What is the EBIT/EPS for debt financing? What is the EBIT/EPS for
equity financing? Assume the company will engage in a capital
acquisition that will improve EBIT by 10%.
Common Shares Outstanding = 48.88 Million
Earnings before interest and taxes (EBIT)=110,451  
Income before tax =100,945
Income tax expense =37,600
27% tax rate 
I'm not sure how to start the calculations and from the calculations
which is the best capital structure? Calculations and source of info
would be great! Thanks much.

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Request for Question Clarification by omnivorous-ga on 07 May 2005 05:58 PDT

Topaz11 --

Setting up the answer here can be done easily but there are a couple
of things that you need to clarify for researchers:
1.  are all of these number from BEFORE the acquisition?  (It appears
that we need to create the post-acquisition numbers.  It's not hard
but we will be inventing a couple of figures.)
2.  you cite a tax rate of 27% -- but show income taxes of 37.3%. 
Will the future tax rate be 27%?   The increase in EPS just from a tax
rate change is significant. . .
3.  With 48.88 million shares outstanding, are we to assume that the
earnings numbers are in millions.  E.g., that EBIT is $110,451,000?

Best regards,

Omnivorous-GA

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Clarification of Question by topaz11-ga on 07 May 2005 10:51 PDT

Clarification for omnivorous-ga.
These numbers are before acquisition. I'm sorry the numbers I gave
need to be changed. Capital acquisition will still improve EBIT by
10%.
Common shares outstanding still = 48.88 Million
EBIT = 341,617 (thousand)
Income before tax = 297,663 (thousand)
Income tax expense = 113,336 (thousand)
Tax rate to calculate the firm's tax rate by dividing its Income
Before Tax by its Income Tax Expense. 262 is this correct?? or is it
26% What the tax rate calculates at is what it will be in the future.
Thanks so much for your help.

Topaz11 ?

The intent of calculations like this is to show the value of leverage
to shareholders.  By borrowing, they can get a much better return
per-share than if stock is used to pay for an acquisition.

Let?s set up the numbers pre-acquisition first:

Common shares: 48.88 M
EBIT = $341.6 M
Pre-tax income = $297.7 M
Taxes = $113.3 M (113.3/297.7 = 38.1%)
Net income = $184.3 M

Earnings per share (EPS) = $3.77


THE ACQUISITION
=================

We?re going to acquire a company that will increase EBIT by 10% or
$34.2 million.  You?re going to see some dramatic differences based on
whether it?s done with debt or equity ? and they get more dramatic in
a year with the tax effects of being able to write off interest from
income taxes.

EQUITY
------------

We?ll make an assumption that we can do the acquisition by increasing
the number of common shares by 10% to, adding 4.89 million shares to
the base.  (Note that this is rarely the case, as acquiring companies
often buy faster-growing companies with higher P-E ratios. But we?re
trying to keep this simple.

In the case of equity financing, here are the new numbers:

Common shares: 48.88M + 4.89M = 53.77M
EBIT = $341.6M + $34.2M = $375.8M
Pre-tax income = $297.7M = $297.7M + $29.8M = $327.5M
Taxes = 0.381 * $327.5M = $124.8M
Net income = $202.7M

Earnings per share (EPS) = $3.77


As you can see, though the income increased, the EPS have stayed the
same.  There?s no dilution ? but no gain in EPS.  Again, this isn?t a
real world example ? as management would do the acquisition with the
goal of cutting costs ? but this sample financial problem is really
meant to show the effects of leverage.  Which comes in the next
section.


DEBT FINANCING
===============

We?re going to set an arbitrary value of $10 per share for our company
? and for the acquisition.  But instead of swapping stock, we?ll raise
$48.9 million in bonds to buy the fast-growing Topaz Corp.  Current
rates on corporate bonds in the U.S. are 7%.

Here are the new numbers ? immediately after acquisition:

Common shares: 48.88M 
Long-term bond liability: $48.9M
EBIT = $341.6M + $34.2M = $375.8M
Pre-tax income = $297.7M = $297.7M + $29.8M = $327.5M
Taxes = 0.381 * $327.5M = $124.8M
Net income = $202.7M

Earnings per share (EPS) = $4.15

You?ve been able to boost EPS with leverage ? a commonly-used
technique.  But, of course, you?ve increased the risk of the firm with
debt.


NEXT YEAR
==========

Let?s see what happens with our firm after a year?s worth of
operations.  We won?t assume any sales growth ? but we will have
annual costs of $3.42M on bond interest:

Common shares: 48.88M 
Long-term bond liability: $48.9M
EBIT = $341.6M + $34.2M = $375.8M
Pre-tax income = $297.7M = $297.7M + $29.8M  - $3.42M = $324.1M
Taxes = 0.381 * $324.1M = $123.5M
Net income = $200.6M*

Earnings per share (EPS) = $4.10

Note here that you?ve added $3.42M in expenses ? but only lost $2.1M
in net income.  That?s because the taxes are ?subsidizing? the debt.
You can see that, even with the cost of debt, you?re way ahead of the
$3.77 in earnings, if you?d financed this acquisition with equity.

In fact, if there had even been modest sales growth (of say 5%) with
no increase in costs, you?d have seen dramatic increases in leverage ?
in part due to the financing and in part due to ?operating leverage.?

I hope that this is clear, but if any aspect of the calculations are
not, please don?t hesitate to request a clarification before rating
the answer.

Best regards,

Omnivorous-GA

Thanks for keeping it simple.