What are some limitations of EPS/EBIT analysis?

Question

What are some limitations of EPS/EBIT analysis?

Answer 1

The EBIT-EPS approach is based upon the assumption that the firm, by attempting to maximize earnings per share, will also maximize the owners' wealth.  The theoretical approach described in 12-12 evaluates capital structure based upon the minimization of the overall cost of capital and maximizing value; the EBIT-EPS approach involves selecting the capital structure providing maximum earnings per share, which is assumed to be consistent with the maximization of share price.  This approach is believed to indirectly be consistent with wealth maximization, since earnings per share and share price are believed to be closely related.  It is used to select the best of a number of possible capital structures, rather than to determine an "optimal capital structure." The financial breakeven point is the level of EBIT at which the firm's earnings per share would equal zero.  The financial breakeven point can be determined by finding the before-tax cost of interest and preferred dividends.  Letting I = interest, PD = preferred dividends, and t = the tax rate, the expression for the financial break-even point is:



The following graph illustrates this concept.

Financial Breakeven



EPS

($)

EBIT ($)

12-14 It is very unlikely that the two objectives of maximizing value and maximizing EPS would lead to the same conclusion about optimal capital structure.  Generally, the optimal capital structure will have a lower percentage of debt under wealth maximization than with EPS maximization.  This is because maximization of EPS fails to consider risk.

12-15 Basically, the firm should find the optimal capital structure that balances risk and return factors to maximize share value.  This requires estimates of required rates of return under different levels of risk: the estimate of risk associated with each level of debt and the value of the firm under each level of debt given the risk.  The firm should then choose the one that maximizes its value.  In addition to quantitative considerations, the firm should take into account factors related to business risk, agency costs, and the asymmetric information.  These include 1) revenue stability, 2) cash flow, 3) contractual obligations, 4) management preferences, 5) control, 6) external risk assessment, and 7) timing.



SOLUTION TO PROBLEMS

12-1 LG 1:  Breakeven Point–Algebraic

Q = FC ¸ (P - VC)

Q = $12,350 ¸ ($24.95 - $15.45)

Q = 1,300

12-2 LG 1:  Breakeven Comparisons–Algebraic

a. Q = FC ¸ (P - VC)

Firm F:

Firm G:

Firm H:

b. From least risky to most risky: F and G are of equal risk, then H.  It is important to recognize that operating leverage is only one measure of risk.

12-3 LG 1:  Breakeven Point–Algebraic and Graphic

a. Q = FC ¸ (P - VC)

Q = $473,000 ¸ ($129 - $86)

Q = 11,000 units



b.

Graphic Operating Breakeven Analysis

Cost/Revenue

($000)



Sales (Units)

12-4 LG 1:  Breakeven Analysis

a.

b. Total operating costs = FC + (Q x VC)

Total operating costs = $73,500 + (21,000 x $10.48)

Total operating costs = $293,580

c. 2,000 x 12 = 24,000 CDs per year.  2,000 records per month exceeds the operating breakeven by 3,000 records per year.  Barry should go into the CD business.

d. EBIT = (P x Q) - FC - (VC x Q)

EBIT = ($13.98 x 24,000) - $73,500 - ($10.48 x 24,000)

EBIT = $335,520 - $73,500 - $251,520

EBIT = $10,500

12-5 LG 1:  Breakeven Point–Changing Costs/Revenues

a. Q = F ¸ (P - VC) Q = $40,000 ¸ ($10 - $8) = 20,000 books

b. Q = $44,000 ¸ $2.00 = 22,000 books

c. Q = $40,000 ¸ $2.50 = 16,000 books

d. Q = $40,000 ¸ $1.50 = 26,667 books

e. The operating breakeven point is directly related to fixed and variable costs and inversely related to selling price.  Increases in costs raise the operating breakeven point, while increases in price lower it.

12-6 LG 1:  Breakeven Analysis

a.

b. Sales $10,000

Less:

  Fixed costs 4,000

  Variable costs ($6 x 1,500) 9,000

EBIT -$ 3,000

c. Sales $15,000

Less:

  Fixed costs 4,000

  Variable costs ($6 x 1,500) 9,000

EBIT $ 2,000

d.

e. One alternative is to price the units differently based on the variable cost of the unit.  Those more costly to produce will have higher prices than the less expensive production models.  If they wish to maintain the same price for all units they may have to reduce the selection from the 15 types currently available to a smaller number which includes only those that have variable costs of $6 or less.

12-7 LG 2:  EBIT Sensitivity

a. and b.

8,000 units 10,000 units 12,000 units

Sales $72,000 $90,000 $108,000

Less:  Variable costs 40,000 50,000 60,000

Less:  Fixed costs   20,000   20,000   20,000

EBIT $12,000 $20,000 $28,000

c. Unit Sales 8,000 10,000 12,000

Percentage (8,000 - 10,000) ¸ 10,000 (12,000 - 10,000) ¸ 10,000

change in

unit sales = - 20% 0 = + 20%

Percentage (12,000 - 20,000) ¸ 20,000 (28,000 - 20,000) ¸ 20,000

change in

EBIT = -40% 0 = + 40%

d. EBIT is more sensitive to changing sales levels; it increases/decreases twice as much as sales.

12-8 LG 2:  Degree of Operating Leverage

a.

b.

