In this comprehensive blog, I’m going to explain the full theory of EBIT-EPS break even analysis. After going through the full blog you will be able to know how to calculate the EBIT-EPS break even analysis and its decision criteria.
What is EBIT-EPS Analysis and what is its goal?
EBIT-EPS Analysis is a tool businesses use to compare different ways to finance their operations (like through debt or issuing shares) and see how each affects the company’s earnings per share (EPS).
With the help of this financial metric, we can decide whether to opt for borrowed funds or issue new shares.
The goal is to find the point where EPS is the same, regardless of which financing method is used. This point is called the break even point, where a specific level of earnings before interest and taxes (EBIT) results in the same EPS under two or more financing methods.
Let’s break down the concept of EBIT-EPS Break Even Analysis with a simple story to make it more relatable.
Scenario: “Green Power Tech Expansion”
Green Power Tech is a company that manufactures eco-friendly solar panels. The company wants to expand its operations and needs $100,000 to do so.
They have two options:
- Alternative 1: Fund 100% of the expansion through equity, meaning Green Power Tech will raise the entire $100,000 by issuing new shares.
- Alternative 2: Fund 50% of the expansion through debt at an interest rate of 10%, and the other 50% through equity.
- Tax Rate: 50%
- Share Value: $100 per share
Breakdown of the Two Alternatives:
Alternative 1: 100% Equity
- Green Power Tech will raise the entire $100,000 by issuing 1,000 new shares (100,000 / 100 per share).
- There is no interest payment in this case because they are not borrowing money.
Alternative 2: 50% Debt, 50% Equity
- The company will borrow $50,000 at 10% interest, so they will have to pay 5,000 dollars in annual interest.
- They will raise the other $50,000 through equity, issuing 500 new shares (50,000/100 per share).
The management team is trying to figure out which option will provide the best return for shareholders, so they decided to use EBIT-EPS Break Even Analysis to compare the impact of these two financing options on the company’s earnings per share (EPS).
Understanding the Key Concepts
- EBIT (Earnings Before Interest and Taxes): This is the company’s profit before paying any interest on loans or taxes. It’s important because it’s the operating income generated from the core business.
- EPS (Earnings Per Share): This is the amount of profit each shareholder receives. If the company earns more money, the EPS increases. However, if there are more shareholders (due to issuing new shares), the profit is divided among more people, reducing the EPS.
- Break-Even Point: The break-even point in EBIT-EPS analysis is the level of EBIT where the EPS is the same for both financing options. Below this point, one option might be better than the other, depending on how profits are affected by interest payments (for debt) or by issuing more shares (for equity).
EBIT-EPS Break Even Analysis Formula:
Now, let’s calculate the EBIT-EPS Break Even Analysis. The formula for EBIT-EPS Break-Even Analysis is:
$$ (EBIT – I)(1 – t) – \frac{PD}{S_1} = (EBIT – I)(1 – t) – \frac{PD}{S_2} $$
Where:
- EBIT = Earnings before interest and taxes.
- I = Interest on debt.
- t = Tax rate.
- PD = Preferred dividends (if any).
- S1 = Number of shares after issuing new equity.
- S2 = Number of shares without issuing new equity
Let’s start calculating EBIT-EPS break even analysis:
Step 1: Define the Variables
- Tax rate (t) = 50% = 0.50
- Interest (I) = $5,000 (for Alternative 2)
- Number of shares in Alternative 1 (S1) = 1,000 shares
- Number of shares in Alternative 2 (S2) = 50% equity = 500
Now, the company uses this formula to calculate the break-even EBIT. Let’s say the break-even EBIT comes out to $10,000
This $10,000 came out after calculating the EBIT-EPS break-even analysis representing the level of profit (EBIT) where both financing options—borrowing money (debt) or issuing new shares (equity)—will result in the same earnings per share (EPS) for shareholders. It’s the point where either financing choice would have an equal impact on shareholder returns.
Proofing the calculation of EBIT-EPS break-even analysis
Alternative 1: 100% Equity
- EBIT (Earnings Before Interest and Taxes): $10,000.
- Since there is no debt in this option, there are no interest expenses.
- EBT (Earnings Before Taxes) is the same as EBIT: $10,000.
- Applying the tax rate of 50%, the tax is $5,000.
