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Q: EBIT/EPS ( Answered 5 out of 5 stars,   0 Comments )
Subject: EBIT/EPS
Category: Business and Money
Asked by: topaz11-ga
List Price: $25.00
Posted: 06 May 2005 21:52 PDT
Expires: 05 Jun 2005 21:52 PDT
Question ID: 518771
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.

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,


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
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.
Subject: Re: EBIT/EPS
Answered By: omnivorous-ga on 07 May 2005 15:58 PDT
Rated:5 out of 5 stars
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


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.


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


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


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,

topaz11-ga rated this answer:5 out of 5 stars and gave an additional tip of: $10.00
Thanks for keeping it simple.

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