9,000 units 10,000 units 11,000 units

Sales $571,500 $635,000 $698,500

Less:  Variable costs 144,000 160,000 176,000

Less:  Fixed costs 380,000 380,000 380,000

EBIT $  47,500 $  95,000 $142,500

c.

9,000 units 10,000 units 11,000 units

Change in Unit Sales - 1,000 0 + 1,000



% Change in Sales -1,000 ¸ 10,000 = 0 1,000 ¸ 10,000 =

- 10% + 10%



Change in EBIT -$47,500 0 +$47,500



% Change in EBIT -$47,500 ¸ 95,000 0 $47,500 ¸ 95,000

- 50% + 50%

d. 9,000 units 11,000 units

- 50 ¸ - 10 = 5 50 ¸ 10 = 5

e.





12-9 LG 2:  Degree of Operating Leverage–Graphic

a.

b.









c.

DOL versus Unit Sales



Degree of

Operating

Leverage

Unit Sales

d.

At the operating breakeven point, the DOL is infinite.

e. DOL decreases as the firm expands beyond the operating breakeven point.

12-10 LG 2:  EPS Calculations

(a) (b) (c)

EBIT $24,600 $30,600 $35,000

Less:  Interest     9,600     9,600     9,600

Net profits before taxes $15,000 $21,000 $25,400

Less:  Taxes     6,000     8,400    10,160

Net profit after taxes $9,000 $12,600 $15,240

Less:  Preferred dividends     7,500     7,500     7,500

Earnings available to   common shareholders $1,500 $5,100 $7,740

EPS (4,000 shares) $0.375 $1.275 $1.935

12-11 LG 2:  Degree of Financial Leverage

a.

EBIT $80,000 $120,000

Less:  Interest   40,000   40,000

Net profits before taxes $40,000 $80,000

Less:  Taxes (40%)   16,000   32,000

Net profit after taxes $24,000 $48,000



EPS (2,000 shares) $12.00 $24.00

b.



c.

EBIT $80,000 $120,000

Less:  Interest   16,000   16,000

Net profits before taxes $64,000 $104,000

Less:  Taxes (40%)   25,600   41,600

Net profit after taxes $38,400 $62,400



EPS (3,000 shares) $12.80 $20.80



12-12 LG 2, 5:  DFL and Graphic Display of Financing Plans

a.



b.

Graphic Display of Financing Plans



EPS

($)

EBIT ($000)

c.

d. See graph

e. The lines representing the two financing plans are parallel since the number of shares of common stock outstanding is the same in each case.  The financing plan, including the preferred stock, results in a higher financial breakeven point and a lower EPS at any EBIT level.

12-13 LG 1, 2:  Integrative–Multiple Leverage Measures

a.

b.



c. EBIT = (P x Q) - FC - (Q x VC)

EBIT = ($1.00 x 400,000) - $28,000 - (400,000 x $0.84)

EBIT = $400,000 - $28,000 - $336,000

EBIT = $36,000





d.





DTL = DOL x DFL

DTL = 1.78 x 1.35 = 2.40

The two formulas give the same result.

12-14 LG 2:  Integrative–Leverage and Risk

a.



DTLR = 1.25 x 1.71 = 2.14

b.



DTLR = 1.71 x 1.25 = 2.14

c. Firm R has less operating (business) risk but more financial risk than Firm W.

d. Two firms with differing operating and financial structures may be equally leveraged.  Since total leverage is the product of operating and financial leverage, each firm may structure itself differently and still have the same amount of total risk.

12-15 LG 1, 2:  Integrative–Multiple Leverage Measures and Prediction

a. Q = FC ¸ (P - VC) Q = $50,000 ¸ ($6 - $3.50) = 20,000 latches

b. Sales ($6 x 30,000) $180,000

Less:

  Fixed costs 50,000

  Variable costs ($3.50 x 30,000) 105,000

EBIT 25,000

  Less interest expense 13,000

EBT 12,000

  Less taxes (40%) 4,800

Net profits $7,200

c.



d.



e. DTL = DOL x DFL = 3 x 75.08 = 225.24

f.

% Change in EBIT = % change in sales x DOL = 50% x 3 = 150%

New EBIT = $25,000 + ($25,000 x 150%) = $62,500

% Change in net profit = % change in sales x DTL = 50% x 225.24 = 11,262%

New net profit = $7,200 + ($7,200 x 11,262%) = $7,200 + $810,864 =$818,064

12-16 LG 3:  Various Capital Structures

Debt Ratio Debt Equity

10% $100,000 $900,000

20% $200,000 $800,000

30% $300,000 $700,000

40% $400,000 $600,000

50% $500,000 $500,000

60% $600,000 $400,000

90% $900,000 $100,000

Theoretically, the debt ratio cannot exceed 100%.  Practically, few creditors would extend loans to companies with exceedingly high debt ratios (>70%).

12-17 LG 3: Debt and Financial Risk

a. EBIT Calculation

Probability .20 .60 .20

Sales $200,000 $300,000 $400,000

Less: Variable costs (70%) 140,000 210,000 280,000

Less: Fixed costs    75,000   75,000   75,000

EBIT $(15,000) $15,000 $45,000

Less Interest    12,000   12,000   12,000

Earnings before taxes $(27,000) $3,000 $33,000

Less: Taxes    (10,800)   1,200   13,200

Earnings after taxes $(16,200) $1,800 $19,800