- Net Income (profit after taxes) is $5,000.
EPS Calculation: Since Green Power Tech has issued 1,000 shares, the Earnings Per Share (EPS) is calculated as:
$$ \frac{5,000 \, \text{(Net Income)}}{1,000 \, \text{(Shares)}} = 5 $$
Alternative 2: 50% Debt, 50% Equity
- EBIT (Earnings Before Interest and Taxes): $10,000.
- In this option, the company took on $50,000 in debt at 10% interest, so the interest expense is $5,000.
- EBT (Earnings Before Taxes) is now lower because of the interest payments: 10,000 (EBIT) – 5,000 (Interest) = 5,000.
- Applying the tax rate of 50%, the tax is $2,500.
- Net Income (profit after taxes) is $2,500.
EPS Calculation: In Alternative 2, 500 new shares were issued, making the total number of shares 500. The EPS is calculated as:
$$ \frac{2,500 \, \text{(Net Income)}}{500 \, \text{(Shares)}} = 5 $$
So, the EPS for Alternative 2 is also $5 per share.
Interpretation
- At $10,000 EBIT, the Earnings Per Share (EPS) is the same ($5 per share) in both financing options.
- This means that $10,000 EBIT is the break-even point for these two financing options. At this level of profit, it doesn’t matter whether Green Power Tech chooses 100% equity or 50% debt/50% equity; both options will result in the same EPS.
Decision Criteria
- If EBIT were higher than $10,000, the debt option (Alternative 2) would likely provide a higher EPS because interest payments are fixed, meaning more of the additional profit goes to shareholders.
- If EBIT were lower than $10,000, the equity option (Alternative 1) would be better because the company wouldn’t have to worry about interest payments eating into profits, and the EPS wouldn’t fall as much.
Watch a video on the topic of EBIT-EPS Break Even Analysis
Conclusion: Why Does This Matter?
The EBIT-EPS Break Even Analysis helps Green Power Tech make an informed decision based on their expectations for future earnings. It shows the company at what point each financing option becomes more beneficial to shareholders in terms of earnings per share. This type of analysis is crucial because choosing the wrong financing option can result in lower returns for shareholders or unnecessary financial strain on the company.
By understanding this break-even point, companies like Green Power Tech can make financing decisions that align with their growth projections and financial health, ensuring that they maximize shareholder value while minimizing risks
If you want to know more or if you’re still confused regarding the topic. Let me know in the comment box.
FAQ
1. How do you calculate EBIT (Earnings Before Interest and Taxes)?
Ans: EBIT is calculated by subtracting operating expenses (excluding interest and taxes) from revenue.
EBIT=Revenue−OperatingExpenses.
Alternatively, if net income and taxes are given, EBIT can be calculated as:
EBIT=NetIncome+Interest+Taxes.
2. What does EPS stand for in finance, and how is it calculated?
Ans: EPS stands for Earnings Per Share. It represents the profit allocated to each outstanding share of a company. The formula is: EPS = Net Income/Total Number of Shares Outstanding. A higher EPS indicates better profitability for shareholders.
3. What is the EBIT-EPS Break Even Point?
Ans: The EBIT-EPS break-even point is the level of EBIT where EPS is the same for two different financing options (e.g., debt vs. equity). It helps businesses decide the best way to finance their operations.
4. How do you calculate the EBIT-EPS Break Even Point?
Ans: The break-even EBIT is found using this equation: (EBIT−I)(1−t)/S1 = (EBIT−I)(1−t)/S2
Where:
– EBIT = Earnings Before Interest and Taxes
– I = Interest on debt
– t = Tax rate
– S1 & S2 = Number of shares under different financing options
By solving for EBIT, we get the break-even point.
5. When should a company choose debt financing over equity financing?
Ans: A company should choose debt financing if it expects high EBIT, as interest expenses remain fixed, allowing more profits to be distributed among fewer shareholders. However, if EBIT is uncertain or low, equity financing is safer, as there are no interest obligations.
6. Why is EBIT-EPS Analysis important for businesses?
Ans: EBIT-EPS Analysis helps companies:
✅ Compare financing options (debt vs. equity).
✅ Understand the impact of financing choices on EPS.
✅ Make informed decisions to maximize shareholder value.
✅ Avoid unnecessary financial risks associated with debt.