## Sunday, 24 June 2012

### Differing amounts of debt financing cause changes in EPS and thus a company's stock price.

Effect of Changes in Sales or Earnings on EBIT
Differing amounts of debt financing cause changes in EPS and thus a company's stock price. The calculations for EBIT and EPS are as follows:

Formula 11.16

 EBIT = sales - variable costs - fixed costsEPS = [(EBIT - interest)*(1-tax rate)] / shares outstanding

This LOS is best explained by the use of an example.

Example:The following is Newco's cost of debt at various capital structures. Newco has \$1 million in total assets and a tax rate of 40%. Assume that, at a debt level of zero, Newco has 20,000 shares outstanding.

Figure 11.10: Newco's cost of debt at various capital structures

In addition, Newco has annual sales of \$5 million, variable costs are 40% of sales and fixed costs are equal to \$2.4 million. At each level of debt, determine Newco's EPS.

Shares outstanding are 20,000 and interest costs are 0.
EPS = [(\$5,000,000 - 2,000,000 - 2,400,000-0)*(1-0.4)]/20,000
EPS = \$18 per share

At debt level 20%:
Shares outstanding are 16,000 [20,000*(1-20%)] and interest costs are 8,000 (200,000*0.04).
EPS = [(\$5,000,000 - 2,000,000 - 2,400,000-8,000)*(1-0.4)]/16,000
EPS = \$22.20 per share

At debt level 40%:
Shares outstanding are 12,000 [20,000*(1-40%)] and interest costs are 24,000 (400,000*0.06).
EPS = [(\$5,000,000 - 2,000,000 - 2,400,000-24,000)*(1-0.4)]/12,000
EPS = \$28.80 per share

At debt level 60%:
Shares outstanding are 8,000 [20,000*(1-60%)] and interest costs are 48,000 (600,000*0.08).
EPS = [(\$5,000,000 - 2,000,000 - 2,400,000-48,000)* (1-0.4)]/8,000
EPS= \$41.40 per share

At debt level 80%:
Shares outstanding are 4,000 [20,000*(1-80%)] and interest costs are 80,000 (800,000*0.10).
EPS = [(\$5,000,000 - 2,000,000 - 2,400,000-80,000)* (1-0.4)]/4,000
EPS = \$78.00 per share

With each increase in debt level (accompanied with the decrease in shares outstanding), Newco's earnings per share increases.