Question

What is Earnings Before Interest and Taxes-Earnings Per Share (EBIT-EPS) analysis? What is the indifference curve? How is risk factored into the EBIT-EPS analysis? What are basic shortcomings of EBIT's analyses?

Answer 1

1. What is Earnings Before Interest and Taxes-Earnings Per Share (EBIT-EPS) analysis?

Earnings before Interest and Taxes (EBIT) helps to measure the profit a company generates from its operations. It focuses only on a company’s capability to generate income from its operation by ignoring tax and interest expenses
EBIT analysis is the study of effect of different types of financing on the levels of returns while a shareholder can get under different cases of EBIT

2. What is the indifference curve?

An indifference curve represents various combination of two goods where customer treats them equally, without having preference and they are expected to provide the same level of utility to a customer.

3. How is risk factored into the EBIT-EPS analysis?

EBIT-EPS analysis has no consideration for risk; this technique ignores the risk which is associated leverage. It does not factor the risk premium factor in cost of financing which can be misleading to investors in some adverse scenarios

4. What are basic shortcomings of EBIT's analyses?

• It concentrates on the maximization of EPS rather than the maximization of owner's wealth
• The EBIT-EPS approach places heavy emphasis on maximizing earnings per share rather than controlling costs and limiting risk.
• Leverage increases the level of risk. This aspect is not dealt in EBIT-EPS analysis.