Untitled-29

(^86) Financial Management
A 40-percent increase in the firmís EBIT will result in a 56-percent increase in EPS.
Applying Equation 3.6 to these values yields

1. 4

40 %

56 %=

+

+

The value of 1.4, when compared to the financial leverage value of 2.5 calculated

earlier indicates that this plan has a lower degree presented initially. Each of these

plans is graphed m Figure 3.8, The original plan, first graphed in Figure 3.1, is labeled

plan A; the current plan is labeled plan B.

Figure 3.2: A graphical comparison of differing financing plans

As Figure 3.8 illustrates, the slope of plan A is steeper than that of plan B

This indicates that plan A has more financial leverage than plan B∑ This result

is as expected, since the ratio of the change in EPS for a given change in

EBIT is 2.5 for plan A and 1.4 for plan B. The higher this ratio is, the more

leverage a plan has. The reader should recognize from Figure 3∑8 that financing plans

with higher degrees of leverage have steeper slopes when plotted on EBIT -EPS axes.

The point of intersection of each plan with the EBIT axis represents the amount of

earnings before interest and taxes necessary for the firm to cover its fixed financial

charges, that is, the point at which EPS = 0. This point of intersection can be thought

of a financial break-even point since it represents the level of EBIT necessary for

the firm to break even on its fixed financial charges. The break-even EBIT for plan

A is Rs. 6,000, and for plan B it is Rs. 3,000 In other words, earnings before interest

and taxes of less than Rs.6,000 with plan A or less than Rs.3,000 with plan B will result

in a loss, or negative EPS.

The point labeled X in Figure 3.2 represents, the point of intersection between plan A

loss, or negative EPS. and plan B∑ It indicates that at a level of EBIT of Rs.9,000, EPS

of Rs. 1.50 would result under either plan. At levels of EBIT below Rs.9,000, plan

Plan A

EBIT(Rs)

EPS (Rs.)

Plan B