Santos Unlimited (SU) was originally unlevered with 4300 shares outstanding. How

Question

Santos Unlimited (SU) was originally unlevered with 4300 shares outstanding. However, after a major financial restructure, SU now has $39000 of debt, with an annual interest expense of 11 percent. The restructuring has reduced the number of shares to 3500. 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 32 percent corporate tax rate.

Answer : $_______

Explanation / Answer

The Financial leverage is used to enhance the stockholders value as the cost of debt introduced is always less than the Required rate of return as we can claim tax benefits on the cost of debt. Till the time the cost of debt is below the Required rate of return, the introduction of debt content will going to benefit the stockholders.

As per the problem, suppose the EBIT of the company being $30000, so prior debt, the unlevered EPS was 30000 * (1-0.32) = $20400/4300 = $4.74 per share and after introduction of leverage ie. debt, the cost of debt per year is $39000*11% = $4290, with the tax effect the levered EPS is (30000 - 4290) (1-0.32) / 3500 = $5 per share. As per this example the EPS has risen to $5 from $4.74 on introduction of leverage i.e. debt.

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