Question

Santos Unlimited (SU) was originally unlevered with 4600 shares outstanding. However, after a major financial restructure, SU now has $39000 of debt, with an annual interest expense of 11percent. The restructuring has reduced the number of shares to 3000. A group of shareholders of SU are not convinced that this move towards adopting financial leverage is a good idea. Their main argument is that there is now some range of EBIT, however low, that will make the shareholders worse off than before. Help understand the situation better by computing the level of earnings before interest and tax (EBIT) that would make shareholders indifferent between being unlevered (i.e. not having any debt) and levered (i.e. having debt). Assume a 34 percent corporate tax rate.

Answer 1

Shareholders will be indifferent when earnings per share (EPS) in both options are equal. When the firm has an EBIT of $12,334, EPS in both plans are equal as shown below.

	Debt	W/O Debt
EBIT	12334	12334
Interest	4290	0
EBT	8044	12334
Tax (34%)	2735	4194
Net Income	5309	8140
EPS	1.7697	1.7697

With debt, interest expense = 39,000 x 11% = 4,290

EPS = Net Income / No. of shares.

We can find EBIT level such that EPS is same using trial and error method.