The management of Peerless Fabrics Inc. is considering a change in its capital structure.
Currently, Peerless has 100,000 shares outstanding at a market price of $40 each. It is also carrying loans
worth $1,500,000 on its balance sheet with an interest rate of 6% p.a, thus implying a corporate D/E ratio of
0.375:1
The EBIT is $575,000 and is expected to remain constant every year for an indefinite time. Since Peerless
produces indigenous fabric, it enjoys a tax holiday which is available to all businesses that promote import
substitution. As such, Peerless lives in a tax-free world for now and passes on the benefit to its shareholders
in the form of 100% dividend payout.
The proposal for a change in capital structure is about reducing the reliance on debt during uncertain times
that the ongoing pandemic has created. After lengthy negotiations with the lenders, the lenders have agreed
for Peerless to pre-pay 25% of its outstanding loan without penalty. The management is keen to follow through
with this. However, 100% dividend payout will still continue.
Tristan has been a shareholder in the firm, not because he has any special knowledge about textile industry
but because he is so much in love with the firm’s name – Peerless! He holds 2,000 shares in the firm. At a
price of $40 per share, his investment in Peerless is therefore, $80,000. Tristan has financed his investment of
$80,000 as follows:
Own funds = $50,000; Borrowed funds = $30,000
He is proud of himself to have invested in a firm that offers him a healthy percentage return on his investment.
The breakdown of his percentage return is as follows:
Number of shares currently held = 2,000
Price per share = $40
Total value of investment = 2,000 x 40 = $80,000
Earning summary:
Current Earning = 2,000 shares x DPS = $9,700
Less, interest on borrowing = 0.06 x 30,000 = $1,800
Net earning = 9,700 – 1,800 = $7,900
% earning = 7,900 / ? = ?
Tristan is not happy about the firm paying off 25% of its debt. He believes that doing so will compromise the
advantage of using cheaper debt in the capital structure. He therefore, wishes to use homemade leverage to
ensure that his percentage earnings stay the same even if the firm moves to the new capital structure.
Questions:
d) Compute the weighted average cost of capital for the firm under the current capital structure?
e) What will be the outstanding loan amount in the new capital structure?
f) How will the 25% loan repayment be funded? Hint: Think about capital restructuring.
g) What will be the D/E of Peerless Inc. in the new capital structure?