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Homework answers / question archive / Santos Unlimited (SU) was originally unlevered with 4500 shares outstanding
Santos Unlimited (SU) was originally unlevered with 4500 shares outstanding. However, after a major financial restructure, SU now has $36000 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 33 percent corporate tax rate.
this question requires one to calculate - 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).
In short the Indifference Point i.e Level of EBIT where EPS of both the plans are equal.
Plan 1-Only 4500 share outstanding
Plan 2-$36000 Debt+ 3400 share outstanding
Assume x to EBIT
{(x-I)(1-Taxrate)}/no. of equity shares
P1=P2
{x-0(0.67)}/4500={(x-3600)(0.67)/3400
0.67x/4500={0.67x-2412}/3400
By cross multiplying
2278x=3015x-1085400
x=10854000/747
Hence x = EBIT=$14727.27
Answer=14728
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