BUSINESS 5039

INDIFFERENCE ANALYSIS / EBIT/EPS ANALYSIS

Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years.
The company is now operating at 100% of capacity and must expand in order to meet the
demand for its new line of video games.
The current financial statements for Thunder Bay Industries is as follows:
Thunder Bay Industries
Balance Sheet
as at December 31, 20xx
($ '000s Cdn.)

Assets:
Cash
Accounts receivable
Inventories
Net Fixed Assets
Total Assets

1,000
2,100
2,766
16,244
_______
$22,110

Liabilities and Owner's Equity:

Accounts payable
550
Accruals
249
Other current liabilities
1
8% bonds maturing in 10 years
5,000
Common stock (100,000 outstanding) 1,000
Retained earnings
15,310
Total Liabilities and Owner's Equity $22,110

Thunder Bay Industries

Income Statement
for the year ended December 31, 20xx
($ '000s Cdn)

Sales
Cost of Goods Sold
Gross Margin on Sales
Administrative and Selling Expenses
Earnings before Interest Expense and Taxes
Interest expense
Earnings before tax
Taxes
Net Income

$25,002
18,252
$ 6,750
4,000
2,750
400
$ 2,350
1,011
$1,339

If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company
undertakes the planned expansion management has identified a probability distribution for possible EBIT
levels:
Possible EBIT
$2,200
$2,700
$3,200
$3.700

Probability
.1
.4
.4
.1
Page 1

The planned expansion will require Thunder Bay Industries to raise $10,000,000 in new capital.
If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. New common stock
could be sold for $250.00 per share.
Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater than the
indifference point? Which method of financing is most likely to maximize earnings per share?
What method of financing do you recommend? Why? Discuss the limitations of indifference
analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.

Page 2

Thunder Bay Industries

Indifference Analysis
Possible EBIT
Probability
Wtd EBIT
2200
0.1
220
2700
0.4
1080
3200
0.4
1280
3700
0.1
370
Expected EBIT =
2950

EBIT = .1( 750 2 ) +.4( 250 2 ) +.4( 250 2 ) +.1(750 2 )

= 56250 + 25,000 + 25,000 +56250
= 162,500
= 403.11
= $403,110

Our prediction for EPS at EBIT=$2,675,000 for the common share financing alternative is

EPS common =
EPS debt =

( EBIT I )(1 T )
n1 + n2

( EBIT I1 I 2 )(1 T )
n1

EPS common = EPS debt

( EBIT I1 )(1 T ) ( EBIT I1 I 2 )(1 T )
=
n1 + n2
n1
( EBIT 400,000)(1 .43) ( EBIT 400,000 650,000)(1 .43)
=
100,000 + 40,000
100,000
EBIT = $2,675,000
($2,675,000 $400,000)(1 .43)
EPS commonshare =
= $9.26
140,000
($2,675,000 $1,050,000)(1 .43)
EPS Debt =
= $9.26
100,000

The probability than EBIT will favour common stock financing (ie. be less than the indifference
point) is:
z=

Where z = the number of standard deviations away from the mean

Page 3

X = the point of interest

= the standard deviation of the probability distribution
= the mean of the probability distribution
2,675,000 2,950,000
403,110
= 0.6822

z=

The negative sign indicates that the point of interest (X) or (indifference point) lies on the lefthand side of the mean. It lies .6822 of 1 standard deviation away from the mean.

Area = .5

Area = .2517

=$2,950,000
X=$2,675,000

Going to the table for Values of the Standard Normal Distribution Function we find the area
under the curve between the point of interest and the mean of the distribution to be:
.2517 or 25.27%
Therefore the probability that EBIT will exceed the indifference point (favouring debt financing)
is 75.17% The probability that EBIT will be below the indifference point (favouring equity
financing is (1- .7517) 24.83%.

Page 4

EPS
Debt
Financing

$9.26

Area = .5

Area = .2517

$400,000

$1,050,000

=$2,950,000
X=$2,675,000

Equity
Financing

EBIT

Page 5

Values of the Standard Normal Distribution Function

Z

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.0
0.1
0.2
0.3
0.4
0.5

.0000
.0398
.0793
.1179
.1554
.1915

.0040
.0438
.0832
.1217
.1591
.1950

.0080
.0478
.0871
.1255
.1628
.1985

.0120
.0517
.0910
.1293
.1664
.2019

.0160
.0557
.0948
.1331
.1700
.2054

.0199
.0596
.0987
.1368
.1736
.2088

.0239
.0636
.1026
.1406
.1772
.2123

.0279
.0675
.1064
.1443
.1808
.2157

.0319
.0714
.1103
.1480
.1844
.2190

.0359
.0753
.1141
.1517
.1879
.2224

0.6
0.7
0.8
0.9
1.0

.2257
.2580
.2881
.3159
.3413

.2291
.2611
.2910
.3186
.3438

.2324
.2642
.2939
.3212
.3461

.2357
.2673
.2967
.3238
.3485

.2389
.2704
.2995
.3264
.3508

.2422
.2734
.3023
.3289
.3531

.2454
.2764
.3051
.3315
.3554

.2486
.2794
.3078
.3340
.3577

.2517
.2823
.3106
.3365
.3599

.2549
.2852
.3133
.3389
.3621

1.1
1.2
1.3
1.4
1.5

.3643
.3849
.4032
.4192
.4332

.3665
.3869
.4049
.4207
.4345

.3686
.3888
.4066
.4222
.4357

.3708
.3907
.4082
.4236
.4370

.3729
.3925
.4099
.4251
.4382

.3749
.3944
.4115
.4265
.4394

.3770
.3962
.4131
.4279
.4406

.3790
.3980
.4147
.4292
.4418

.3810
.3997
.4162
.4306
.4429

.3830
.4015
.4177
.4319
.4441

1.6
1.7
1.8
1.9
2.0

.4452
.4554
.4641
.4713
.4773

.4463
.4564
.4649
.4719
.4778

.4474
.4573
.4656
.4726
.4783

.4484
.4582
.4664
.4732
.4788

.4495
.4591
.4671
.4738
.4793

.4505
.4599
.4678
.4744
.4798

.4515
.4608
.4686
.4750
.4803

.4525
.4616
.4693
.4756
.4808

.4535
.4625
.4699
.4761
.4812

.4545
.4633
.4706
.4767
.4817

2.1
2.2
2.3
2.4
2.5

.4821
.4861
.4893
.4918
.4938

.4826
.4864
.4896
.4920
.4940

.4830
.4868
.4898
.4922
.4941

.4834
.4871
.4901
.4925
.4943

.4838
.4875
.4904
.4927
.4945

.4842
.4878
.4906
.4929
.4946

.4846
.4881
.4909
.4931
.4948

.4850
.4884
.4911
.4932
.4949

.4854
.4887
.4913
.4934
.4951

.4857
.4890
.4916
.4936
.4952

2.6
2.7
2.8
2.9
3.0

.4953
.4965
.4974
.4981
.4987

.4955
.4966
.4975
.4982
.4987

.4956
.4967
.4976
.4982
.4987

.4957
.4968
.4977
.4982
.4988

.4959
.4969
.4977
.4984
.4988

.4960
.4970
.4978
.4984
.4989

.4961
.4971
.4979
.4985
.4989

.4962
.4972
.4979
.4985
.4989

.4963
.4973
.4980
.4986
.4990

.4964
.4974
.4981
.4986
.4990

z is the number of standard deviations from the mean. Some area tables are set up to indicate the area to the left or
right of the point of interest. In this table, we indicate the area between the mean and the point of interest.

Page 6