Capital structure and payout
Leverage, EPS and ROE
See how borrowing to buy back shares raises EPS and ROE in good years and cuts them in bad ones.
Learning objectives
- Calculate EPS and ROE under different capital structures and EBIT scenarios
- Find the EBIT at which two financing plans give the same EPS
- Explain why higher expected EPS from leverage does not by itself create value
Borrowing to buy back shares changes two things at once: interest rises, so net income falls, and the number of shares falls, so each share gets a bigger slice. Which effect wins depends on how much the business earns.
When operating profit is high relative to the after-tax cost of the new debt, leverage magnifies EPS and ROE. When profit falls, the fixed interest bill eats into a smaller base and EPS falls faster than it would have without the debt. Leverage doesn't change the business; it changes how the business's ups and downs are shared, and makes shareholders' results more volatile.
EPS = (EBIT − Interest) × (1 − t) ÷ Shares EBIT* = (I₂ × N₁ − I₁ × N₂) ÷ (N₁ − N₂)
- I₁, N₁
- interest and shares under the current structure
- I₂, N₂
- interest and shares after the debt-funded buyback
- EBIT*
- the EBIT at which both plans give the same EPS; above it, leverage raises EPS
Included with a Formula Quest membership
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