EBIT-EPS ANALYSIS

This mean examining the effect of leverage on earning per share. The companies with high level of earnings before interest and taxation (EBIT) can make good use of leverage ( use of fixed cost securities ) to increase return to shareholders. Example:ABC Ltd. Wanted to purchase fixed assets worth Rs. 80 lacs for execution of a project. The company has a number of options for financing its project. we take two options as: Rising entire Rs. 80 lacs as equity Raising Rs. 30 lacs as equity capital and Rs. 50 lacs as debt @18% Raising Rs. 30 lacs as equity and Rs. 50 lacs as preferance shares at 18% divident. The company is required to pay dividend @20% to equity shareholders as other companies of this type were paying this much return and investors will subscribe to their shares only if they hope to get this much return. The taxation rate for the company is 40%. The earning power of ABC Ltd. Is 40%( before taxes and interest). Rs. 80 lacs as share capital Rs. 30 lacs as sharecapital plus Rs. 50 lacs as debt @ 18% 30 lacs are equity share capital and 50 lacs as preference share @18%

Earning on assets of Rs. 80 lacs @40% Less Interest : 18% on Rs. 50 lacs Earning after Interest Taxes @ 40 %

32 32 12.8

32 9 23 9.20

32 32 12.8

Earning after taxes Less preference dividend Earning available to equity shareholders Earning after interest and taxes as % of share capital

19.2 19.2 24%

13.80 13.80 46%

19.2 9 10.2 34%

If we analysis the result it is seen that the net return on equity is 24% when no debt is used but it is 46% when debt is used and it is 34% when preference share capital is used. Why it has come down even when the cost of debt and preference capital is same. It is because the interest on debt is an expense and therefore tax deductible while the preference dividend is not an expense and is not tax deductible. Supposing in the above example the earning power of ABC Ltd. Is only 15%. Rs. 80 lacs as share capital Rs. 30 lacs as sharecapital plus Rs. 50 lacs as debt @ 18% 30 lacs are equity share capital and 50 lacs as preference share of Rs.10 each at 12% 12

Earning on assets of Rs. 80 lacs @15% Less Interest : 18% on Rs. 50 lacs Earning after Interest Taxes @40% Earning after taxes

12

12

12 4.8 7.2

3 1.20 1.8

12 4.8 7.2

Less preference dividend Earnings available to equity shareholders Earning after interest and taxes as % of share capital

7.2

1.8

6 1.2

9%

6%

4%

In the above case the use of debt has reduced the earning % of shareholders. Because:in this case the earning power (15%) of the company is less than the cost of debt (18%), therefore the return to the shareholder has been reduced as the company has not able to earn the cost of debt. So if the chances of earning more than the cost of debt is there then the use of debt will be beneficial to the share holder and if it not then it will reduce the earning available to shareholders