EBIT/EPS Analysis

The tax benefit of debt

Trade-off theory

Practical considerations in the

determination of capital structure

CAPITAL STRUCTURE

Lecture 2

Kevin Campbell, University of Stirling, October 2006

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Capital structure

Issues:



EBIT-EPS analysis



The tax shield benefit of debt



The trade-off theory of capital structure



Practical considerations that affect the
capital structure decision

Kevin Campbell, University of Stirling, October 2006

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3

Business Risk vs Financial
Risk



Business risk is the variability of a
firm’s Earnings Before Interest and
Taxes (EBIT)



Financial risk arises from the use of
debt, which imposes a fixed cost in
the form of interest payments =

financial leverage

.

Kevin Campbell, University of Stirling, October 2006

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4

EBIT/EPS analysis



Examines how different capital
structures affect earnings available to
shareholders (EPS) and risk



Question: for different levels of

EBIT

,

how does financial leverage affect

EPS

?

Kevin Campbell, University of Stirling, October 2006

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5

Risk and the Income
Statement

Sales

Business – Variable costs
Risk – Fixed costs

EBIT

– Interest expense

Financial Earnings before taxes
Risk – Taxes

Net Income

EPS

= Net Income / no. of shares

Kevin Campbell, University of Stirling, October 2006

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Current and Proposed Capital
Structures

CURRENT

PROPOSED

Total assets

$100 million $100 million

Debt

0 million

50 million

Equity

100 million

50 million

Share price

$25

$25

No. of shares

4,000,000 2,000,000

Interest rate

10%

10%

Note: for the purpose of simplicity we ignore taxes in this
example

Kevin Campbell, University of Stirling, October 2006

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CURRENT CAPITAL STRUCTURE

No Debt, 4 Million Shares (millions
omitted)

EBIT 50%

EBIT 50%

EBIT 50%

EBIT 50%

BELOW

BELOW

ABOVE

ABOVE

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EBIT

$6.00

$12.00 $18.00

– Int 0.00

0.00 0.00

NI

$6.00

$12.00 $18.00

EPS

$ 1.50

$ 3.00

$ 4.50

Kevin Campbell, University of Stirling, October 2006

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8

EBIT 50%

EBIT 50%

EBIT 50%

EBIT 50%

BELOW

BELOW

ABOVE

ABOVE

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EBIT

$6.00

$12.00 $18.00

– Int 5.00

5.00 5.00

NI

$1.00

$ 7.00

$13.00

EPS

$ 0.50

$ 3.50

$ 6.50

PROPOSED CAPITAL STRUCTURE

50% Debt (10% Coupon), 2 million
Shares

(millions

omitted)

Kevin Campbell, University of Stirling, October 2006

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9

EBIT/EPS analysis

Current versus Proposed

Current
(no debt)

Proposed
(with
debt)

EPS

8

6

4

2

0

-2

-4

3

6

9 10

12

15

18

EBIT

For EBIT up to £10m,
equity financing is
best

For EBIT greater than
£10m, debt financing is
best

Kevin Campbell, University of Stirling, October 2006

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10

The impact of financial
leverage



If EBIT is > 10, the levered capital
structure is preferable, ie EPS is higher



If EBIT is < 10, the unlevered capital
structure is preferable



Conclusion: whether or not debt is
beneficial is dependent upon the
capacity of firms to generate EBIT

Kevin Campbell, University of Stirling, October 2006

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11

Indifference Level



The break-even EBIT occurs where the
lines cross



At that level of EBIT both capital
structures have the same EPS

Kevin Campbell, University of Stirling, October 2006

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

Set the two EPS values equal to each other
and solve for EBIT:

Current (unlevered) Proposed (levered)

(EBIT-Int)(1-T) = (EBIT-Int)(1-T)

S S

Since we assume T=0

(EBIT-Int)

=

(EBIT-Int)

S S

Breakeven Point

Kevin Campbell, University of Stirling, October 2006

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Break-even EBIT

(millions

omitted)

10

$

20

$

2

)

5

($

4

4

2

2

)

1

.

