Ebit Eps Analysis: Three Recent Graduates Of Computer Scienc

Ebit Eps Analysis Three Recent Graduated Of The Computer Science Pro

EBIT-EPS analysis - Three recent graduated of the computer science program at the University of TN are forming a company that will write and distribute new application software for the iPhone. Initially, the corporation will operate in the southern region of Tennessee, Georgia, NC, and SC. A small group of private investors in the Atlanta, Georgia area is interested in financing the startup company, and two financing plans have been put forth for consideration. The first plan (Plan A) is an all-common equity capital structure, raising $2.1 million by selling common stock at $20.00 per share. Plan B involves financial leverage, with $1.3 million raised by selling bonds with an effective interest rate of 10.7% per annum, and the remaining $0.8 million raised by issuing common stock at $20.00 per share. The use of financial leverage is considered a permanent part of the firm’s capitalization, so no fixed maturity date is needed for the analysis. A 30% tax rate is deemed appropriate for the analysis.

The assignment involves: (a) finding the EBIT indifference level associated with the two financing plans, and (b) determining which plan will generate the higher EPS, given that the long-term EBIT is projected to be above $332,000 annually. The specific question is: what is the EBIT indifference level associated with the two financing plans? The EBIT indifference level is to be rounded to the nearest dollar.

Paper For Above instruction

The analysis of financing strategies using EBIT-EPS analysis is vital in understanding the impact of different capital structures on the company's profitability ratios, particularly when evaluating the effectiveness of leverage versus an all-equity structure. For the nascent software company formed by recent computer science graduates, selecting the optimal financing plan involves calculating the EBIT (Earnings Before Interest and Taxes) level at which both plans yield equal EPS (Earnings Per Share). This EBIT indifference point allows management to understand the risk and growth implications associated with each financing strategy, guiding long-term decision-making.

Calculating the EBIT Indifference Level

Plan A, being an all-equity structure, involves no interest expense, thus its EPS depends solely on net income and the number of shares outstanding. The total equity capital raised is $2.1 million, with each share costing $20, resulting in 105,000 shares (2,100,000 / 20).

Plan B, featuring leverage, raises $1.3 million via bonds at 10.7% interest, and $0.8 million through stock issuance at $20 per share. The bond interest expense annually is calculated as:

Interest Expense = 1,300,000 * 10.7% = $138,100

The number of shares issued for equity in Plan B is:

Number of shares = 800,000 / 20 = 40,000

Total shares in Plan B = 40,000

The total number of shares remains constant, but the interest expense affects net income.

EPS Calculation

For Plan A, EPS is calculated as:

EPS_A = (EBIT - Taxes) / SharesOutstanding

With taxes a rate of 30%, net income is EBIT (1 - 0.3) = 0.7 EBIT, so:

EPS_A = (0.7 * EBIT) / 105,000

Similarly, for Plan B, interest expense reduces EBIT to EBIT - Interest. Taxes are calculated on EBIT - Interest:

Net Income = (EBIT - Interest) * (1 - 0.3)

EPS_B = [(EBIT - Interest) * (1 - 0.3)] / 40,000

Setting EPS_A equal to EPS_B to find the indifference EBIT:

(0.7 EBIT) / 105,000 = [(EBIT - 138,100) 0.7] / 40,000

Cross-multiplied to solve for EBIT:

0.7 EBIT 40,000 = 105,000 0.7 (EBIT - 138,100)

Simplify both sides:

28,000 EBIT = 73,500 (EBIT - 138,100)

Expand the right side:

28,000 EBIT = 73,500 EBIT - 73,500 * 138,100

Bring all EBIT terms to one side:

28,000 EBIT - 73,500 EBIT = -73,500 * 138,100

-45,500 EBIT = -73,500 138,100

Divide both sides by -45,500:

EBIT = (73,500 * 138,100) / 45,500

Calculate numerator:

73,500 * 138,100 = 10,153,350,000

Divide:

EBIT ≈ 10,153,350,000 / 45,500 ≈ 223,128.57

Conclusion

The EBIT indifference level between the two financing plans is approximately $223,129, rounded to the nearest dollar. This is the level of EBIT where both plans will produce the same EPS, given the difference in leverage and interest expenses.

Implications for the Company

Since the company's long-term EBIT is projected to be above $332,000 annually, it indicates that the leveraged plan (Plan B) will likely produce higher EPS once EBIT surpasses the indifference level. Leverage enhances EPS in favorable EBIT conditions because fixed interest expenses are paid regardless of EBIT, so above the indifference EBIT, the tax shield provided by interest expense magnifies the net income attributable to equity holders. Conversely, if EBIT falls below this point, the all-equity plan (Plan A) becomes more advantageous because it avoids interest obligations that could further diminish net income.

Limitations and Considerations

While the EBIT-EPS analysis provides vital insights, it assumes stable EBIT levels and does not account for operational risks or changes in market conditions. The use of leverage, while beneficial in high EBIT scenarios, increases financial risk, especially if EBIT drops below the indifference point. This analysis underscores the importance of forecasting EBIT accurately and considering risk tolerance when choosing a capital structure.

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