The EBIT-EPS capital structure approach focuses on finding the capital structure that results in the highest earnings per share (EPS) over the expected range of earnings before interest and taxes (EBIT). While this approach considers maximizing returns through higher EPS, its major shortcoming is that it ignores risk. As financial leverage increases with more debt, so does risk, but shareholders require higher returns to compensate for the increased risk. Therefore, this approach is not fully appropriate because it does not consider the key factor of risk, which is necessary to maximize shareholder wealth. Risk can be considered in two ways using this approach - through the financial breakeven point and the slope of the capital structure line.

1. EBIT-EPS Capital Structure Approach
The EBIT-EPS capital structure approach focuses on finding a capital structure with the highest
EPS (earnings per share) over the expected range of EBIT (earnings before interest and taxes).
The reason why we are interested in finding a capital structure which will permit maximization
of the EPS over the expected range of EBIT is because it partially helps us to achieve the
ultimate objective of the enterprise. The ultimate objective of the enterprise is to maximize
shareholders’ wealth by maximizing its stock price. Two key variables that affect stock price are
return (earnings attributed to owners of the enterprise) and risk (which can be measured by
required return (rs)). This approach explicitly considers maximization of returns (EPS).
However, it is important to note that this approach ignores risk (does not explicitly consider
risk).
Major shortcoming of the EBIT-EPS approach
The fact that this approach fails to explicitly consider risk is the major shortcoming of this
method. As firm obtains more debt (its financial leverage increases), the risk also increases and
shareholders will require higher returns to compensate for the increased financial risk. Therefore,
this approach is not completely appropriate because it does not consider one of the key variables
(risk), which is necessary for maximization of shareholders’ wealth.
Considering financial risk
As per above, the approach does not explicitly consider financial risk. However, when utilizing
the approach, financial risk can be considered in two ways:
1) The approach measures financial risk by the financial breakeven point. The higher the
breakeven point the greater the financial risk.
2) The approach also measures the financial risk by the slope of the capital structure line. The
steeper the capital structure line the greater the financial risk.

2. EBIT-EPS Graph
It is a graphical approach. EPS is plotted on the vertical axis (x-axis) and EBIT on the horizontal
axis (y-axis). By connecting the coordinates for different capital structures (different variations
of equity versus debt), capital structure lines for each capital structure are graphed.
We will need to represent EBIT-EPS coordinates (capital structure lines) for different capital
structures to ascertain at which levels of EBIT which capital structure is preferred. This will
allow us to find a capital structure with the highest EPS over the expected range of EBIT.
For the purposes of this article it is sufficient to mention that to find EBIT-EPS coordinates we
can assume particular EBIT values (and associated earnings available for common stockholders
values) and calculate EPS in line with such values for different capital structures.
The formula to calculate EPS is as follows:
EPS = Earnings Available for Common Stockholders/ Number of Shares of Common Stock
Outstanding
Another easy way to find one of the EBIT-EPS coordinates is to use the financial breakeven
point calculation. Financial break-even point occurs at the level of EBIT (earnings before interest
and taxes) at which EPS (earnings per share) equals zero. At this level of EBIT all fixed financial
costs are covered. The formula for calculation of the financial break-even point is as follows:
Financial break-even point = (I + PSD)/ (1-T)
Where:
I – interest charges
PSD – preferred stock dividends
T – tax rate

3. This capital structure approach does NOT allow us to determine the point where weighted
average cost of capital is at a minimum and where stock price is at a maximum (where wealth of
the owners of the firm is maximized). The approach focuses on maximizing earnings rather than
on maximizing wealth. Therefore, although it is helpful to use when analyzing alternative capital
structures, the major shortcoming of this approach should be taken into account.