50

($

4

















EBIT

EBIT

EBIT

EBIT

EBIT

EBIT

EPS

EPS

L

U

Kevin Campbell, University of Stirling, October 2006

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14

EPS

U

1.5 3.0 4.5

EPS

L

0.5 3.5 6.5

Spread

U

3.0

Spread

L

6.0 … that’s RISK

The impact of financial
leverage

EBIT 50%

EBIT 50%

EBIT 50%

EBIT 50%

BELOW

BELOW

ABOVE

ABOVE

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EXPECTED

EXPECTED

Kevin Campbell, University of Stirling, October 2006

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The impact of financial
leverage



Leverage increases EPS if EBIT is high
enough.



At very low levels of EBIT, EPS can be
negative – as interest on debt has
priority over payments to shareholders.



Financial leverage produces a broader
spread of EPS values, ie shareholders’
returns are less predictable. This
represents added RISK.

Kevin Campbell, University of Stirling, October 2006

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Summary: EBIT/EPS analysis



Indicates EBIT values when one capital
structure may be preferred over
another



Analysis of expected EBIT can focus on
the likelihood of actual EBIT exceeding
the indifference point

Kevin Campbell, University of Stirling, October 2006

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

Because interest on debt is
deducted from EBIT before the
amount of tax paid is calculated,
there is a benefit to debt … in the
form of lower corporate taxes



Consider an example …

The tax benefit of debt

Kevin Campbell, University of Stirling, October 2006

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Firm

U

nlevered Firm

L

evered

No debt

$10,000 of 12% Debt

$20,000 Equity $10,000 in Equity
40% tax rate 40% tax rate

The tax benefit of debt

Both firms have same business risk and
EBIT of $3,000.

They differ only with respect to use of

debt.

U

has $20K in Equity &

L

has $10K in

Equity

Kevin Campbell, University of Stirling, October 2006

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EBIT

$3,000

$3,000

Interest

0

1,200

EBT

$3,000

$1,800

Taxes (40%) 1 ,200 720
NI

$1,800

$1,080

ROE

9.0

%

10.8

%

Firm U Firm L

U; 1.8/20K =

9

% L; 1.08 / 10K =

10.8

%

The tax benefit of debt

Kevin Campbell, University of Stirling, October 2006

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Why does financial leverage
increase the overall return to
investors?



Investors include both:



Debtholders (banks & bondholders)



Shareholders



Total return to investors:



U: NI = $1,800.



L: NI + Interest = $1,080 + $1,200 = $2,280.



Taxes paid:



U: $1,200



L: $720 Difference = $480



More EBIT goes to investors in Firm L

Kevin Campbell, University of Stirling, October 2006

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

Because the Government subsidizes debt,
and the tax savings go to the investors.



The tax savings are called the “

tax shield

”

and grows proportionally with the increase of
debt.

Why does financial leverage
increase the overall return to
investors?

Kevin Campbell, University of Stirling, October 2006

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

Debt versus Equity



Basic point. A firm’s

cost of debt

is always

less than its

cost of equity

.

Why?



debt has seniority over equity



debt has a fixed return



the interest paid on debt is tax-deductible.



It may appear a firm should use as much

debt and as little equity as possible due to

the cost difference … but this ignores the

potential problems associated with debt.

A Basic Capital Structure
Theory

Kevin Campbell, University of Stirling, October 2006

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A Basic Capital Structure
Theory



There is a

trade-off

between the

benefits

of using debt and the

costs

of

using debt.



The use of debt creates a

tax shield

benefit

from the interest on debt.



The costs of using debt, besides the obvious
interest cost, are the additional

financial

distress costs

and

agency costs

arising from

the use of debt financing.

Kevin Campbell, University of Stirling, October 2006

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

The costs of

financial distress

associated with debt



Bankruptcy costs

including legal and

accounting fees and a likely decline in the
value of the firm’s assets



Financial distress may also cause
customers, suppliers, and management to
take actions harmful to firm value.

A Basic Capital Structure
Theory

Kevin Campbell, University of Stirling, October 2006

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

Agency costs

arise from conflicts between

shareholders and bondholders



When you lend money to a business, you are

allowing the shareholders to use that money in

the course of running that business.



