Introduction to Finance

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C H A PT E R 1 8 Capital Structure and The Cost of Capital
18.6
EBIT/Eps Analysis
As a fi rst step in capital structure analysis, let’s examine how diff erent capital structures 
aff ect the earnings and risk of a fi rm in a simple world with no corporate income taxes. We 
use a tool of fi nancial analysis called EBIT/eps analysis. 
EBIT/eps analysis
allows man-
agers to see how diff erent capital structures aff ect the earnings and risk levels of their fi rms. 
Specifi cally, it shows the graphical relationship between a fi rm’s operating earnings, or 
earnings before interest and taxes (EBIT), and earnings per share (eps). If we ignore taxes, 
these two quantities diff er only by the fi rm’s interest expense and by the fact that eps is net 
income stated on a per-share basis. Examining scenarios with diff erent EBIT levels can help 
managers to see the eff ects of diff erent capital structures on the fi rm’s earnings per share.
Let’s assume the Bennett Corporation is considering whether it should restructure its 
fi nancing. As seen in 
Table 18.3
, Bennett currently fi nances its $100 million in assets entirely 
with equity. Under the proposed change, Bennett will issue $50 million in bonds and use this 
money to repurchase $50 million of its stock. If the stock’s price is $25 a share, Bennett will 
repurchase 2 million shares of stock. Bennett expects to pay 10 percent interest on the new 
bonds, for an annual interest expense of $5 million. 
Assuming that Bennett’s expected EBIT for next year is $12 million, let’s see how the 
proposed restructuring may aff ect earnings per share. For simplicity, we will ignore taxes, so 
earnings per share (eps) will be computed as (EBIT – interest expense) divided by the number 
of shares. As shown in 
Table 18.4
, the scenario analysis assumes that Bennett’s EBIT will be 
either $12 million, 50 percent lower ($6 million), or 50 percent higher ($18 million). Figure 18.6 
graphs the EBIT/eps combinations that result from the scenario analysis of the current and 
proposed capital structures. For lower EBIT levels, the current all-equity capital structure 
leads to higher earnings per share. At higher levels of EBIT, the proposed 50 percent equity 
50 percent debt capital structure results in higher eps levels.
Indiff erence Level
Figure 18.6
shows that the EBIT/eps lines cross. This means that, at some EBIT level, Bennett 
will be indiff erent between the two capital structures, inasmuch as they result in the same 
earnings per share.
Under Bennett’s current capital structure, eps is computed as (EBIT – $0 interest)∕4 
million shares. Under the proposed structure, eps is calculated as (EBIT – $5 million interest)/
2 million shares. To fi nd the level of EBIT where the lines cross—that is, where the combin-
ation of eps and EBIT are the same under each capital structure—we set these two earnings 
per-share values equal to each other and solve for EBIT:
EBIT − 0
4
=
EBIT − 5
2
Doing so, we learn that the earnings per share under the two plans are the same when 
EBIT equals $10 million.
13
When EBIT exceeds $10 million, the proposed, more-highly