# Firmsconsulting

## EBIT-EPS Capital Structure Approach

In Capital structure, Finance, MBA on October 27, 2010 at 6:35 pm

The EBIT-EPS capital structure approach focuses on finding a capital structure with the highest EPS (earnings per share) over the expected range of EBIT (earnings before interest and taxes).

The reason why we are interested in finding a capital structure, which will permit maximization of the EPS over the expected range of EBIT, is because it partially helps us to achieve the ultimate objective of the enterprise. The ultimate objective of the enterprise is to maximize shareholders’ wealth by maximizing its stock price. Two key variables that affect stock price are return (earnings attributed to owners of the enterprise) and risk (which can be measured by required return (rs)). This approach explicitly considers maximization of returns (EPS). However, it is important to note that this approach ignores risk (does not explicitly consider risk).

### Major shortcoming of the EBIT-EPS approach

The fact that this approach fails to explicitly consider risk is the major shortcoming of this method. As firm obtains more debt (its financial leverage increases), the risk also increases and shareholders will require higher returns to compensate for the increased financial risk. Therefore, this approach is not completely appropriate because it does not consider one of the key variables (risk), which is necessary for maximization of shareholders’ wealth.

### Considering financial risk

As per above, the approach does not explicitly consider financial risk. However, when utilizing the approach, financial risk can be considered in two ways:

1) The approach measures financial risk by the financial breakeven point. The higher the breakeven point the greater the financial risk.

2) The approach also measures the financial risk by the slope of the capital structure line. The steeper the capital structure line the greater the financial risk.

### EBIT-EPS graph

It is a graphical approach. EPS is plotted on the vertical axis (x-axis) and EBIT on the horizontal axis (y-axis). By connecting the coordinates for different capital structures (different variations of equity versus debt), capital structure lines for each capital structure are graphed.

We will need to represent EBIT-EPS coordinates (capital structure lines) for different capital structures to ascertain at which levels of EBIT which capital structure is preferred. This will allow us to find a capital structure with the highest EPS over the expected range of EBIT.

For the purposes of this article it is sufficient to mention that to find EBIT-EPS coordinates we can assume particular EBIT values (and associated earnings available for common stockholders values) and calculate EPS in line with such values for different capital structures.

The formula to calculate EPS is as follows:

EPS = Earnings Available for Common Stockholders/ Number of Shares of Common Stock Outstanding Another easy way to find one of the EBIT-EPS coordinates is to use the financial breakeven point calculation. Financial break-even point occurs at the level of EBIT (earnings before interest and taxes) at which EPS (earnings per share) equals zero. At this level of EBIT all fixed financial costs are covered. The formula for calculation of the financial break-even point is as follows:

Financial break-even point = I + PSD/1-T

Where:

I – interest charges

PSD – preferred stock dividends

T – tax rate

### ***

This capital structure approach does NOT allow us to determine the point where weighted average cost of capital is at a minimum and where stock price is at a maximum (where wealth of the owners of the firm is maximized). The approach focuses on maximizing earnings rather than on maximizing wealth. Therefore, although it is helpful to use when analyzing alternative capital structures, the major shortcoming of this approach should be taken into account.

## Optimal capital structure

In Finance, MBA, Capital structure on October 27, 2010 at 6:34 pm

Theoretically, enterprises should try to maintain a certain optimal capital structure, a perfect mix of financing (debt and equity), which results in the lowest possible weighted average cost of capital. At this combination of debt and equity, the stock price is at the maximum. Therefore, attainment of the optimal structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. The optimal structure is also referred to as the target capital structure. However, it is important to note the optimal structure exists only in theory.

Theory does not yet offer a methodology that would allow firms’ financial managers to find the optimal capital structure. However, financial managers can determine the approximate optimal structure range, which is close to what they believe the optimal structure for the firm is.

As per above, an optimal structure maximizes the value of the firm. To find the value of the firm, we can use the following formula:

V=EBIT*(1-T)/ra

Which simplifies into:

V=NOPAT/ra

Where:

V = is the value of the firm

EBIT = is earnings before interest and taxes (see the income statement for how it is calculated)

NOPAT = is the net operating profit after taxes (calculated by formula EBIT*(1-T)/ra)

ra = is the weighted average cost of capital (WACC)

If we assume that NOPAT is consistent, then the value of the firm is affected by WACC (ra, weighted average cost of capital). WACC is affected by both, the cost of debt and equity.

