Chapter 10Making Capital Structure Decisions

EBIT-EPS AnalysisCalculation of EPS

Break-even, or indifference, analysis

Use of EBIT-EPS information

Calculation of EPSEBIT indifference points

EBIT-EPS analysisFocuses on the EBIT indifference between financing methods with respect to EPS

Capital Structure ManagementEBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity.

Capital Structure ManagementEBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity.EPS = (EBIT - I)(1 - t) - P S

Capital Structure ManagementEBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity.EPS = (EBIT - I)(1 - t) - P SI = interest expense, P = preferred dividends,S = number of shares of common stock outstanding.

EBIT-EPS ExampleOur firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need Rs.6,000,000 to finance a proposed project. We are considering two options:Sell 200,000 shares of common stock at Rs.30 per share,Borrow Rs.6,000,000 by issuing 10% bonds.

If we expect EBIT to be Rs.2,000,000:Financing stock debt EBIT2,000,0002,000,000- interest 0 (600,000)EBT2,000,0001,400,000- taxes (40%) (800,000) (560,000)EAT1,200,000 840,000# shares outst.1,000,000 800,000EPS Rs.1.20 Rs.1.05

If we expect EBIT to be Rs.4,000,000:Financing stock debt EBIT4,000,0004,000,000- interest 0 (600,000)EBT4,000,0003,400,000- taxes (40%) (1,600,000) (1,360,000)EAT2,400,000 2,040,000# shares outst.1,000,000 800,000EPS Rs.2.40 Rs.2.55

If EBIT is Rs.2,000,000, common stock financing is best. If EBIT is Rs.4,000,000, debt financing is best.So, now we need to find a breakeven EBIT where neither is better than the other.

If we choose stock financing:

If we choose bond financing:

Breakeven EBIT

Breakeven PointSet 2 EPS calculations equal to each other and solve for EBIT: Stock Financing Debt Financing(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S

Breakeven Point Stock Financing Debt Financing(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S

(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800,000+200,000 800,000

Breakeven Point Stock Financing Debt Financing .6 EBIT = .6 EBIT - 360,000 1 .8

.48 EBIT = .6 EBIT - 360,000

.12 EBIT = 360,000

EBIT = Rs.3,000,000

Breakeven EBIT

Breakeven EBITFor EBIT up to Rs.3 million,stock financing is best.For EBIT greaterthan Rs.3 million, debt financing isbest.

In-class ProblemPlan A: sell 1,200,000 shares at Rs.10 per share (Rs.12 million total)Plan B: issue Rs.3.5 million in 9% debt and sell 850,000 shares at Rs.10 per share (Rs.12 million total)Assume a marginal tax rate of 50%.

Breakeven EBIT Stock Financing Levered Financing(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S

EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) 1,200,000 850,000

EBIT = Rs.1,080,000

Analytical Income Statement Stock LeveredEBIT1,080,0001,080,000I 0 (315,000)EBT1,080,000 765,000Tax (540,000) (382,500)NI 540,000 382,500

Shares1,200,000 850,000EPS.45.45

Breakeven EBIT

Breakeven EBITFor EBIT up to Rs.1.08 m,stock financing is best.

Breakeven EBITFor EBIT up to Rs.1.08 m,stock financing is best.For EBIT greaterthan Rs.1.08 m, the levered plan isbest.

Use of EBIT-EPS InformationFinancing alternatives have different impacts on EPS Comparing with existing and expected EBITHigher EBIT (stronger case for debt)Lower EBIT (stronger case for common stock)Assess likelihood of EBIT falling below IPGives insight into risk-return trade-off that governs valuation

Cash-Flow Ability to Service DebtFixed chargesTimes interest earnedDebt-service coverageEBIT, depreciation, and amortization (EBITDA)Probability of cash insolvencyDonaldson approach

Fixed ChargesIncludePrincipal and interest payments on debtLease paymentsPreferred stock dividendsInability to meet fixed charges may result in financial insolvencyIncreased stability of expected future CFs results in increased debt capacity

Times Interest EarnedImportant test of credit-worthiness

Concern arises when ratio falls below 3 to 1Difficult to achieve an investment-grade credit rating

Debt-Service CoverageCoverage ratioInterest before taxPrincipal payment after taxInclude lease paymentsDebt service and business riskElectric utilities versus manufacturing

EBITDAEBITDA versus EBIT

EBITDA may not be a good measure of the cash available for debt service

Probability of Cash InsolvencyWhat are the chances of insolvency?AssessThe possible deviation of actual from expected CFsPurchase or sale of assetsLiquidity of the firmDividendsSeasonal patternsOther factors impacting CFs

Donaldson ApproachExamine the CFs of the companyUnder the most adverse circumstances (i.e. recession)Debt capacityDebt that can be comfortably servicedCalculate the probability of cash inadequacyCash insolvency versus cash inadequacy

Effect on Debt RatiosPro forma debt ratiosCompare new debt ratiosWith past ratiosTrend analysisOther companiesSimilar business riskIn same industryJustify position if capital structure is out of line

Effect of Security RatingsEffect of financing alternativesRating agenciesChanges in Ratings of existing securitiesRatingsIndicate credit worthiness of a borrowerFirst 4 are considered investment grade

Analysis Before Assigning a GradeTrends in ratios

Business risk

Capital requirementsSpecific security features

Cash-flow ability

Proportion of debt

Timing and FlexibilityTiming security issuesDebt or common stockFinancing is lumpyGeneral market conditionsExpectations for the companyFlexibilityKeeping open future financing options

A Pecking Order of FinancingInternal financingStraight debtPreferred stockHybrid securitiesConvertible bondsStraight equityLeast desirableFinancing decision should be based on a rigorous analysis embracing valuation

Financing ChecklistTaxesExplicit costFinancial signalingEBIT-EPS analysisAgency costs and incentive issuesDebt ratioSecurity ratingTimingFlexibilityCash flow ability to service debt

In-class ProblemPlan A: sell 1,200,000 shares at Rs.20 per share (Rs.24 million total)Plan B: issue Rs.9.6 million in 9% debt and sell shares at Rs.20 per share (Rs.24 million total)Assume a 35% marginal tax rate.

Breakeven EBIT Stock Financing Levered Financing(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S

(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) 1,200,000 720,000

EBIT = Rs.2,160,000

Analytical Income Statement Stock LeveredEBIT2,160,0002,160,000I 0 (864,000)EBT2,160,0001,296,000Tax (756,000) (453,600)NI1,404,000 842,400Shares1,200,000 720,000EPS1.17 1.17

Breakeven EBIT

Breakeven EBIT

Breakeven EBIT

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