536 PART 4 Long-Term Financial Decisions
- The relationship that is expected to exist between EPS and owner wealth is not one of cause and effect. As indi-
cated in Chapter 1, the maximization of profits does not necessarily ensure that owners’ wealth is also being maxi-
mized. Nevertheless, it is expected that the movement of earnings per share will have some effect on owners’ wealth,
because EPS data constitute one of the few pieces of information investors receive, and they often bid the firm’s
share price up or down in response to the level of these earnings. - A convenient method for finding one EBIT–EPS coordinate is to calculate the financial breakeven point,the level
of EBIT for which the firm’s EPS just equals $0. It is the level of EBIT needed just to cover all fixed financial costs—
annual interest (I) and preferred stock dividends (PD). The equation for the financial breakeven point is
Financial breakeven pointI
where Tis the tax rate. It can be seen that when PD$0, the financial breakeven point is equal to I, the annual
interest payment.
PD
1 Tfinancial breakeven point
The level of EBIT necessary to
just cover all fixed financial
costs;the level of EBIT for which
EPS$0.
Presenting a Financing Plan Graphically
To analyze the effects of a firm’s capital structure on the owners’ returns, we con-
sider the relationship between earnings before interest and taxes (EBIT) and earn-
ings per share (EPS). A constant level of EBIT—constant business risk—is
assumed, to isolate the effect on returns of the financing costs associated with
alternative capital structures. EPS is used to measure the owners’ returns, which
are expected to be closely related to share price.^20The Data Required
To graph a financing plan, we need to know at least two EBIT–EPS coordinates.
The approach for obtaining coordinates can be illustrated by an example.EXAMPLE EBIT–EPS coordinates can be found by assuming specific EBIT values and calcu-
lating the EPS associated with them.^21 Such calculations for three capital struc-
tures—debt ratios of 0, 30, and 60%—for Cooke Company were presented in
Table 12.12. For EBIT values of $100,000 and $200,000, the associated EPS val-
ues calculated there are summarized in the table within Figure 12.6.Plotting the Data
The Cooke Company data can be plotted on a set of EBIT–EPS axes, as shown in
Figure 12.6. The figure shows the level of EPS expected for each level of EBIT.
For levels of EBIT below the x-axis intercept, a loss (negative EPS) results. Each
of the x-axis intercepts is a financial breakeven point,the level of EBIT necessary
to just cover all fixed financial costs(EPS$0).Comparing Alternative Capital Structures
We can compare alternative capital structures by graphing financing plans as
shown in Figure 12.6.EXAMPLE Cooke Company’s capital structure alternatives were plotted on the EBIT–EPS
axes in Figure 12.6. This figure shows that each capital structure is superior to
the others in terms of maximizing EPS over certain ranges of EBIT. The zero-
leverage capital structure (debt ratio0%) is superior to either of the other capi-