Case synopsis: Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys real estate and rents it to the tenants. The firm has a profit each year. Before the foundation of Company S, Person R was a CEO and the founder of Company A, which is a farming operation. Company A was a failure as a firm, which ended up with bankruptcy. This situation made Person R 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 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 determined 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 found an optimal range of capital structure between 70% equity and 30% debt. 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 and a greater coupon as the possibility of financial distress and the associated cost will increase. Company S also has a corporate rate of tax. To discuss: The method of financing that would increase the per-share stock price of the equity of Company S.

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Chapter 16, Problem 5M

Summary Introduction

Case synopsis:

Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys real estate and rents it to the tenants. The firm has a profit each year. Before the foundation of Company S, Person R was a CEO and the founder of Company A, which is a farming operation. Company A was a failure as a firm, which ended up with bankruptcy. This situation made Person R 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 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 determined 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 found an optimal range of capital structure between 70% equity and 30% debt.

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 and a greater coupon as the possibility of financial distress and the associated cost will increase.

Company S also has a corporate rate of tax.

To discuss: The method of financing that would increase the per-share stock price of the equity of Company S.

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