Volcan Real Estate Company was founded 25 years ago by the current CEO, John Volcan. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year for the past 18 years, and the shareholders are satisfied with the company’s management. Prior to founding Volcan Real Estate, Volcan was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity financed, with 12 million shares of common stock outstanding. The stock currently trades at $48.50 per share.
Volcan is evaluating a plan to purchase a huge tract of land in the southeastern China for $45 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Volcan’s annual pretax earnings by $11 million in perpetuity. Kim Weyand, the company’s new CFO, has been put in charge of the project. Kim has determined that the company’s current cost of capital is 11.5 percent. She feels that the company would be more valuable if it included debt in its capital structure, so she is evaluating whether the company should issue debt to entirely finance the project. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with a coupon rate of 7 percent. Based on her analysis, she also believes that a capital structure in the range of 70 percent equity∕30 percent debt would be optimal. If the company goes beyond 30 percent debt, its bonds would carry a lower rating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Volcan has a 40 percent corporate tax rate.
1. If Volcans wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.
2. Compute Volcans’s market value of equity before it announces the purchase.
3. Suppose Volcan decides to its internally generated funds to finance the purchase.
a. What is the net present value of the project?
b. What would be the new price per share of the firm’s stock?
Suppose Volcan decides to issue new shares to finance the purchase instead of its internally generated funds:
c. How many new shares should Volcan issue?
d. Construct Volcan market value balance sheet after the purchase has been made.
4. Suppose Volcan decides to issue debt to finance the purchase:
a What will the market value of the Volcan’s Company?
b. What would be the new per share value?
5. Which method of financing maximizes the per-share stock price of Volcans’s equity? Explain.