ROE under two capital structures is the same when ROI is
equal to the cost of Debt. Hence the indifference/breakeven value
of ROI is equal to the cost of debt.
The ROE under capital structure B is higher than the ROE under
Capital structure A, when ROI is more than the cost of Debt.
Mathematical Relationship
The influence of ROI and Financial Leverage on ROE is mathematically
as follows,
ROI = (EBIT/Total Assets)
ROE = [ROI+(ROI-r)D/E](1-t)
Applying the above equation to Korex Limited, when its D/E ration is 1,
we may calculate the value of ROE for two values of ROI, 15% & 20%.
ROI-ROE Analysis
ROI = 15%
ROE = [15+(15- 10)1](0.5)
= 10.0%
ROI = 20%
ROE = [20 +(20 - 10)1](0.5)
= 15.0%

EBIT EPS Analysis

Uploaded by

Copyright:

Available Formats

EBIT EPS Analysis

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

EBIT EPS Analysis

Uploaded by

Copyright:

Available Formats

EBIT-EPS

RISK AND UNCERTAINTY

Risk refers to the variability in the actual returns vis--vis

Interest Rate Risk

Research and development

b. External Business Risk

Social and regulatory factors

Factors affecting capital structure decisions

EBIT-EPS analysis: involves a comparison of alternative methods of

Further assume that existing EBIT are Rs. 1,20,000, tax

(iii) Either equity capital of Rs. 30,00,000 or 13% preference capital of

ROI = (EBIT/Total Assets)

Average cost of capital is fixed at 10%, the ROI(EBIT/Total Assets) may

5% 10% 15% 20% 25%

5% 10% 15% 20% 25%

2.5% 5% 7.5% 10% 12.5%

0% 5% 10% 15% 20%

You might also like