Santos Unlimited (SU) was originally unlevered with 4200 shares outstanding. How

Question

Santos Unlimited (SU) was originally unlevered with 4200 shares outstanding. However, after a major financial restructure, SU now has $38000 of debt, with an annual interest expense of 10 percent. The restructuring has reduced the number of shares to 3600. 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.

Explanation / Answer

$ Let us assume that EPS of unlevered equity was 10 Total Eaning 42000 After issue of debt, EPS shall be for indifferent position 10 So, earnings for Equity (3600*10) 36000 EAT 36000 Add Tax (36000/0.68 * 0.32) 16941 Eearning before interest 52941 Add Interest (38000*10%) 3800 EBIT of indifference point 56741

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