6.5 Analysis of Operating profit (EBIT), Earning per share (EPS) at the point of indifference in the firm’s earnings; Determination of the range of firm’s operating profit (EBIT) within which each financing option will be recommended

To analyze the operating profit (EBIT) and earnings per share (EPS) at the point of indifference and determine the range of operating profit within which each financing option is recommended, we need to consider the impact of different financing structures on the company’s earnings.

1. Point of Indifference: The point of indifference is the level of operating profit (EBIT) at which the earnings per share (EPS) is the same, regardless of the financing option chosen. It is the point where two financing options have an equal impact on EPS.

To determine the point of indifference, we compare the EPS under different financing options at different levels of EBIT. We calculate the EPS for each financing option by dividing the earnings available to equity shareholders by the number of outstanding shares.

For example, let’s consider two financing options: an all-equity option and a mix of equity and debt (leveraged) option. At a specific level of EBIT, we calculate the EPS for both options. The point of indifference is reached when the EPS for both options is equal.

2. Range of Operating Profit for Each Financing Option: Once we determine the point of indifference, we can identify the range of operating profit within which each financing option is recommended. This range depends on the financial structure and the impact of interest expenses on EPS.

a) All-Equity Option: In this option, the company is financed entirely by equity, and there is no debt. As a result, there are no interest expenses. This means that the EPS will increase proportionally with the increase in operating profit (EBIT). The range of operating profit where the all-equity option is recommended is typically the entire range of positive operating profits.

b) Leveraged Option: In this option, the company uses a mix of equity and debt for financing. As the company takes on debt, it incurs interest expenses, which reduce the earnings available to equity shareholders. Therefore, the impact of interest expenses on EPS needs to be considered.

The range of operating profit within which the leveraged option is recommended depends on the level of interest expenses and the sensitivity of EPS to changes in EBIT. If interest expenses are relatively low and the company’s operations are not highly sensitive to changes in EBIT, the leveraged option may be recommended across a wider range of operating profits. However, as interest expenses increase and the company becomes more sensitive to changes in EBIT, the range of recommended operating profits for the leveraged option may narrow.

It’s important to note that the specific range of operating profit for each financing option will vary based on the company’s financial structure, interest rates, tax rates, and other factors. An in-depth financial analysis and modeling will be required to determine the precise range for a given company and financing options.