Question on EPS with leverage

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rajagopalan_v

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Hello,
I was under the impression that EPS is simply earnings over outstanding shares, irrespective of capital structure (assuming no dilutive effects).

While studying the topic on leverage, I found out that the outstanding shares are adjusted when the D/A ratios change. Eg. Outstanding share (No debt) = 10, with D/A of 10%, outstanding shares is reduced by 10% to 9 . More debt results in higher EPS

Could anyone please comment on the concept why outstanding shares are reduced with higher D/A? To me, the outstanding shares should not change unless the company issues debt to buy come shares back?

Appreciate your thoughtful comments
Raj
 
Found this in the Scheweser's material that covers topics on Optimal capital structure, financial leverage etc. (couldn't recall the exact LOS).
They had a working example that showed how the EPS changed with increasing Debt/Asset ratio and kind of reasoned that even though the EPS goes up with debt, the risk (std. dev. of EPS) also goes up. So one needs to consider what is the source of higher EPS etc.

Does this help?
 
I was confused about this too...

But I guess the Schweser example refers to the composition of capital structure, so as debt increases the there is a decrease in equity...

For example, Capital:$10,000, $1 per Share

D/A, 0%: Debt 0 , Equity$10,000

D/A,10%:Debt $1000, Equity`$9000

And so on...

Anyway this is my understanding of this example... please clarify

cheers
 
I was confused about this too...

But I guess the Schweser example refers to the composition of capital structure, so as debt increases the there is a decrease in equity...

For example, Capital:$10,000, $1 per Share

D/A, 0%: Debt 0 , Equity$10,000

D/A,10%:Debt $1000, Equity`$9000

And so on...

Anyway this is my understanding of this example... please clarify

cheers
 
I think you guys are referring to convertible debt. If debt is convertible to equity and visa-versa this will decrease the ratio.
 
MikeMilken, thanks. I am confused too.
Crossover, my question was generic debt and I was not referring to convertible debt. Thanks for pointing this out anyway.

When I did a google search the closest I could find in a presentation on leverage is the following:

EPS = ROE * Book value per share;
ROE = Net Income/Equity
Net income = (EBIT - (debt)*interest)*(1-tax)
Equity = Total capital (Asset?) - Debt
As Debt increases, equity decreases, ROE goes up and so does EPS

Having said that, I couldn't relate to what will happen in practice....of calculating EPS on shares outstanding. As the company issues debt, will it retire some common stock outstanding? how and why? i am still unclear. I am sure you are in the same dilemma

Super I, any comments from your side?
 
Something is messed up in Schweser or your reading of it. EPS is not affected by the debt of the company. It is, as you say, (Net income - preferred div)/shares outstanding.

A company might issue debt to buy back stock but that is not a primary purpose of issuing debt. In any event, the EPS would not be affected because the company would usually hold treasury stock and not "retire" it (I think that's true, but Super I definitely knows more about this than me).
 
I think that the poster MikeMilken above had the right answer.

This is not accounting question per se, rather it is a discussion of the benefits of the use of leverage as viewed from a corporate finance perspective.

rajagopalan_v said that he found this in a Schweser section covering optimal capital structure, so the comment on eps should be viewed only in that context, where you are analyzing the effects of a trade-off between between debt and equity financing for a given total capital structure, rather than an increase in debt without a corresponding reduction in equity.

If you look at the last part of the presentation that rajagopalan_v has in his post above from his google search:

Equity = Total capital (Asset?) - Debt
As Debt increases, equity decreases, ROE goes up and so does EPS


It does appear that increasing debt will reduce equity, but you have to remember that for every increase in debt, there is going to be a corresponding increase in assets from the cash raised (or reduction in other debt that was refinanced, etc.) so both numbers on the right side of the equation will be increased by the same dollar amount, with no net change in equity. The only way equity changes is if asset levels remain constant, meaning a trade-off between the two in your capital structure, not incremental debt.
 
Super I, JoeyD and MikeM
Thank you very much for your in-depth comments. I think I understand what the notes was trying to do.

As Super I mentioned, I think they are talking about 'Scenario' type analysis of what is the effect of Debt vs. Equity, before raising the capital for the first time. Any subsequent issues of debt are incremental and have no impact as you have pointed out. I can understand this line of logic.
I only wish Schweser's had been a bit more explicit about this while showing the working example.

Once again, thank you very much for your comments!!
Raj
 
My final take on this is that , I think Schweser is looking at this question as

Capital= Equity+ Debt

I agree with Raj about Schweser being more explicit with this example...

Btw Raj have you finised going through the Schweser notes? Do you plan to use Schweser products to work on practice questions?

Cheers
Tarik
 
Thanks, Tarik.

No, I still have quite a way to go on Scheweser's notes. My current aim is complete the full notes, go through my personal notes I took during study sessions and complete the 3 tests before Dec.

I think I will have just enough time to accomplish that. So, for now, no more extra Q banks.

cheers
Raj
 
Hi Raja,

The example you are talking about is the relation of DEBT proportion in the Capital Structure and how it effects EPS, so its like taking every scenario with different capital strucuture, its not about how the firm, if it chooses to move from one Capital Structure to other would achieve it.

hope it helps.

regards,
Ravi
 
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