You may attempt this question 3 more times for credit Santos Unlimited (SU) was

Question

You may attempt this question 3 more times for credit Santos Unlimited (SU) was originally unlevered with 4200 shares outstanding. However, after a major financial restructure, SU now has $37000 of debt, with an annual interest expense of 10 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 30 percent corporate tax rate. Answer: $ Place your answer to the nearest dollar without a dollar sign or a comma (if applicable)

Explanation / Answer

Let breakeven EBIT be $x

Unlevered Firm:

Number of shares outstanding = 4,200

EPS = (Net Income - Interest Expense) * (1 - tax) / Number of shares outstanding
EPS = ($x - $0) * (1 - 0.30) / 4,200
EPS = $x * 0.70 / 4,200

Levered Firm:

Number of shares outstanding = 3,400
Value of Debt = $37,000

Interest Expense = 10% * $37,000
Interest Expense = $3,700

EPS = (Net Income - Interest Expense) * (1 - tax) / Number of shares outstanding
EPS = ($x - $3,700) * (1 - 0.30) / 3,400
EPS = ($x - $3,700) * 0.70 / 3,400

EPS of Unlevered Firm = EPS of Levered Firm
$x * 0.70 / 4,200 = ($x - $3,700) * 0.70 / 3,400
17*$x = 21*$x - $77,700
$77,700 = 4*$x
$x = $19,425

So, shareholders will be indifferent at EBIT of $19,425

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