### The cost of equity

The cost of equity is higher than the cost of debt and increases as financial leverage increases. This is because equity suppliers will demand higher return for increasing financial risk due to increasing financial leverage.

### The cost of debt

The cost of debt initially is relatively low. The major reason for this is due to the fact that interest on debt is tax deductible. This tax deductibility of interest paid on debt is also commonly called the tax shield. However, as debt increases, at certain debt ratio lenders will begin to require higher and higher interest payments from the borrower. This is undertaken in order to compensate for increasing risk due to increasing financial leverage.

There are two other costs of debt that the firm needs to consider:

(1) Debt increases the probability of bankruptcy. This is because lenders can force the firm into bankruptcy if the firm cannot meet its financial obligations to the lender.

(2) Another aspect to consider is the agency cost. This refers to the fact that lenders usually protect themselves from increases in risk of the borrower by imposing different loan provisions, which place constraints on actions and choices of the firm. Such provisions commonly include, but are not limited to, minimum levels of liquidity to be maintained, limits on compensation of the executives and limitations on asset acquisitions.

### ***

As debt increases from a zero point onwards, WACC initially decreases to the theoretical optimal capital structure point. Thereafter, the increasing equity cost and increasing cost of debt causes WACC to start increasing again. Therefore the theoretical optimal capital structure is obtained at the point where the WACC is the lowest.

In other words, the theoretical optimal capital structure occurs at the point where the benefits from using debts are in equilibrium (in balance) with the costs of using debt. The optimal capital structure can also be seen as the balance between risk and return where the firm’s stock price is maximized.

## Capital structure decisions analysis with debt ratios

In Finance, MBA, Capital structure on October 27, 2010 at 6:32 pm

When analyzing capital structure decisions, external stakeholders can obtain an approximate idea of the capital structure of the particular firm by using information in the firm’s financial statements to calculate various debt ratios.

When analyzing capital structure decisions of firms as outsiders, we need to consider two types of debt measures:

The first type of debt ratio measures the degree of indebtedness. This refers to how much debt the firm has relative to other balance sheet’s amounts. The debt ratio will measure the degree of indebtedness.

The second type of debt ratio measures the ability to service debts. This type of debt ratios measures the ability of the business to meet its obligations associated with debt, as they come due. Times Interest Earned Ratio and Fixed Payment Coverage Ratio will be considered to measure the ability to service debts.

Both techniques are very simple to use and effective at analysing capital structure decisions.

### Measuring the degree of indebtedness

(1) THE DEBT RATIO

A direct measure of debt is a debt ratio. Debt ratios provide direct information on the financial leverage of an enterprise. Debt ratios measure how many of the firm’s assets are financed by debt. The higher the debt ratio, the higher the degree of financial leverage (amount of debt) and the higher the risk. The formula for the debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

Example:

For example, assume that ABC’s total liabilities are \$1,700,000 and total assets are \$4,000,000.

The debt ratio of ABC is as follows: \$1,700,000/\$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

### Measuring the ability to service debts

(1) TIME INTEREST EARNED RATIO (INTEREST COVERAGE RATIO)

The Times Interest Earned Ratio (TIER or Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due).

When analyzing capital structure decisions, we can use the Times Interest Earned Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Times Interest Earned Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Times Interest Earned Ratio is as follows:

Times Interest Earned Ratio =EBIT/interest charges

EBIT refers to the earnings before interest and taxes, which is also called operating profit (refer to the Income Statement format to see how it is calculated).

EXAMPLE:

Assume ABC Company has an operating profit of \$550,000 and interest charges of \$100,000.

The TIER of ABC is as follows:

\$550,000/\$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

When using the Times Interest Earned Ratio, it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio. It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest. The calculation above excludes the principal amount borrowed.

Generally, the higher the Times Interest Earned Ratio the lower the risk an enterprise will not be able to meet its contractual interest obligations on time. Therefore, generally, a higher Times Interest Earned Ratio is the better.

However, cognizance needs to be taken of the fact that the higher the Times Interest Earned Ratio, the lower the risk and lower the return. Therefore, at some point, the Times Interest Earned Ratio may be too high. This will occur if the business is unnecessarily careful with taking up debt as a source of financing, which results in very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

(2) FIXED PAYMENT COVERAGE RATIO

Fixed Payment Coverage Ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. When analyzing capital structure decisions, we can use the Fixed Payment Coverage Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Fixed Payment Coverage Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Fixed Payment Coverage Ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT – earnings before interest and tax (operating profit)

LP – lease payments/

I – interest charges

PP – principal payments

PSD – preferred stock dividends

T – tax rate

EXAMPLE:

Assume ABC Company has an operating profit of \$550,000 and interest charges of \$100,000. The lease payments are fixed at \$20,000, principal payments are at \$60,000 and preferred stock dividends are at \$15,000. The corporate tax rate of ABC is 40%.

