Capital Structure Theories^313
It can be seen from above Table that when the EBIT level exceeds the financial break-
even level (Rs 25,000, Rs 60,000 and Rs 38,462 for financing alternatives, B, C and D'
respectively) EPS increases. The percentage increase in EPS is the greatest when
EBIT is nearest the break-even point. Thus, in Plan C an increase of 25 per cent in
EBIT (from Rs 80,000 to Rs 1,00,000) results in a 100 per cent increase in EPS (from
Re 1.3 to Rs 2.6), whereas the percentage increase in EPS is only 40 per cent (from Rs
6.5 to Rs 9.1) as a result of the change in EBIT at higher levels from Rs 1,60,000 to Rs
2,00,000 (i.e. 25 per cent increase).
We can also see from Tables that the EPS for different financing plans at a given level
of EBIT is equal. At EBIT levels above or below the given level, the EPS is higher or
lower. Thus, for alternatives A and C at the EBIT level of Rs 1,20,000 the EPS is the
same, that is, Rs 3.9. If EBIT is below this level, alternative A (ordinary shares) will
provide higher EPS; above this level, the 1 debt alternative (C) is better from the viewpoint
of EPS.
Between preference share (D) and ordinary share (A) alternatives, the EPS is equal
(Rs 5.2) at Rs 1,60,000 EBIT level. above this level alternative D will give better EPS;
while below it, alternative A. The earnings per share (EPS) in alternatives A and B are
the same at EBIT level of Re 1,00,000. Above B would provide higher EPS.
The debt alternative (B) gives higher EPS for all levels of EBIT as compared to the
preference share alternative (D).
Indifference Point
The EBIT level at which the EPS is the same for two alternative financial plans is
referred to as the indifference point/level. The indifference point may be defined as the
level of EBIT beyond which the benefits of financial leverage begin To operate with
respect to earnings per share (EPS). In operational terms, if the expected level is to
exceed the indifference level of EBIT, the use of fixed-charge source of funds (debt)
would be advantageous from the viewpoint of EPS, that is, financial leverage will be
favourable and lead to an increase in the EPS available to the shareholders. The capital
structure should include debt. If, however, the expected level of the EBIT is less than
the indifference point, the advantage of EPS would be available from the use of equity
capital.
The indifference point between two methods of financing can be obtained mathematically
(algebraic approach) as well as graphically.
Algebraic Approach Mathematically, the indifference point can be obtained by using
the following symbols:
X = earnings before interest and taxes (EBIT) at the indifference point