Explain Earnings before interest and tax (EBIT) – Earnings per share (EPS) approach in capital structure.

Before going for Earnings before interest and tax (EBIT) – Earnings per share (EPS) approach, let us discuss briefly about EBIT and EPS.

With the help of Earnings before interest and tax (EBIT), investors and managers can analyse company’s performance without considering balance sheet.

With the help of Earnings per share (EPS), investors can measure profit-earning ability of a company and investors will calculate the returns for their shares.

EBIT – EPS approach determines optimal capital structure having high EPS for a given EBIT. It also determines best debt and equity ratio that used to finance the business. It examines effect of financial leverage by observing EPS with different levels of EBIT.

Formula

            (EBIT – In(a)) (1-T) – Pd(a) / OSa = (EBIT – In(b)) (1-T) – Pd(b)) / OSb

L.H.S.

EBIT = Earnings before interest and tax, In(a) = Interest in plan A, T = corporate income tax,

Pd(a) = preference dividends in plan A, OSa = total number of outstanding stock in plan A

R.H.S.

EBIT = Earnings before interest and tax, In(b) = Interest in plan B, T = corporate income tax,

Pd(b) = preference dividends in plan B, OSb = total number of outstanding stock in plan B

Advantages of this approach are −

• Best financial plan can be selected.
• With the help of this approach, we can compare between company, specific products, departments etc.
• Capital structure can be determined to obtain maximum EPS.
• Performances of various sources can be evaluated.

Disadvantages of this approach are −

• Risk is not considered.
• Complex to calculate.
• No limitations for source of financing.
• Determination of over capitalisation is difficult.