## Relationship between EBIT, EPS and MPS
### Core Objective
The basic objective of financial management is to design an appropriate capital structure that provides the highest wealth → measured by highest MPS, which in turn depends on EPS.
```
Capital Structure Decision → EPS → MPS → Shareholder Wealth
```
### How Financing Mix Affects EPS
Given a level of EBIT, EPS will differ under different financing mixes depending on the extent of debt financing. This happens due to the existence of fixed financial charges (interest on debt + fixed preference dividend).
### Trading on Equity (Favourable Leverage)
The effect of fixed financial charge on EPS depends on the relationship between:
- Rate of return on assets (ROA) and
- Rate of fixed financial charge (cost of debt/pref.)
| Condition | Effect on EPS | Name |
|---|---|---|
| ROA > Cost of fixed-charge financing | EPS increases with more debt | Favourable Leverage / Trading on Equity |
| ROA < Cost of fixed-charge financing | EPS decreases with more debt | Unfavourable / Negative Leverage |
### Choice between Debt vs Preference Shares
When choosing between debt financing and issuing preference shares, debt is generally preferred for two reasons:
1. Lower explicit cost — interest rate on debt is generally lower than fixed preference dividend rate.
2. Tax deductibility — interest is tax-deductible, so the after-tax (real) cost of debt is even lower than the cost of preference share capital (preference dividends are not tax-deductible).
### Formula Linkage
$$
EPS = \frac{(EBIT - Interest)(1 - t) - Preference\ Dividend}{Number\ of\ Equity\ Shares}
$$
$$
MPS = EPS \times P/E\ Ratio
$$