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).
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.
