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Indifference Point Debt Funding

Indifferent point Debt, Equity Capital Assignment / Homework Help
Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the same for two alternative financial plans. The indifferent point can be defined as "the level of EBIT beyond which the benefits of financial leverage begin to operate with respect to Earnings Per share (EPS)". If the EBIT exceeds the indifference point level of EBIT, the use of fixed-cost source of funds would be beneficial from the EPS viewpoint. In this case, financial leverage would be favorable. In the reverse scenario, if the expected level of EBIT is less than the indifference point, the advantage of EPS would be available from the use of equity capital and not debt capital.

The point of indifference can be calculated using the following formula:

Indiffernce point

Where:

X = EBIT indifference level

I1 = Fixed interest costs under alternative 1.

I2 = Fixed interest costs under alternative 2.

PD = Preference dividend, if any.

T = Tax rate

S1 = Number of equity shares outstanding under alternative 1.

S2 = Number of equity shares outstanding under alternative 2.

Example:

A new project is under consideration by a company which involves a capital investment of $15,000,000. Fixed interest on debt capital is 12% and tax rate is 50%. If the debt-equity ratio insisted by the financing agencies is 2:1, calculate the point of indifference. The new equity shares can be issued for $100 par value. There are no preference shares.

Solution:

The 2 alternatives available are:

  • Raising the entire amount by equity shares and

  • Raising $10,000,000 by equity and $5,000,000 by debt to maintain a debt-equity ratio of 2:1.

Alternative 1:

Interest = $0 (as no debt)
Number of equity shares = $15,000,000/$100 par ⇒ 150,000 shares.

Alternative 2:

Interest = $5,000,000 x 12% ⇒ $600,000
Number of equity shares = $10,000,000/$100 par ⇒ 100,000 shares.
Preference dividend in both alternatives is zero.

Calculation of Indifference point:

Intermediate Difference

X (.50) ⁄ 150,000 = (.50X - 300,000) ⁄ 100,000

Solving for the above equation, we get X = $1,800,000.

X = Indifference EBIT level = $1,800,000.

If the EBIT crosses the above indifference level EBIT, the use of fixed-cost source of funds would be beneficial from the EPS viewpoint and the financial leverage would be favorable.


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