Operating and Financial Leverage^83
Thus, when EBIT is Rs. 1,20,000, proposal B involving a total capitalisation of 75
percent common stock and 25 per cent debt would be the most favorable with respect
to earnings per share. It may further be noted that proposition of common stock in total
capitalisation is the same in both the proposals Band D but EPS is altogether different
because of induction of preferred stock. While preferred stock dividend is subject to
taxes where as interest on debt is tax-deductible expenditure resulting in variation in
EPS in proposals B and D. With a 50 percent tax rate the explicit cost of preferred
stock is twice the cost of debt.
We have so far assumed that level of earnings would remain the same even after the
expansion of funds. Now assume that level of earnings before interest and taxes
doubles the present level in correspondence with increase in capitalisation, changes in
earnings per share to common stockholders under different alternatives would be as
follows:
Illustration
Proposal Proposal Proposal Propsal
A B C D
Rs. Rs. Rs. Rs.
EBIT 2,40,000 2,40,000 2,40,000 2,40,000
Less Interest - 2,5000 60,000 -
EBT 2,40,000 2,15,000 1,80,000 2,40,000
Less Taxes @ 50% 1,20,000 1,07,000 90,000 1,20,000
EAT 1,20,000 1,07,000 90,000 1,20,000
Less: Preferred Dividend - - - 25000
Earnings Available to
Common stock holders 1,20,000 1,07,000 90,000 1,20,000
No of Equity Shares 20,000 15,000 10,000 15,000
EPS 6 7.17 9 6.33
EPS before Additional
Issue 3 3 3 3It is evident from illustration that increase in earnings before interest and taxes is
magnified on the earnings per share where debt has been inducted. Thus, in proposal
Band d where debt comprises a portion of total capitalisation, EPS would increase by
more than twice the existing level while in proposal A EPS has improved exactly in
proportion to increase in earnings before interest and taxes. Since dividend in preferred
stock is a fixed obligation and is less than the increase in earnings, EPS in proposal D
also increases more than twice the rise in earning.
Another important conclusion that could be drawn from the above illustration is that
the larger the ratio of debt to equity, the greater the return to equity. Thus, in proposal
C where debt represents 50 per cent of the total capitalisation, EPS is magnified three
times over the existing level while in proposal B where debt has furnished one-third