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Capital Structure Theories^319

(1-0.35). Thus, the starting point of preference share financial plan would be Rs 2 lakh.

The indifference points of Figs. 1 and 2 correspond to what we have determined through
the algebraic approach. But the utility of the EBIT-EPS chart lies in its being more
informative regarding the EBIT-EPS relationship. It gives a bird's eye view of EPS at
various Levels of EBIT. The EPS value at the estimated level of EBIT can be promptly
ascertained. Moreover, it more easily explains why an equity financing plan is better
than other plans requiring debenture and/or preference shares for the EBIT level below
the BEP. For instance, Fig 2. indicates that for all EBIT levels below Rs d lakh, the EPS
under equity alternative is greater than 33 per cent preference share financing plan and
for all EBIT levels above Rs 6 lakh, the EPS is greater under 33 per cent financing plan
than 100 per cent equity financing. The IP can be compared with the most likely level
of EBIT. If the likely level of EBIT is more than the IF, the use of fixed cost financing
plan may be recommended, otherwise equity plan would be more suitable. To sum up,
the greater the likely level of EBIT than the indifference point, the stronger is the case
for using levered financial

Figure 2: EBIT-EPS Analysis

plans to maximise the EPS. Conversely, the lower the likely level of EBIT in relation to
the indifference point. the more useful the unlevered financial plan would be froni the
view point of EPS. In other words, financial leverage will be favourable and shareholders
will get higher EPS if the return on total investment is more than the fixed cost (interest
and preference dividend). If the return is less than the fixed financial charge, the EPS
will decline with the use of debt and the leverage will be unfavourable. The financial
leverage will have no effect on EPS in case the return on investment is exactly equal to
the fixed financial costs.

The indifference point may be computed in another way using nlarket value as the
basis. Since the operational objective of financial management is the maximisation of
share prices, the market price of shares of a firm with two different financial plans

EBIT (Rs in lakhs)

Equity

Advantage

Equity + Preference

Advantage

Equity + Preference

Alternative

Equity Alternative

Indifference point

EPS (Rs) 19.5^

13

6.5

26

32.5

0 1 2 3 4 5 6 7 8 9 10 11 12