An Examination of Indifference: Definition
When a company is looking to make financing decisions that will result in increased earnings per share (EPS), the debt-equity mix is a useful tool to utilize.
An EBIT-EPS study entails identifying the crossover or indifference EBIT, which is the point at which the EPS is the same for both of the potential sources of funding.
In other words, indifference analysis refers to the utilization of a financial break-even point (BEP) in conjunction with the return on investment derived from alternative financial strategies.
The Analysis of Indifference: an Explanation
Analyzing EBIT-EPS requires making comparisons between various forms of financing and the impact that these techniques have on earnings.
When it comes to making choices about their finances, businesses have a variety of options. A corporation that needs to raise capital in order to finance its investment projects, for instance, has options including the following:
Raise money only through the sale of equity in your company.
Raise money solely through the collection of debts.
Raise money only through the purchase of preference shares.
Combination of three revenue streams, in which the organization determines what fraction of (1), (2), and (3) will contribute most to the rise in EPS value
The proportions of the various funding methods described above are selected in order to guarantee the maximum possible earnings per share (EPS) at the specified level of earnings before interest and taxes (EBIT).
Consequently, the EBIT-EPS analysis is useful for determining EPS under a variety of different financial strategies. In most cases, the formula that is shown further down is used to carry out the indifference analysis.
The formula for the analysis of indifference
Finding the Indifference Point Through Calculation
The following are the prerequisites that must be met before attempting to compute the indifference point:
The capital structure of the company ought to include equity capital as one of its components.
Different equity capital bases should be used in different financial plans.
Example: In order to carry out its recommended strategy, XYZ Company needs one million dollars. The following options are accessible to you in terms of finances:
Plan A: One Hundred Percent of the Capital Contributed (Face Value $100)
Plan II consists of a 50/50 split between equity capital with a face value of $100 and debt with a 6% interest rate.
Plan III consists of a 50/50 split between equity capital with a face value of $100 and preference shares with a dividend yield of 6%.
Plan IV consists of a 25% equity capital investment with a face value of $100, a 25% debt investment with a 6% interest rate, and a 50% preference share investment with a 6% dividend rate.
The corporation is subject to taxation at a rate of fifty percent. The EBIT that the corporation anticipates will be $4,000,000.
Essential : Perform the following computations:
EPS for each plan in question
Point of financial break-even Point of difference between EBIT for each of the several plans
Solution 1: EPS in accordance with a variety of strategies
2. Establishment of the point at which a business is profitable again
Plan I stipulates that there will not be any predetermined financial costs (such as debt interest or preference dividend). As a result, there is no point when the finances are even.
Plan II: The amount of $30,000 will be charged monthly for fixed financial expenses (interest on debentures). Therefore, $30,000 is the point at which we are financially stable.
Plan III: The set financial charge for Plan III is $30,000 (the preferred dividend), and it is a deferred payment plan. A preference dividend is paid out of the after-tax profit of the company. The appropriate tax rate is 50% of total income. Therefore, the amount of money necessary to achieve financial neutrality is $60,000 (Dividend $30,000 + Tax $30,000).
Plan IV: The fixed financial charges for Plan IV are $75,000, which includes $15,000 in interest on debentures, $30,000 in preference dividends, and $30,000 in taxes on profits. These costs are broken down as follows: $60,000.