Question

Founded 25 years ago by CEO Steve Robertson, Robertson Real Estate (RRE) purchases commercial real estate (land and buildings), rents both to tenants. The company has shown consistent annual profits over the past 18 years, and shareholders have been pleased with the company's management. Before he started RRE, Steve was also the founder and CEO of a now bankrupt Ostrich farm. This previous bankruptcy has made him extremely reluctant to undertake any type of debt financing, and he has financed the real estate company 100% with equity. Robertson Real Estate stock currently trades at $37.80 per share and has 8 million shares of common stock outstanding.

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

1. If RRE seeks to maximize total market value, should the company issue debt or equity to finance the land purchase? Explain.

Answer 1

RRE has to issue Equity for land purchase to Maximize the Total market Value at globally.

Becasue Equity Finance have less risk compare to Debt Finance.

In past experience of Steve as a CEO they have undertake Debt finance & was bankrupt.

By doing such transaction the PBITA (Profit Before Interest & Tax) increase 14.125 Million USD.

If we will be issuing More debt than Our coupon rate exceed drastically which will lead to reduce Company goodwill.

Hence we have to issue Maximize the Equity....