The company has been reviewing an opportunity to purchase a large segment of land in the southeastern United States for $85 million and plans to lease this property to one or more farming operations. The land purchase is expected to increase RRE’s annual pretax earnings by $14.125 million in perpetuity. Raylynne Givins, the company’s new CFO, determined the company’s current cost of capital is 10.2%. She feels the company would be more valuable if it added some debt to its capital structure, so she is evaluating whether the company should issue debt to fully finance the project. Based on conversations with several investment banks, Raylynne believes RRE can issue bonds at par value with a 6% coupon rate. Her analysis suggests a capital structure using 70% equity / 30% debt would be optimal. If the company’s debt structure exceeds 30%, RRE’s bond rating would be lower and require a significantly higher coupon due to the increased exposure to financial distress and the associated higher financing costs. RRE has a combined state and federal corporate tax rate of 23%. Questions: If RRE seeks to maximize total market value, should the company issue debt or equity to finance the land purchase? Explain. Suppose RRE decides to issue equity to finance the purchase. What is the net present value (NPV) of the project? Construct RRE’s market value balance sheet after it announces the firm will finance the purchase using equity. What would be the new price per share of the firm’s stock? How many shares will RRE need to issue to finance the purchase? Construct RRE’s market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does RRE have outstanding? What is the price per share of the firm’s stock? Suppose RRE decides to issue debt to finance the purchase. What will be the market value of RRE if the purchase if financed with debt? Construct RRE’s market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm’s stock? Which method of financing maximizes the per-share stock price of RRE’s equity?
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