Question

Let say we live in a perfect world! what would happen to the expected EPS and volatility in EPS when we add corporate taxes and leverage? explain.

Answer 1

EPS is primarily the earning available to the each share of the company after payment of all expenses including interest and corporate taxes.

Corporate taxes: Company have to pay a portion of their profit back to the government which will reduce the overall profit available to the shareholders which will bring down the EPS. Normally taxes are fixed hence it will reduce the EPS and EPS volatility depends upon the tax rates.

Leverage: The more debt financing a company uses, the higher its leverage. A high degree of financial leverage means the more capital employed and correspondingly high interest payments.

· Interest payment would reduce the overall EPS

· In case the company is paying taxes, interest will provide some tax shield to the company.

· But the capital employed will yield some return to the company.

· So if the additonal yield from additional investment via debt is higher than the cost of debt, EPS will increase i.e. return in investment (from debt) > Cost of debt= Favourable for EPS

· So if the additonal yield from additional investment via debt is lower than the cost of debt, EPS will decrease i.e. return in investment (from debt) > Cost of debt= Unfavourable for EPS

Leverage can bring volatility on the EPS as there will be constant interest payment towards debt with uncertainty over the return in additiona investment funded by the debts. So we can conclude EPS will rise and fall depending upon the additional contribution of profit from the investment via debt.