The EBIT-EPS approach to capital structure is a tool businesses use to determine the best ratio of debt and equity that should be used to finance the business' assets and operations.
At its core, the EBIT-EPS approach is a way to mathematically project how a balance sheet's structure will impact a company's earnings.
The basic concept of the EBIT-EPS approach
To understand how the EBIT-EPS method works, first we must understand the two primary metrics involved, EBIT and EPS.
EBIT refers to a company's earnings before interest and taxes. This metric strips out the impact of interest and taxes, showing an investor or manager how a company is performing excluding the impacts of the balance sheet's composition. In terms of EBIT, it doesn't matter if a a company is overloaded with debt or has no loans at all. EBIT will be the same either way.
EPS stands for earnings per share, which is the profit the company generates including the impact of interest and tax obligations. EPS is particularly helpful to investors because it measures profits on a per share basis. If a company's total profit is soaring but its profit per share is declining, that's a bad thing for the investor owning a fixed number of shares. EPS captures this dynamic in a simple, easy to understand way.
The ratio between these two metrics can show investors and management how the bottom line results, the company's EPS, relates to its performance independent of its capital structure, its EBIT.
For example, let's say a company wants to maintain stable EPS but is considering taking out a new loan to grow its balance sheet. In order for EPS to remain stable, the company's EBIT must also increase at least as much as the new interest expense from the debt. If EBIT increases the same as the next interest expense, then EPS should remain stable, assuming no change in taxes.
A more complex example
The analysis becomes more complicated when a company is considering increasing its debt and its equity financing at the same time. We can attack this problem using a formula that puts the relationship between EPS and EBIT into mathematical terms. For simplicity, we will assume there are no preferred shares to consider.
Let's work through an example. Assume a company has 100 shares outstanding, EPS of $5, no debt, and a tax rate of 30%. With this information we can use the formula to calculate the company's current EBIT.
First, we'll rearrange the formula, solving for EBIT.
Filling in the variables and solving the formula, this company's EBIT to be $714 with no debt today.
As part of a growth plan, the company is considering accepting a new loan for $10,000 with a 5% interest rate and a new equity investment from a strategic partner, which will require the company to issue 15 new shares.
The company's management team forecasts that this new funding will allow the company to grow its EBIT to $1,000 over the next year. That's a great growth rate, but with the new interest expense and shares outstanding, it isn't obvious how this growth will translate to earnings per share. The ultimate goal is to grow the company's $5 earnings per share, but at a minimum management should work to at least maintain it.
To understand how this capital structure and growth plan will impact EPS, we can solve the formula again, this time using the proposed 15 new shares outstanding (for 115 total shares outstanding), the new $500 in annual interest expense, and the projected $1,000 in EBIT. The resulting EPS will tell us if this capital structure is the best way to fund the growth plan and also improve EPS.
This works out to a projected EPS of $3.05, well below the existing $5 per share.
This analysis tells the company's management and investors that this plan is far from optimal. While it may increase EBIT, the cost of the new debt and the new shares outstanding are too great to support the company's earnings per share.
In order to pursue this growth plan, the company must either change the balance of debt and equity financing, find cheaper sources of funding, or find a new plan that can generate a higher growth rate to support the costs of interest and equity.
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