The Fixed Payment Coverage Ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The Fixed Payment Coverage Ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, Fixed Payment Coverage Ratio should be compared to industry averageS before any conclusions are drawn. Generally, the higher the Fixed Payment Coverage Ratio the lower the risk that enterprise will not be able to meet its fixed-payment obligations on time. Therefore, a higher Fixed Payment Coverage Ratio is the better.

However, as with Times Interest Earned ratio, cognizance needs to be taken of the fact that the higher the Fixed Payment coverage ratio the lower the risk and lower the return. Therefore, at some point, the Fixed Payment Coverage Ratio may be too high. This will occur if the business is unnecessarily careful with taking up more debt which results in a very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

### ***

When analyzing capital structure decisions with the help of debt ratios, one should compare debt ratios of individual firms to industry averages. There is a large variability of debt ratios’ industry averages between industries. This is because different industries have different operations requirements. There is no one perfect ratio: this is determine by the company in question, its strategy, operating environment, competitive environment and finances.

## Capital structure decisions

In Capital structure, Finance, MBA on October 27, 2010 at 6:31 pm

Capital structure decisions refer to the decisions businesses have to make with regards to the mix of financing they use. The mix consists of debt and/or equity as sources of capital. In other words, it is a structure of the liabilities side of the balance sheet , excluding current liabilities. Enterprises usually try to maintain a certain optimal mix of financing (debt and equity), referred to as the target capital structure.

The modern approach to capital structures is largely influenced by the work of Franco Modigliani and Merton H. Miller. This is also known as the M and M, or MM work. Their work published in 1958 in American Economic Review (June 1958) entitled “The Cost of Capital, Corporation Finance, and the Theory of Investment” suggests that under condition of perfect markets, capital structure decisions do not affect the value of the firm. Any increase in Return on Equity goes hand in hand with increase in risk. Therefore, weighted average cost of capital (WACC) stays constant.

In their later work, Franco Modigliani and Merton H. Miller introduced taxes into the model. Their further conclusion was that if corporate taxes are present then the value of the enterprise will increase continuously as more debt is added to capital structure.

This is possible because debt interest payments are tax deductible. However, it is evident that personal taxes will decrease the advantage gained. As a result, it is still profitable to use debt financing. However, the advantage gained is lessened by the existence of personal taxes versus existence of just corporate taxes.

Theoretically, enterprises can increase the value of the firm by finding the optimum capital structure (mix of equity and debt). The optimum capital structure refers to capital structure decisions according to which the weighted average cost of capital is at its minimum value and, as a result, the value of the firm is maximized.

Therefore, the optimum capital structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. However, it is important to note that the optimal capital structure exists only in theory.

### Sources of capital

Sources of capital include debt and equity. Equity is further subdivided into preferred stock and common stock. In turn, common stock is even further subdivided into new common stock and retained earnings.

When making capital structure decisions, it is important to keep in mind that generally debt is the least expensive source of capital. This is due to the fact that the lender takes much less risk than suppliers of the equity capital. This is occurs because:

(1) Debt has obligatory scheduled payments. Whereas, equity suppliers, especially in case of common stock, will only be paid when company can afford to do so.

(2) In case of liquidation, lenders have priority claim on assets of the company over equity suppliers.

(3) If firm misses obligatory interest or principal payments, lenders can force the firm into bankruptcy. Therefore, lenders have more power in ensuring that payments will be made on time.

Moreover, interest on debt is tax deductible, which makes it an even cheaper source of capital for the firm. Overall, and as stated above, debt is generally the cheapest source of capital for the firm.

### How capital structure decisions affect the risk of a company?

Enterprises deal with three types of risks: financial risk, business risk and total risk. The capital structure directly affects the financial and total risk of the firm.

FINANCIAL RISK – a chance that firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by the firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.

BUSINESS RISK – a chance that firm will not be able to cover its operating costs. There are three factors that affect business risk. These are an increase in the degree of operating leverage, revenue instability and cost instability. Capital structure decisions do not affect business risk.

TOTAL RISK – a combination of financial and business risk. Since capital structure decisions affect financial risk, the total risk is also affected.