The earnings before interest and taxes (EBIT) and earnings per share (EPS) are two important figures to understand when you are trying to raise money for a company. Three basic ways to raise money are: issuing preferred stock, issuing common stock and borrowing money. By graphing the earnings per share for various projected EBIT earnings, you can determine where the common stock EPS crosses over the other two lines. These are indifference points--the points where it doesn't matter which one you use, because the EPS will be the same either way.
It is important to note that debt and preferred stock, due to their similar nature (paying regular instalments), never cross. Common stock is the only stock that will have an indifference point with the other two.
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Calculate the annual interest payments for a debt financing option. If you are borrowing £650 and the interest rate is 5 per cent, then the annual interest payments are £32.
Calculate the annual dividend payments for each of the stock financing options. Assume that in this case you are offering a 6 per cent annual interest rate--$60. Note that common stock options do not come with mandatory dividends.
Subtract the interest or dividends from your projected annual earnings. Assume your projected annual earnings are £325. Both options leave you with £292 and £286, respectively. Common stock leaves you with £325, as there is no dividend.
Set a number of shares. Common stock will need to have more shares, as it needs to compensate for the lack of dividends. Assume you are selling 10 shares of debt, 10 shares of preferred stock and 20 shares of common stock.
Divide the number of shares by the earnings available. The equations for debt, preferred stock and common stock are 450/10, 440/10 and 500/20, or £29, £28 and £16. These are the values each share will sell for.
Repeat this process for different projected earnings levels.
Graph your results with EPS on the x axis and EBIT on the y axis and find where they intersect. The two points where the common stock intersect with the other two lines are your indifference points--the sales levels where it is irrelevant whether you use common stock or not.
Tips and warnings
- This process really only applies to common stock. Preferred stock and debt both have different advantages, such as debt's tax-deductibility. However, debt is harder to come by than preferred stock, and preferred stock is harder to come by than common stock.
- This article simplifies the process, removing many salient details such as tax.
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