Question

1. Lancaster Real Estate Company was founded 25 years ago by the current CEO, Robert Lancaster. 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 Lancaster Real Estate, Robert 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 8 million shares of common stock outstanding. The stock currently trades at $37.80 per share. Lancaster is evaluating a plan to purchase a huge tract of land in the southeastern United States for $85 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Lancaster's annual pretax earnings by $14.125 million in perpetuity. Jennifer Weyand, the company's new CFO, has been put in charge of the project. Jennifer has determined that the company's current cost of capital is 10.2 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 6 percent coupon rate. From 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. Lancaster has a 23 percent corporate tax rate (state and federal). If Lancaster wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

Answer 1

Note: As per answering guidelines, only the first question has been answered.

Solution 1:-

The main objective of managerial decision making is to maximize the wealth of its shareholders. An optimal capital structure plays a crucial role in extracting the true value of any business in the markets.

Designing an optimal capital structure includes deciding the debt to equity ratio that the company should have to minimize the cost of capital while keeping financing risk at affordable levels at the same time.There is no doubt that debt portion of the capital increases financing risk in the business as debt includes compulsory repayment and interest payments under its terms. But, since the cost of debt is lower than the cost of equity, management must try to issue debt which lowers the overall cost of capital without getting financing risk out of hand.

In the given situation Lancaster Real Estate Company has an equity of $302.4 million. If the company decides to issue debt of $85 million to fund the land purchase, it's new capital structure would have 78% equity [302.4/(302.4+85)] and 22% debt [85/(302.4+85)]. Also, the cost of debt at 6% interest and 23% tax rate would be 4.6% [Calculated as 6%*(1-23%)]. Considering all the details, the following makes a strong case for issue of debt to fund land purchase instead of equity:

• Cost of debt 4.6% is substantially lower than the cost of equity of 10.2% and therefore including debt in the capital structure would reduce the overall cost of capital
• The pre-tax return on investment of the land project is 16.6% [calculated as $14.125m/$85m] which is substantially more than the cost of debt and offers enough safety cushion for the company to meet its interest payments in tough times
• Post issue of debt of $85m, the debt and equity components (22% & 78% respectively) of the capital structure would remain well north of the optimal range of 70% equity and 30% debt
• The company has made profits for 18 years straight which shows the low operating risk in the business which is generally regarded as a key component of a business' ability to include debt in its capital structure

Therefore, due to above reasons, the company should issue debt to acquire the land of $85 million to maximise the wealth of its shareholders.