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• Effect of leverage
• Favorable r > kd
• Unfavorable r < kd
• Neutral r = kd
EBIT–EPS ANALYSIS
• One useful way of examining the effect of financial
leverage is to analyze the behavior of EPS with
varying levels of EBIT under alternative financing
plans. As noted earlier, the formula to calculate EPS
is:
• EPS = (X –R) (1 – t) / N
a bx EPS = a + bx
0 (0. 05) (Rs. 20) = Rs. 1 Rs 1
0 (0. 05) (Rs. 40) = Rs. 2 Rs 2
0 (0. 05) (Rs. 60) = Rs. 3 Rs 3
0 (0. 05) (Rs. 80) = Rs. 4 Rs 4
0 (0.05) (Rs. 100)= Rs. 5 Rs 5
0 (0.05) (Rs. 120)= Rs. 6 Rs 6
0 (0.05) (Rs.140) = Rs. 7 Rs 7
0 (0.05) (Rs.150) = Rs. 7.5 Rs 7.5
Table 5: EPS Calculation for Financial Plan - II
a bx EPS=a+bx
-3 (0. 1) (Rs. 20) = Rs. 2 Rs(-)1
-3 (0. 1) (Rs, 40) = Rs. 4 Rs 1
-3 (0. 1) (Rs. 60) = Rs. 6 Rs 3
-3 (0. 1) (Rs. 80) = Rs. 8 Rs 5
-3 (0.1) (Rs.100) = Rs.10 Rs 7
-3 (0.1) (Rs.120) = Rs.12 Rs 9
-3 (0.1) (Rs.140) = Rs.14 Rs 11
-3 (0.1) (Rs.150) = Rs.15 Rs 12
Table 6: EPS Calculation for Financial Plan - III
a bx EPS=a+bx
-12 (0. 25) (Rs. 20) = Rs. 5 Rs(-)7
-12 (0. 25) (Rs, 40) = Rs. 10 Rs (-)2
-12 (0. 25) (Rs. 60) = Rs. 15 Rs 3
-12 (0. 25) (Rs. 80) = Rs. 20 Rs 8
-12 (0. 25) (Rs.100) = Rs.25 Rs 13
-12 (0. 25) (Rs.120) = Rs.30 Rs 18
-12 (0. 25) (Rs.140) = Rs.35 Rs 23
-12 (0. 25) (Rs.150) = Rs.37.5 Rs 25.5
• A comparison of tables 4, 5 and 6
indicates that EPS of Financial Plan
which employs more financial leverage,
increases at a faster rate than that of
financial plan which employs less
financial leverage. But at low level of
EBIT the danger of reduced EPS is
more in case of financial plans
employing more leverage.
GRAPHIC PRESENTATION OF
EBIT – EPS ANALYSIS
• As noted earlier:
• EPS = -(1 – t) R/N + (1 – t) X/N
• = a + bx
• Conclusion:
1. Shareholders will benefit by the use of Financial leverage if r
> kd
2. Shareholders will reduce EPS if r < kd.
3. Their earnings will not be affected by the level of leverage if
r = kd.
Figure 1
• II (D=50%)
• I (D=0)
• 30 48 60 80 100 X
• 3% 4.8% 6% 8% 10%
2% 20 1 -1 -7
4% 40 2 1 -2
6% 60 3 3 3
8% 80 4 5 8
10 % 100 5 7 13
12 % 120 6 9 18
14 % 140 7 11 23
15 % 150 7.5 12 25.5
• When EBIT increase from 120 to 140
• EPS increase from
• Rs. 6 to 7 Financial Plan – I
• Rs. 9 to 11 Financial Plan – II
• Rs. 18 to 23 Financial Plan – III
• Assumption:
• Total costs = Total Fixed cost + Total Variable cost.
• When a cost changes in direct proportion to changes in volume, it is
called variable cost. Variable costs vary in a proportionate manner
with volume. Mathematically, a liner relationship exists between a
variable cost and volume.
•
• cost
• Total variable cost
• volume
• When a cost does not change with change in volume, it is called fixed cost. Fixed costs remain at the same level
irrespective of the changes in volume. It is the total fixed cost which is constant.
• cost
• Fixed cost
• volume
• cost
• &
• revenue
How to calculate Break – Even Quantity (QBE )?
• We know,
• Total Cost = T. Variable Cost + T. Fixed Cost
• Or T.C = T.VC + F = V.Q + F
• where, V is variable cost per unit, Q is quantity, and F is total fixed
cost.
Situation – I Situation – II
Low Automation High Automation
Price per product Rs 8 Rs 8
(Unit) P
• The degree of operating and financial leverage can be combined to see the effect of
total leverage on EPS associated with a given change in sales.
• Again when Q changes from 100 unit to 105 units, EBIT changes
from Rs. 120 to Rs. 140, and EPS changes from;
• Rs. 6 to Rs. 7 (Fin. Plan – I, when D = 0)
• Rs. 9 to Rs. 11 (Fin. Plan – II, when D = 50%)
• Rs. 18 to Rs. 23 (Fin. Plan – III, When D = 80%).
0% Rs2.40 Rs1.70
10 2.55 1.88
20 2.72 2.13
30 2.91 2.42
40 3.12 2.83
50 3.18 3.39
60 3.03 4.24
Expected EPS for alternative capital structures
• 3.18
E
x
SPE det c epx E
• Financial Risk
• 1.70
• Business Risk
SPEf o DS