5.4 The Crossover Point
The EBIT “crossover” point represents the unique level of EBIT for both plans, at which the EPS and ROE respectively will simultaneously be the same for both plans. In other words, at a certain EBIT (“the crossover point”), the EPS for both plans will be the same, as will the ROE be the same for each. (In fact, the crossover point will be the same regardless of the amount of leverage employed; we will see this later.)
We shall – arbitrarily – choose to use the ROE (rather than the EPS) formula in order to calculate the EBIT crossover point. (We know this choice does not matter as the choices – EPS and ROE – are congruent diagrammatically and mathematically identical; this too we will see later.) Using the prior example, we will set the unknown EBIT to equate to the unique ROE of each alternative, as follows, and then solve for the EBIT. In other words, we will set the ROE formula for each plan to be equal to one another and then solve for EBIT!
ROE _{Case 1} = ROE_{ Case 2}
ROE = NI ÷ Eq. = [(EBIT – Interest Exp.) (1- T)] ÷ Eq.
Again, by definition, the EBIT value where the ROE (or EPS) of each alternative is the same is the crossover point! The formula for ROE, in both cases, is simple accounting (as above in general and as solved below):
ROE_{1} = (EBIT – 0) (1 – .40) ÷ $200,000 =
ROE_{2} = (EBIT – 12,000) (1 – .40) ÷ $100,000 = EBIT (.6) ÷ $200,000 = (EBIT – $12,000) (.6) ÷ $100,000
To simplify, let’s solve for EBIT:
(.6) (EBIT) / 200 = [(.6) (EBIT – 12)] / 100
(.6) (EBIT) / [(.6) (EBIT – 12)] = 2
EBIT = 2 (EBIT – 12)
EBIT – 2 (EBIT) = -24
EBIT = 24
When EBIT = $24,000:
ROE = NI/Equity
ROE_{1 } = 14.4/200 = 7.2%
ROE_{2} = 7.2/100 = 7.2%
Here is a tabular summary:
No Leverage | 50/50 Leverage | |
EBIT | 24 | 24 |
Interest Exp. | 00 | (12) |
Taxes | (9.6) | (4.8) |
Net Income | 14.4 | 7.2 |
ROE | 14.4/200 = .072 | 7.2/100 = .072 |
EPS | 14.4/10 = $1.44 | 7.2/5 = $1.44 |
Note: EPS = NI NOSO
The exact value of the crossover point matters in terms of capital planning. If the firm projects an EBIT level to the right – or left – of the crossover point, the capital funding decision will be affected accordingly. To the right of the point, leverage is favorable.
We note that we have used just two cases above (i.e., no-leverage, and leverage set at 50%). In fact, we could use multiple cases, addressing increasing levels of leverage and risk. We could still calculate a crossover point – and it would be the same locus point regardless of the degree of leverage (see below)!
Finally, we ask that if debt under certain conditions maximizes EPS and ROE, how much debt should the company use? Although we have only illustrated 50/50 leverage, it is an easy step to show that more debt provides even greater earnings per share leverage – at greater risk!
Note 1:
[(EBIT) (0.6) ÷ 200] = [(EBIT – 6) (0.6) ÷ 150]
EBIT = $24
Note 2:
Again, let’s assume that EPS_{1} = EPS_{2}.
- And EPS = [(EBIT – I) (1 – T)] ÷ NOSO
- (“NOSO” = number of shares outstanding)
- Only the denominator is different in this formulation
- This time, we’ll substitute “x” for EBIT. Next….
- [(x – 0) (1 – 0.40)] ÷ 10,000 = [(x – 12) (1 – 0.40)] ÷ 5,000
- Skipping along….
- X = 2 (x -12)
- X = EBIT = 24