CHAPTER CASE RECAPITALIZATION eterson Real Estate Company is a company en then l
ID: 2784752 • Letter: C
Question
CHAPTER CASE RECAPITALIZATION eterson Real Estate Company is a company en then leased to farmers. The purchase is expected to gaged in the business of purchasing and selling increase annual pretax earnings by $18 million in per- real estate, including land and buildings, and renting petuity. Kenneth is in charge of the project. He has property. The company earns a profit every year and determined that the cost of capital of the company is the shareholders are satisfied with the management 12.5percent. Kenneth is evaluating whether the com- of the company. In the past 25 years, the company pany should issue debt to finance the project. Based has been entirely equity financed, with 15 million on discussion with investment banks, Kenneth thinks shares of common stock outstanding. The stock cur the company can issue bonds at par value with an 8 percent coupon rate. From his analysis, the optimal Peterson is evaluating a plan to purchase a capital structure is 70 percent equity and 30 percent rently trades at $41.50 per share. huge tract of land for $60 million. The land will be debt. The corporate tax rate is 40 percent. QUESTIONS 1. To maximize the total market value of the com- pany, would you recommend to issue debt or Construct the market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does Peterson have outstanding? What c. equity to finance the land purchase? 2. Calculate the market value of the company (in the form of a balance sheet) before it announces is the price per share of the firm's stock? the purchase. d. Construct the market value balance sheet 3. Suppose Peterson decides to issue equity to after the purchase has been made. finance the purchase. a b. 4. Suppose Peterson decides to issue debt to finance the purchase a. What will be the market value of Peterson? What is the net present value of the project? Construct Peterson's market value balance sheet after it announces that the firm will fi- nance the purchase using equity. What would be the new price per share of the firm's stock? How many shares wll Peterson need to issue b. Construct the market value balance sheet after both the debt issue and land purchase. What is the share price now? 5. Which method of financing maximizes the per- to finance the purchase? share stock price of Peterson's equity? 450Explanation / Answer
1. As incurring debt has interest expenses that creates tax shields to the company,thus adding to the overall value to firm value, issue of debt is recommended.Debt interest expenses are tax-deuctible. 2 Market Value Balance Sheet Liabilities & Equity Equity 622500000 15000000Shares*41.5 Assets 622500000 3. a. NPV of purchase Initial Investment -60 PV of after-tax earnings (18*(1-40%))/12.5% 86.4 NPV of the project 26.4 (86.4-60) Millions b. Market Value Balance Sheet after announcement ,but before issue of equity Liabilities & Equity Equity 648900000 Same 15000000 shares Existing Assets 622500000 Add: NPV of purchase 26400000 Total assets 648900000 Now, value of 15000000 shares= 648900000 So, market price per share= 648900000/15000000=43.26 No.of shares to be issued to finance the purchase =60000000/43.26= 1386963 shares c. Market Value Balance Sheet after the equity issue but before purchase Liabilities & Equity Equity 682500000 at 41.5 Existing Assets 622500000 Cash 60000000 Total assets 682500000 Total No.of shares o/s at 41.5 = 682500000/41.5= 16445783 shares Market Value Balance Sheet after the purchase Liabilities & Equity Equity 708900000 at 43.26 Existing Assets 622500000 Cash 60000000 NPV of purchase 26400000 Total assets 708900000 Total No.of shares o/s at 43.26 =708900000/43.26= 16386963 shares d. Market Value Balance Sheet after the purchase has been made Liabilities & Equity Equity 708900000 at 43.26 Existing Assets 622500000 PV of purchase 86400000 Total assets 708900000 Total No.of shares o/s at 43.26 =708900000/43.26= 16386963 shares 4 .a. V(L)=V(UL)+Tax Rate*Debt V(L)=708900000+(40%*60000000) 732900000 b. Market Value Balance Sheet with debt Liabilities & Equity Equity 672900000 Debt 60000000 Value --unlevered 708900000 Tax -shield 24000000 Total assets 732900000 No.of shares o/s 15000000 Price/share 672900000/15000000= 44.86 8. From the above, it is clear that debt-financing maximises the per share price of the stock.