Chapter 16, Problem 1M

Summary Introduction

Case synopsis:

Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys a real estate and rents it to the tenants. The firm gains profit every year. Before the foundation of Company S, Person R was the CEO and the founder of Company A, which is a farming operation. Company A was a failure firm, which ends up with bankruptcy. This situation made Person R to be extremely averse towards debt financing.

Hence, the company is completely financed through equity. Company S is assessing a plan to buy a huge tract of land, which would be leased to the tenant farmers. This purchase is predicted to raise the annual earnings before tax in perpetuity. Person J is the new CFO (chief financial officer) of Company S, who has found the present capital cost of the company.

Person J felt that the company will be very valuable if it adds debt in its capital structure. While evaluating whether the company could issue debt to completely finance the project, she found that it can issue bonds at a par value with the coupon rate. She also found an optimal range of capital structure between 70% equity and 30% debt to maximize its value.

Characters in the case:

• Company S
• Company A
• Person S
• Person J

Adequate information:

• If Company S moves beyond the 30% debt, the bonds issued by the company will have a lower rating, a greater coupon as it is the possibility of financial distress, and the associated cost would increase.
• Company S also has a corporate rate of tax.

To discuss: Whether Person X will suggest equity or debt to finance the purchase of land, if Person S wants to expand the market value of the company.