Question 4 AJCroft Sdn. Bhd. currently has RM200,000 debt outstanding carrying a

Question

Question 4 AJCroft Sdn. Bhd. currently has RM200,000 debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are RM100,000, and it is a zero-growth company. The company's cost of equity is 10 percent, and its tax rate is 27%. The company has 10,000 shares of common stock outstanding. The dividend payout ratio is 100%. AJCroft Sdn. Bhd. Is considering recalling the 6 percent debt by issuing RM400,000 new 7 percent debt. The new funds would be used to replace the old debt and to repurchase stock at the existing price. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on equity to increase to 11 percent. If this pier is carried out, what would be the company's new stock price?

Explanation / Answer

At present, the company EBIT = RM 100,000 and its interest expense = RM (200000 * 6%) = RM 12000 .

Profit before tax = (100000-12000) = 88000 and taxes = 88000 * 27% = 23760

Net Profit = (88000-23760) = RM 64240

Earnings per share (EPS) which is also dividend per share (dps) = 64240/10000 = RM 6.42

With zero growth rate, cost of equity of 10% , the equity price per share (using dividend discount model) = 6.42/10% = RM 64.24

After the proposed changes:

EBIT = RM 100,000

Debt = RM 400,000 at 7%

Equity shares repurchased at 64.24 = (200000/64.24) = 3113.33 or rounded to integer value 3113

Residual equity shares outstanding = (10000-3113) = 6887

Now Profit before tax = 100000 - (400000 * 7%) = 72000

Taxes @ 27% = 72000 * 27% = 19440

Net Profit = (72000 - 19440) = 52560

EPS = DPS = 52560/6887 = 7.63

Equity share price at 11%, zero growth using dividend discount model = (7.63/11%) = 69.36

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