ABC Company was founded by the current CEO, Fred Law. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year since it was founded, and the shareholders are satisfied with its management. Because Mr. Law is extremely averse to debt financing, the company is completely equity financed, with 9 million shares of common stock outstanding. The stock currently trades at $37.80 per share. Mr. Law is evaluating a plan to purchase a land for $95 million. The land will be leased to tenants in mainland China. This purchase is expected to increase ABC Company’s annual pretax earnings by $18.75 million in perpetuity. Tina Ng, the company’s CFO, has been put in charge of the project. Tina has determined that the company’s current cost of capital is 10.2%. She feels that the company would be more valuable if its capital structure will be changed by including debt, so she is assessing whether the company should issue debt to finance the entire project. Based on the discussion with investment banks, she thinks that the company can issue bonds at par value with a 6% coupon rate. From her analysis, she believes that a capital structure of 70% equity/30% debt would be optimal. So far, ABC Company has a 40% corporate tax rate.
1. Construct ABC Company’s market value balance sheet before it announces the purchase.
2. Suppose Mr. Law decides to issue equity to finance the purchase.
a. What is the net present value of the project?
b. Construct ABC Company’s market value balance sheet after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm’s common stock? How many shares will ABC Company need to issue to finance the purchase?
c. Construct ABC Company’s market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does ABC Company have outstanding? What is the price per share of the firm’s common stock?
d. Construct ABC Company’s market value balance sheet after the purchase has been made.
3. Suppose Mr. Law decides to issue debt to finance the purchase.
a. What will the market value of the ABC Company be?
b. Construct ABC Company’s market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm’s common stock?
4. Which method of financing maximizes the stock price of ABC Company?