Santos Unlimited (SU) was originally unlevered with 4900 shares outstanding. How

Question

Santos Unlimited (SU) was originally unlevered with 4900 shares outstanding. However, after a major financial restructure, SU now has $35000 of debt, with an annual interest expense of 11 percent. The restructuring has reduced the number of shares to 3900. 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 31 percent corporate tax rate.

Explanation / Answer

Let level of earnings before interest and tax (EBIT) = EBIT

to make shareholders indifferent between being unlevered (i.e. not having any debt) and levered (i.e. having debt), EPS should be same in both scenarios

Unlevered EPS =EBIT*(1-31%)/4900

Levered EPS = ( EBIT-11%*35000)*(1-31%)/3900

Unlevered EPS= Levered EPS

EBIT*(1-31%)/4900 = ( EBIT-11%*35000)*(1-31%)/3900

EBIT = $18,865.00

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