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 firms 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. You are required to answer the following questions:

a) Compute the EPS and DPS of Peerless Fabrics under the current capital structure. (2 marks)

b) What is the total amount of dollar dividend paid by Peerless under the current capital structure? (1 mark)

c) What is the cost of equity under the current capital structure? (2 marks)

d) Compute the weighted average cost of capital for the firm under the current capital structure? (2 marks)

e) What will be the outstanding loan amount in the new capital structure? (2 marks)

f) How will the 25% loan repayment be funded? Hint: Think about capital restructuring. (1 mark)

g) What will be the D/E of Peerless Inc. in the new capital structure? (4 marks)

h) Compute the EPS and DPS under the new capital structure. (2 marks)

i) What will be the total dollar amount of dividend paid under the new capital structure? (1 mark)

j) Compute the cost of equity and weighted average cost of capital under the new capital structure (4 marks)

k) Comment on the weighted average cost of capital under the current and new capital structures. (2 marks)

l) What is the level of EBIT at which shareholders will be indifferent between the two capital structures and what will be the firms EPS at this level of EBIT? (4 marks)

m) How did Tristan arrive at $9,700 worth of earnings before paying the interest cost under the current capital structure? (1 mark)

n) What is the percentage net earning for Tristan under the current capital structure? (2 marks)

o) Demonstrate the homemade leverage strategy employed by Tristan to ensure that he earns the same percentage earning under the new capital structure as he is earning in the current capital structure. Hint: Focus on the fact that the firm has chosen to pay off 25% of its loan and Tristan has to undo its effect. In other words, if the company pays off some of its loan, Tristan must take an additional loan. (5 marks)