Calculation of Point of Indifference | Capital Structure

After reading this article you will learn about Calculation of Point of Indifference.

The EPS, earnings per share, ‘equivalency point’ or ‘point of indifference’ refers to that EBIT, earnings before interest and tax, level at which EPS remains the same irrespective of different alternatives of debt-equity mix At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as break-even level of EBIT for alternative financial plans.

The equivalency or point of indifference can be calculated algebraically, as below:

Where, X = Equivalency Point or Point of Indifference or Break Even EBIT Level.

I₁ = Interest under alternative financial plan 1.

I₂ = Interest under alternative financial plan 2.

T = Tax Rate

PD = Preference Dividend

S₁ = Number of equity shares or amount of equity share capital under alternative 1.

S₂ = Number of equity shares or amount of equity share capital under alternative 2.

The point of indifference can also be determined by preparing the EBIT chart or range of earnings chart. This chart shows the expected earnings per share (EPS) at various levels of earnings before interest and tax (EBIT) which may be plotted on a graph and straight line representing the EPS at various levels of EBIT may be drawn. The point where this line intersects is known as point of indifference or break-even point.

The following illustrative example explains the calculation of point of indifference:

Illustration 1:

A project under consideration by your company requires a capital investment of Rs. 60 lakhs. Interest on term loan is 10% p.a. and tax rate is 50% Calculate the point of indifference for the project, if the debt-equity ratio insisted by the financing agencies is 2:1:

Solution:

As the debt equity ratio insisted by the financing agencies is 2:1, the company has two alternative financial plans:

(i) Raising the entire amount of Rs. 60 lakhs by the issue of equity shares, thereby using no debt, and

(ii) Raising Rs. 40 lakhs by way of debt and Rs. 20 lakh by issue of equity share capital.

Calculation of point of Indifference:

Where, X = Point Indifference

I₁ = Interest under alternative 1, i.e. .0

I₂ = Interest under alternative 2, i.e. 10/100 × 40 = 4

T = Tax rate, i.e. 50% or .5

PD = Preference Divided, i.e. O as there are no preference shares.

S₁ = Amount of equity capital under alternative 1, i.e. 60.

S₂ = Amount of equity capital under alternative 2, i.e. 20.

Substituting the values:

Thus, EBIT, earnings before interest and tax, at point of indifference is Rs. 6 lakhs. At this level (6 lakh) of EBIT, the earnings on equity after tax will be 5% p.a. irrespective of alternative debt-equity mix when the rate of interest on debt is 10% p, a.

From the figure given on next page, we find that the equivalency point (point of indifference) or the break-even level of EBIT is Rs. 6 lakhs. In case, the firm has EBIT level below Rs. 6 lakhs then equity financing is preferable to debt financing; but if the EBIT is higher than Rs. 6 lakhs then debt financing; but if the EBIT is higher than Rs. 6 lakhs then debt financing is better.

Illustration 2:

A new project under consideration requires a capital outlay of Rs. 600 lakhs for which the funds can either be raised by the issue of equity shares of Rs. 100 each or by the issue of equity shares of the value of Rs. 400 lakhs and by the issue of 15% loan of Rs. 200 lakhs. Find out the indifference level of EBIT given the tax rate at 50%:

Solution:

Thus, the indifferent level of EBIT is Rs. 90 lakhs. At this level of EBIT, the earnings per share (EPS) under both the plans would be the same.