EBIT-EPS Analysis: Method, Indifference Point and Chart

Understand EBIT-EPS Analysis

Key rules to remember

EPS for a plan

EPS = [(EBIT − I) × (1 − t) − PD] ÷ N

I = total interest under the plan (old plus new debt), t = tax rate, PD = preference dividend, N = number of equity shares after the plan.

Indifference point (no preference shares)

EBIT = (N2 × I1 − N1 × I2) ÷ (N2 − N1)

Plan 1 has N1 shares and interest I1; plan 2 has N2 shares and interest I2. Works when the tax rate is the same in both plans, as the (1 − t) factor cancels.

Indifference point (general, with preference)

(EBIT − I1 − PD1 ÷ (1 − t)) ÷ N1 = (EBIT − I2 − PD2 ÷ (1 − t)) ÷ N2

Gross up the preference dividend by dividing by (1 − t), then solve for EBIT.

Financial breakeven EBIT

EBIT = I + PD ÷ (1 − t)

EPS is zero at this EBIT. It is the x-axis intercept of the plan's line on the chart.

Number of new shares

New shares = Amount raised ÷ Issue price per share

Add to existing shares to get N.

How to solve EBIT-EPS Analysis questions

1. 1List the existing capital: equity shares, existing debt and interest, preference shares and dividend. Note the tax rate and the amount of new funds needed.
2. 2For each financing plan, work out new shares (amount ÷ issue price), total interest (old plus new) and total preference dividend.
3. 3Make one column per plan and rows for EBIT, less interest, EBT, less tax, PAT, less preference dividend, earnings for equity, number of shares, and EPS.
4. 4Fill the EPS table for each EBIT level given in the question. Do not reuse the tax figure of one plan in another.
5. 5If asked for the indifference point, equate the EPS expressions of the two plans and solve for EBIT. Prove it by checking that both plans give the same EPS at that EBIT.
6. 6Compute financial breakeven EBIT for each plan if asked, using I + PD ÷ (1 − t).
7. 7Compare expected EBIT with the indifference point and state the best plan. Mention that the plan with higher EPS at expected EBIT is preferred on this test, but financial risk should also be considered.
8. 8If a chart is asked for, plot two points for each plan (for example, EPS at two EBIT levels, or zero at the breakeven), join them, label axes, plans and the crossing point.

Quickest way: Indifference point first, then compare

Common mistakes in EBIT-EPS Analysis

• Ignoring existing interest when adding new debt

  Students only see the new loan in the plan and forget the old debentures or loans already in the balance sheet.

  Fix: Always write total interest = old interest + new interest for each plan before building the table.

• Deducting preference dividend before tax

  Preference dividend looks like a charge, so it gets treated like interest.

  Fix: Preference dividend is paid out of profit after tax. Deduct it after PAT, and gross it up by (1 − t) when solving for the indifference point.

• Wrong number of shares

  Students forget to add existing shares, or divide by face value instead of issue price when the shares are issued at a premium.

  Fix: New shares = amount raised ÷ issue price. Then add the existing shares.

• Saying debt is always better

  Debt is cheaper and gives tax saving, so it is assumed to win.

  Fix: Debt wins only when expected EBIT is above the indifference point. Below it, equity gives higher EPS.

• Errors in the chart

  Axes are swapped, lines are not labelled, or the breakeven intercepts are ignored.

  Fix: EBIT goes on the x-axis and EPS on the y-axis. Plot each line from its two points, mark the crossing as the indifference point, and label the breakeven points.

• Sign error while solving the indifference equation

  Cross multiplication with negative interest differences creates confusion.

  Fix: Keep the same plan labelling in the numerator and denominator, and always check by substituting the answer back into both EPS expressions.

Worked examples