What is Indifference Analysis?
It is through ‘debt-equity mix’ that financing decision are made to increase EPS of a company, EBIT-EPS analysis involves determining the ‘crossover’ or ‘indifference’ EBIT at which the EPS is the same between two financing alternatives. In other words, the use of a financial break-even level, and the return from alternative financial plans is called indifference analysis.
In fact, EBIT – EPS analysis involves the comparison of alternative methods of financing and their impact on earnings. While making financial decisions, the company has many options. For example, if a company has to raise funds for financing its investment proposals, it has options such as:
- raise funds exclusively through equity capital,
- raise funds exclusively through debts;
- raise funds exclusively through preference shares; or
- combination of these sources, where the company should decide the proportion of (1), (2), and (3) to increase EPS.
The choice of proportion of various sources would be to ensure the highest EPS at the given level of Earnings before Interest and Taxes (EBIT). Thus, EBIT – EPS analysis helps in determining EPS under various financial plans. The indifference analysis is generally done by using the formula stated here.
Formula for the Indifference Analysis
Supposing the company is comparing two possible financing alternatives 1 and 2, then the indifference EBIT is calculated as follows:
EBIT = the indifference EBIT
I = interest
T = tax Rate
D = the dividend on Preference shares
N = the number of equity shares outstanding
If the capital structure of the company does not contain preference shares and the earnings of the company do not come under tax bracket, then the following formula can be applied:
Calculating Indifference Point
Necessary conditions for calculating indifference point:
- Capital structure should have equity capital as one of the components.
- Financial plans should have different equity capital base.
XYZ Company requires $1,000,000 for its proposed plan. Following financial alternatives are available:
Plan I: 100% Equity Capital (Face Value $100)
Plan II: 50% Equity Capital (Face Value $100) and 50% debenture (interest rate 6%)
Plan III: 50% Equity Capital (Face Value $100) and 50% Preference shares (rate of dividend 6%)
Plan IV: 25% Equity Capital (Face Value $100), 25% debentures (interest rate 6%) and 50% preference shares (rate of dividend 6%)
The rate of tax applicable to the company is 50%. The company expects an EBIT of $4,000,000.
- EPS for each plan
- Financial break-even
- Indifference point of EBIT between different plans
1. Calculating of EPS under different plans
2. Determination of financial break-even
Plan I: There is no fixed financial charge (debenture interest or preference dividend). Therefore, there is no financial break-even.
Plan II: Fixed financial charges is $30,000 (interest on debentures). Therefore, the financial break-even is $30,000.
Plan III: In the case of Plan III, the fixed financial charge is $30,000 (preference dividend). Preference dividend is payable out of profit after tax. The tax rate applicable is 50%. Therefore, the financial break-even is $60,000 (Dividend 30,000 + Tax 30,000).
Plan IV: In the case of Plan IV, the fixed financial charges are $75,000, i.e., interest on debentures $15,000 + preference dividend ($30,000 + Tax on profit $30,000) $60,000.
3. Indifference point of EBIT between different plans
Plan I and Plan II
Plan I and Plan III
Plan I and Plan IV
Plan II and Plan III
Plan II and Plan III are not comparable as they have got the same equity capital base.
Plan III and Plan IV
Calculation of EPS at Various Levels
Note: Plan I and III with EBIT $120,000 are considered to be beneficial as they have the highest EPS of $5.