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Q: EBIT/EPS ( Answered ,   0 Comments )
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 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, Omnivorous-GA``` 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.```
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 Subject: Re: EBIT/EPS Answered By: omnivorous-ga on 07 May 2005 15:58 PDT Rated:
 ```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```
 topaz11-ga rated this answer: and gave an additional tip of: \$10.00 `Thanks for keeping it simple.`

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