Shareholders interests are different from your

interests, because



You (as lender) are interested in getting your

money back



Shareholders are interested in maximizing their

wealth

A Basic Capital Structure
Theory

Kevin Campbell, University of Stirling, October 2006

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

Agency costs

associated with debt:



Restrictive covenants meant to protect

creditors can reduce firm efficiency.



Monitoring costs may be expended to insure

the firm abides by the restrictive covenants.



As the level of debt financing increases, the

contractual and monitoring costs are

expected to increase.

A Basic Capital Structure
Theory

Kevin Campbell, University of Stirling, October 2006

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Capital structure:
practical considerations



In addition to the variables described by
the trade-off theory of capital structure, a
variety of practical considerations also
affect a firm’s capital structure decisions:



Industry standards



Creditor and rating agency requirements



Maintaining excess borrowing capacity



Profitability and the need for funds



Managerial risk aversion



Corporate control

Kevin Campbell, University of Stirling, October 2006

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

Industry standards



It is natural to compare a firm’s capital

structure to other firms in the same

industry.



Business risk is a significant factor

impacting a firm’s capital structure and is

heavily influenced by a firm’s industry.



Evidence indicate firms’ capital structures

tend toward an industry average.

Practical considerations

Kevin Campbell, University of Stirling, October 2006

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

Creditor and Rating Agency Requirements



Firms need to abide by restrictive covenants,
which may include restrictions on the amount
of future debt.



Firms typically desire to appear financially
strong to potential creditors in order to
maintain borrowing capacity and low interest
rates.



Using less debt in capital structure helps to
maintain this appearance.

Practical considerations

Kevin Campbell, University of Stirling, October 2006

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

Maintaining Excess Borrowing
Capacity



Successful firms typically maintain
excess borrowing capacity.



This provides financial flexibility to react
to investment opportunities.



The maintenance of excess borrowing
capacity causes firms to use less debt
in their capital structure than otherwise.

Practical considerations

Kevin Campbell, University of Stirling, October 2006

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

Profitability and the Need for Funds



Profits can be paid out as dividends to

shareholders or reinvested in the firm.



If a firm generates high profits and

reinvests a large proportion back into

the firm, then it has a continuous

source of internal funding.



This will reduce the use of debt in the

firm’s capital structure.

Practical considerations

Kevin Campbell, University of Stirling, October 2006

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Practical considerations



Managerial Risk Aversion



Well-diversified shareholders are likely to
welcome the use of financial leverage.



Management wealth is typically much
more dependent upon the success of the
company acting as their employer.



To the extent management can act on their
own desires, the firm is likely to have less
debt in its capital structure than is desired
by shareholders.

Kevin Campbell, University of Stirling, October 2006

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Practical considerations



Corporate Control



Controlling owners may desire to issue
debt instead of ordinary shares since debt
does not grant ownership rights.



Firms with little financial leverage are
often considered excellent takeover
targets.



Issuing more debt may help to avoid a
corporate takeover.

Kevin Campbell, University of Stirling, October 2006

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Summary



EBIT/EPS analysis

may be used to help

determine whether it would be better to

finance a project with debt or equity.



Firms must trade-off the

tax advantage

to

debt financing against the effect of debt on

firm risk

.



Because of the

tradeoff

between the tax

advantage to debt financing and risk, each

firm has an

optimal

capital structure.

Kevin Campbell, University of Stirling, October 2006

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KONIEC

DZIĘKUJĘ ZA UWAGĘ

Kevin Campbell, University of Stirling, October 2006

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Homework…

EBIT/EPS Analysis



A company is considering the following two capital structures:



Plan A:

sell 1,200,000 shares at £10 per share (£12 million total)



Plan B:

issue £3.5 million in debt (9% coupon) and sell 850,000

shares at £10 per share (£12 million total)



Assume a corporate tax rate of 50%

REQUIRED:

(a) What is the break-even value of EBIT?
(b) At this break-even value, what is the income statement for each

capital structure plan and the EPS?
(c) Draw a diagram to illustrate the trade-off between EBIT and EPS