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EBIT Vs. Optimal Leverage

Define EBIT and discuss why the optimal level of leverage from a tax-saving perspective is the level at which interest equals EBIT. Does this have a connection with under-leveraging corporations,both domestically and internationally?

Solution Preview

Earnings Before Interest and Taxes (EBIT) is an item in the income statement of a company or corporation. EBIT is calculated by subtracting all expenses, including depreciation, from the company's sales or revenues, except for interest expenses and taxes.

A simplified income statement of an imaginary corporation is presented below ($ in millions) (Ross, Westerfield, & Jordan, 2011, p. 28):
U.S. Corporation
Income Statement
Sales (Revenues) $1,509
Minus Costs of Goods Sold (COGS) $750
Minus Depreciation $65
= EBIT (Earnings Before Interest and Taxes) ...

Solution Summary

This solution defines EBIT (earnings before interest and taxes) and discusses the optimal level of leverage from a tax-saving perspective. A simplified income statement and another with respective modifications is used to illustrate the main idea in practice.

$2.19