Santos Unlimited (SU) was originally unlevered with 4800 shares outstanding. How

Question

Santos Unlimited (SU) was originally unlevered with 4800 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 3400. 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 33 percent corporate tax rate.

Explanation / Answer

Assuming a $ 100000 EBIT , the situation can be illustrated how the EPS improves after the financial restructure --introducing debt in the capital structure Unlevered Levered EBIT(Assumed) 100000 100000 Less: Interest on debt 0 4290 EBT 100000 95710 Tax at 33% 33000 31584 EAT 67000 64126 No.of shares 4800 3400 EPS 13.96 18.86 Now, equating the EPS, both before & after restructure , with the given data, Earnings Per Share= EPS=(EBIT*(1-Tax rate))/No.of Equity shares EPS(before)/ EPS (after) (EBIT*0.67)/4800=((EBIT-4290)*0.67)/3400 Solving for EBIT, we get The level of EBIT,which when achieved--- for this level of debt & its interest expense charge on the earnings the shareholders can be indifferent ,will be = $14,709 Illustrating the above, Unlevered Levered EBIT(Assumed) 14709 14709 Less: Interest on debt 0 4290 EBT 14709 10419 Tax at 33% 4854 3438 EAT 9855 6981 No.of shares 4800 3400 EPS 2.05 2.05 EBIT below 14709 Unlevered Levered EBIT(Assumed) 13000 13000 Less: Interest on debt 0 4290 EBT 13000 8710 Tax at 33% 4290 2874 EAT 8710 5836 No.of shares 4800 3400 EPS 1.81 1.72 More EBIT above 14709 Unlevered Levered EBIT(Assumed) 15000 15000 Less: Interest on debt 0 4290 EBT 15000 10710 Tax at 33% 4950 3534 EAT 10050 7176 No.of shares 4800 3400 EPS 2.09 2.11 More So, as long as the EBIT does not fall below $ 14709(the indifference point) , the shareholders need not worry about their EPS. Anything above, only improves the EPS (as seen ablove), given this level of debt.

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