Indifference EBIT - Capital Structure of Corporations

Indifference Earnings Before Interest & Taxes (Indifference EBIT) is the point of the capital structure where the corporation does not care about whether they issue new debt, have no debt and 100% equity or have a combination of both debt & equity.

From the graph below, you can determine that the Indifference EBIT point is where the With Debt Capital Structure Line intersects with the No Debt Capital Structure Line. Any point to the left of Indifference EBIT is risky debt while any point to the right of Indifference EBIT is good debt (interest expense that is tax deductible).

Indifference EBIT Example

ABC Corp. currently has 200,000 shares outstanding on the stock market with the current price being $20. The Board of Directors of the Corp want to incur a debt of $1 million by issuing junk bonds that have a coupon interest rate of 9% annually. At what point of EBIT would the Corp. be indifferent to having debt or NO debt?

Solution:

Current Capital Structure = $20 x 200,000 shares = $4,000,000 Equity

New Capital Structure = $3,000,000 Equity & $1,000,000 Debt

- Current Stock Price Remains at $20.
- To attain $3,000,000 of Equity, the # of shares = 150,000.

Annual Interest Expense Coupon Payments = 9% x 1,000,000 = $90,000

	No Debt	With Debt
Indifference EBIT	EBIT - 0 200,000	= EBIT - 90,000 150,000
Indifference EBIT	150,000 EBIT = 200,000 (EBIT - 90,000) 150,000 EBIT = 200000EBIT - 18000000000 18000000000 = 200,000 EBIT - 150,000 EBIT 18000000000 = 50,000 EBIT EBIT = 18000000000 / 50,000 EBIT = $360,000

Interpretation of EBIT

At a point where Earnings Before Interest & Taxes is $360,000, ABC Corp. will not care whether it has any outstanding debt issues, NO debt or a combination of both because at this point, the value of the Capital Structure is NOT affected.