Question 2: Suraj Company Limited (SCL) is a public limited company, whose shares are listed on the Pakistan Stock Exchange. The company produces and markets a wide range of well-known home use products. Because of the fragmented market shares of its products and high completion from small and medium size firms, the sales of the company have grown moderately. The company finances its activities employing both debt and equity. It follows an implicit policy of not allowing its debt level to exceed the industry average. The company's current debt ratio is not high in comparison with industry average. However, the company is constrained by the terms and conditions of debt. At the end of March 2014, the management is worried as it is near violating the terms and conditions of debt that it had borrowed from the Industrial Development Bank of Pakistan (IDBP) in 2008. The interest rates when the company borrowed from IDBP is 2008 were high. It had raised the loan amount at 14% from IDBP to buy plant and machinery for expanding its business. The loan was secured against the plant and machinery. The loan is repayable in equal instalment at par during 2015 - 18. There are three covenants attaching to the loan from IDBP. The covenants are: (1) The company's book value debt equity ratio should not exceed 1:1 (2) the current ratio, defined as sum of stock, debtors and cash divided by the sum of creditors provisions and bank credit shall be at least 1 and (3) the interest coverage ratio should be at least 3 times. The current interest rates are very low. Banks and financial institutions have a lot of liquidity and long term loans are available at about 9% rate of interest. The finance director argues that SCL should take advantage of low interest rates. The company should refinance its existing debt by borrowing funds at about 9% from the banks. IDBP may not agree to the company proposal of prepayment unless it is given some incentives. It will ask for redemption of principal at a premium of 11%. The finance director proposes to pay this premium by drawing down the company surplus cash and negotiate more flexible debt covenants with the new lender. He argues that since the interest rate comes down by 5% points, the 11% redemption premium will be recovered in a profitability and EPS will lead to a rise in the share price. SCL's share is currently selling for Rs.35.25. The average P/E ratio of the companies in the same industry is 8.5. Assume that for income tax purposes, SCL will be able to charge the premium paid as expense in equal annual instalments from 2013 - 14 to 2017-18. Estimated Income Statement for the year ended 31" March 2014 Rs. Millions 7.717,500 Less Variable cost 3.559,600 Less Fixed cost 1.706,000 Profit before interest and taxes 2.451,900 Less Interest 588.000 Profit before tax 1.863,900 Less Tax 35% 652.365 Profit after Tax 1.211,535 Sales Estimated Balance Sheet as on 31 March 2014 Rs. Millions Assets and Liabilities Fixed Assets (net) Land Buildings Machinery & Equipment 1,673.900 1,869,100 4,682,600 8,225,600 Current Assets Stocks Debtors 837.000 839,100 667.400 2,343,500 1,339.100 1.004.400 2.343,500 Cash Current Liabilities Creditors Provisions Net current Assets Net Assets Financed by: Ordinary Shares (Rs. 10 per share) Reserves Stockholder's Equity 14% IDBP loan 0,0.0000 8.225.600 2,170,000 1.855.600 4,025,600 4.200.000 8,225,600 Required: a. How close is SCL to violating the loan covenants? b. Should SCL refinance its existing debt? c. Assuming that the market was not expecting a refinancing, estimate the impact on SCL's share price if it decides to refinance? d. If SCL wants to refinance, which loan covenants will it have to renegotiate with new lender