Question

When conducting an​ EPS-EBIT chart for​ UA, if the resulting EPS for equity financing is​ $0.10 and for debt is​ $0.10 considering a pessimistically forecasted​ year, and​ $0.16 and​ $0.17 during an optimistically forecasted year​ respectively, what conclusion could be​ made?

a) The​ EPS/EBIT analysis is not useful considering the parameters presented.

b) Debt financing is the most attractive method in all economic environments regardless of the debt level of the firm.

c) Equity tends to be the best alternative when EPS is less than​ $0.50.

d) Since there is not much spread between debt and equity EPS​ options, the firm is likely not borrowing a significant level of capital.

Answer 1

a) EPS-EBIT analysis is a useful tool in evaluating debt-equity proportion in financing. Parameters used for EPS-EBIT analysis are estimates calculated based on previous experience and statistical analysis. So EPS-EBIT analysis is a reliable technique in analyzing effect of debt financing and equity financing on earning per share(EPS) of a firm.

b) Debt financing has its own merits as well as demerits. One of its merit is its cost. Cost of debt is much lower than cost of euity.Moreover Debt financing provides tax benefits.Becuase interest is a pre-tax cost. One of the major demerit of debt financing is its risk. There is a high risk associated with debt financing. As result using more debts cause deterioration of market value of the firm.

In this case, both debt financing and equity financing results in a same earning per share of $0.10,in pessimist forecast. In an optimist forecast,Eps on debt financing is $ 0.01 more than EPS on equity financing. So in this case, EBIT-EPS analysis shows that using debt in financing does not provide much return in terms of EPS. Therefore ,here equity financing is more preferable.

c) Equity tends to be the best alternative when EPS is less than​$0.50.Because risk associated with equity financing is much lesser than risk associated with debt financing. In case of debt, we should repay the principle amount borrowed after a period of time. But there is no question of repayment of equity capital, unless there is a liquidation of company

d) Since there is not much spread between debt and equity EPS​options, the firm is likely not borrowing a significant level of capital. Using more debt in financing increases the financial leverage of the firm. There is high risk associated with Debt financing. Using more Debt in financing results in reduction of Market value of shares of the firm.