The document discusses the EBIT-EPS approach for determining appropriate capital structure. The EBIT-EPS approach involves selecting a capital structure that maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes (EBIT). Managers use this approach to balance debt and equity financing by analyzing how different capital structures affect EPS at given EBIT levels. However, the approach does not consider risk premiums associated with higher debt levels and may not always be the best tool for capital structure decisions.

1. APPROACHES TO
DETERMINE APPROPRIATE
CAPITAL STRUCTURE- EBIT –
EPS APPROACH
RADHIKA GUPTA
32- MBA

2. APPROACHES TO DETERMINE
APPROPRIATE CAPITAL
STRUCTURE
• EBI T – EPS Approach
• Valuation Approach
• Cash Flow Approach

3. EBI T – EPS Approach –
• The EPS-EBIT approach to capital structure involves selecting the
capital structure that maximizes EPS over the expected range of
EBIT.
• Using ths approach, the emphasis is on maximizing the owners
returns (EPS).
• The EBIT-EPS approach can help balance a company's debt with its
equity.
• Effective business management requires careful planning and
decision-making about the balance of debt and equity used in
financing the business.

4. EBI T – EPS Approach –
• The EBIT-EPS approach is one method available to managers
to guide them in making decisions about capital structure.
• The EBIT-EPS approach is one tool managers use to decide on
the right mix of debt and equity financing in a business's
capital structure.
• To benefit from the EBIT-EPS approach, it helps to understand
the basics of how it works, as well as its advantages and
drawbacks.

5. EBI T – EPS Approach –
• In the EBIT-EPS approach, the business plots graphs of its
performance at different possible debt-to-equity ratios, such as
40 percent debt to 60 percent equity.
• In a basic graph, the earnings per share as a data point is
plotted for each level of earnings before interest and taxes at
different debt-to-equity ratios.
• The graph is then analyzed to determine the ideal level of debt-
to-equity for the business.

6. EBIT/EPS ANALYSIS
• It design various alternatives of debt, equity and preference shares in
order to maximize the EPS at a given level of EBIT.
• It examines how different capital structures affect earnings available
to shareholders (Earning Per Share).
• It is the analysis of the effect of financing alternatives on earnings
per share.
• To design the capital structure of the firm in such a way so as to
minimize the cost of capital.
• EBIT-EPS analysis is a method to study the effect of leverage under
alternative methods of financing.

7. CALCULATION OF EBIT:
Sales : xxxxx
(-)V.C : xxx
=Contribution : xxxxx
(-)F.C : xxxx
=EBIT {Earning Before Interest andTaxes}

8. CALCULATION OF EPS:
EBIT : xxxxx
(-)INTERSET : xxx
=EBT : xxxxx
(-)TAX : xx
=Earning for ESH : xxxxx
(÷) No. of E.S : xxx
= EPS {Earning Per Share} xxx

9. EBIT – EPS BREAK EVEN ANALYSIS:
• The EBIT level at which the EPS is the same for two
alternative financial plan is referred to as the indifference
point/level.
• Financial break even point obtained by a company at a given
level of EBIT for which the firm’s EPS is zero.
• If EBIT is less than financial break even point, then the EPS is
negative.
• If EBIT is more than the financial break even point, then more
and more fixed cost financing option can be used by a firm.

10. DRAWBACKS
• The EBIT-EPS approach is not always the best tool for making
decisions about capital structuring.
• The EBIT-EPS approach places heavy emphasis on maximizing
earnings per share rather than controlling costs and limiting risk.
• It's important to keep in mind that as debt financing increases,
investors should expect a higher return to account for the greater
risk; this is known as a risk premium.
• The EBIT-EPS approach does not factor this risk premium into the
cost of financing, which can have the effect of making a higher level
of debt seem more advantageous for investors than it actually is.

11. LEVERAGE
Leverage is the employment of an asset/source of finance for
which firm pay fixed cost/fixed return. It may of three types:
• Operating Leverage
• Financial Leverage
• Combined Leverage

12. OPERATING LEVERAGE
• It may be defined as the firm’s ability to use fixed operating
costs to magnify the effects of changes in sales on its earnings
before interest and taxes.
• Operating leverage is associated with investment (assets
acquisition) activities.
• Degree of Operating Leverage (DOL) = Percentage change in
EBIT / Percentage change in sales

13. FINANCIAL LEVERAGE
• Financial leverage is the ability of the firm to use fixed
financial charges to magnify the effects of changes in EBIT on
the firm’s earnings per share.
• Degree of financial leverage (DFL)= Percentage change in
EPS divided by Percentage change in EBIT

14. COMBINED LEVERAGE
salesChange%
EPSinchange%
EBITinChange%
EPSinChange%
*
salesinchange%
EBITinChange%
CL
• The degree of combined leverage may be defined as the
percentage change in EPS due to the percentage change in
sales.
• Thus the combined leverage is: