ADM 2350 ch 16 practice problem

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Practice Problem 4 Capital Structure Decisions Ontario Real Estate Company (ORE Co.) is an all-equity firm with 30 million shares of common stock outstanding worth $65 per share. ORE is planning to purchase a huge tract of land in Southeastern Ontario for $200 million. The land will subsequently be leased to tenant farmers, increasing ORE’s annual expected pre -tax earnings by $50 million in perpetuity. The firm’s un - levered cost of equity is 12%. ORE’s tax rate is 40%. The interest rate on ORE’s bonds is 7% per annum. A) If ORE Co. wishes to maximize its total market value, would you recommend that it issue debt or equity in order to finance the purchase? Explain. Construct ORE’s market value balance sheet before it announces the purchase. B) Suppose ORE Co. decides to issue equity to finance the purchase. What is the net present value of the project? Construct ORE’s market value balance sheet after it announces that the firm will finance the purchase using equity. What is the new price per share of the firm’s stock? How many shares would ORE need to issue in order to finance the purchase? C) Construct ORE’s market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does ORE have outstanding? What is the price per share of the firm’s stock? Answer A) If ORE wishes to maximize the overall value of the firm, it should use debt to finance the $200 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm. Since ORE is an all-equity firm with 30 million shares of common stock outstanding, worth $65 per share, the market value of the firm is $1,950 million (= 30 million shares * $65 per share). ORE’s market -value balance sheet before the announcement of the land purchase is: Assets = $1,950.00 Debt = - $ Equity = $1,950.00 Total Assets = 1,950 $ Total D + E = 1,950 $ Ontario Real Estate

B) As a result of the purchase, the firm’s pre -tax earnings will increase by $50 million per year in perpetuity. These earnings are taxed at a rate of 40%. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by $30 million {($50million) (1 - 0.40)}. Since Stephenson is an all- equity firm, the appropriate discount rate is the firm’s unlevered cost of equity capital (r 0 ), which is 12%. NPV(Purchase) = - $200,000,000 + {($50,000,000)(1 – 0.40) / 0.12} = - $200,000,000 + ($30million / 0.12) = $50,000,000 Therefore, the net present value of the land purchase is $50 million. After the announcement, the value of ORE will increase by $50 million, the net present value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s equity will immediately rise to reflect the NPV of the project. Therefore, the market value of ORE ’s equity will be $2,000 million (= $1950 million + $50 million) after the firm’s announcement. Ore’ s market-value balance sheet after the announcement is: Since the market value of the firm’s equity is $2000 million and the firm has 30 million shares of common stock outstanding, ORE’s stock price after the announcement will be $66.67 per share (= $2000 million / 30million shares). ORE ’s stock price after the announcement is $66.67 per share. Since ORE must raise $200 million to finance the purchase and the firm’s stock is worth $66.67 per share, ORE must issue 3,000000 shares ( = $200 million / $66.67 per share) in order to finance the purchase. ORE must issue 3 million shares in order to finance the initial outlay for the purchase. Old Assets = $1,950,000,000 Debt = - $ NPV PROJECT = 50,000,000 $ Equity = 2,000,000,000 $ Total Assets = 2,000,000,000 $ Total D + E = 2,000,000,000 $ Ontario Real Estate

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