Question

CASE Aya Land Real Estate Recapitalization Aya Land Real Estate Company was founded 25 years ago by the current CEO, Zaw Aya Land. 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 Aya Land Real Estate, Zaw 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 9 million shares of common stock outstanding. The stock currently trades at $42.50 per share. Aya Land is evaluating a plan to purchase a huge tract of land in the southeastern United States for $50 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Aya Land's annual pretax earnings by $12 million in perpetuity Cheng Weyand, the company's new CFO, has been put in charge of the project. Cheng has determined that the company's current cost of capital is 12.5 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 8 percent. 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. Aya Land has a 40 percent corporate tax rate (state and federal). QUESTIONS 1. If Aya Land wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain. 2. Calculate Aya Land's market value before it announces the purchase. 3. Suppose Aya Land decides to issue equity to finance the purchase. a. What is the net present value of the project? b. Calculate Aya Land's market value after it announces that 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 Aya Land need to issue to finance the purchase? Please explain hypothesis used. c. Construct Aya Land's market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does Aya Land have outstanding? What is the price per share of the firm's stock? d. Construct Aya Land's market value balance sheet after the purchase has been made. 4. Suppose Aya Land decides to issue debt to finance the purchase. a. What will the market value of the Aya Land Company be if the purchase is financed with debt? b. Construct Aya Land'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? 5.Which method of financing maximizes the per-share stock price of Aya Land's equity?

Answer 1

Q - 1

In order to maximize its total market value, the firm should issue debt, as debt leads to interest tax shield and thus creates additional value for the firm through present value of interest tax shield. Debt in the capital structure, as long as within optimal limits, tends to lower the weighted average cost of capital and thus enhances the value of the firm.

Q - 2

Market value before it announces the purchase = Price per share x number of shares outstanding = $ 42.5 x 9 mn shares = $  382.50 mn

Q - 3

Part (a)

NPV = - initial investment + Post tax earnings in perpetuity / Cost of equity = - 50 + 12 x (1 - 40%) / 12.5% = $ 7.60 mn

Part (b)

Market value after it announces the purchase = Market value before announcing the purchase + NPV = 382.50 + 7.60 = $ 390.10 mn

New price per share = Market value / Number of shares outstanding = 390.10 / 9 = $ 43.34

Number of new shares to be issued to finance the purchase = Initial investment / New share price = 50 / 43.34 =  1.15355 mn shares

Hypothesis used is:

• Efficient market hypothesis: The value of the firm will reflect the impact of new information fully
• Market value of the firm will go up to the extent of additional value created by the new project

Part (c)

Market value balance sheet:

ASSET	$ mn		LIABILITIES & EQUITY	$ mn
Value of old assets	382.50		Debt	-
NPV	7.60		Equity	390.10
Total	390.10		Total	390.10

Number of shares outstanding = Old number of shares outstanding + number of fresh shares issued = 9 mn + 1.15355 mn =  10.15355 mn

Price per share = $ 43.34 (calculated already in part (b) above)

Part (d)

Market value balance sheet after purchase has been made:

ASSET	$ mn		LIABILITIES & EQUITY	$ mn
Value of old assets	382.50		Debt	-
NPV	7.60		Equity	440.10
New land	50.00
Total	440.10		Total	440.10

Q - 4

Part (a)

As per Modigliani Miller Proposition 2, in the presence of taxes:

Value of a levered firm = Value of unlevered firm + PV of interest tax shield = 440.10 + tax rate x debt = 440.10 + 40% x 50 = $ 460.10 mn

Hence, market value of the firm = $ 460.10 mn

Part (b)

Market value balance sheet after purchase has been made:

ASSET	$ mn		LIABILITIES & EQUITY	$ mn
Value of old assets	382.50		Debt	50.00
NPV	7.60		Equity	410.10
New land	50.00
Interest tax shield	20.00
Total	460.10		Total	460.10

Price per share = Market value of equity / Old number of shares outstanding = 410.10 / 9 = $ 45.57 / share

Q - 5

Share price under pure equity option = $ 43.34

Share price under full debt option = $ 45.57

Share price under debt option > Share price under full equity option

Hence, debt method of financing maximizes the per share stock price of Aya Land's equity.