HR, Inc., another company in Richmond, Indiana in 2008, is currently entirely eq
ID: 2749523 • Letter: H
Question
HR, Inc., another company in Richmond, Indiana in 2008, is currently entirely equity financed. It has only 250,000 shares of common stock outstanding. The stock is selling at $65 per share. HR is considering to purchase a large shopping complex at Orlando, Florida to lease to some well-known high-end retail stores such as Nordstrom, Von Maur, Lord & Taylor, Macy's and Dillard's. The complex is located near Lake Buena Vista on I-Drive. The offer price for this shopping complex is $12.35 million. This project is expected to increase HR’s annual pretax earnings by $4.2 million and the same amount of annual pretax earnings increase will occur forever into the future. HR’s current cost of capital is 15 percent. According to the investment banks in Indiana, HR can issue bonds at par value with a 7 percent coupon rate and the optimal capital structure for HR is 65 percent equity and 35 percent debt. If HR uses more than 35 percent debt, the cost of debt to the firm will increase significantly. HR pays 35 percent corporate taxes (including both state and federal).
1. If HR would like to maximize its total market value, should it issue debt or equity to pay for the shopping complex? Briefly explain. (10 points)
2. How does the market value balance sheet of HR look like before the firm makes the announcement on the shopping complex project? Explain and construct the market value balance sheet. [For this question and any question below that asks for a market value balance sheet, you have to present the balance sheet with the proper format to earn the full points.] (10 points)
3. What is the net present value of the shopping complex project, assuming that HR issues equity (i.e. stock) to finance it? (10 points)
4. How will HR’s market value balance sheet look like after the firm makes announcement on the shopping complex project which will be financed by equity? Explain and construct the market value balance sheet. (15 points)
5. If HR decides to issue equity to fund the purchase of the shopping complex, (a) what will be the price per share of the firm’s stock? (10 points) (b) how many shares will HR need to issue? (10 points) (c) how will the firm’s market value balance sheet look like after the equity issue but before the purchase of the shopping complex has been made? Explain and construct the market value balance sheet. (10 points) (d) how many shares of common stock will be outstanding after the equity issue? (10 points) (e) what is the new price per share of the firm’s stock? (10 points)
(f) how will the firm’s market value balance sheet look like after purchasing the shopping complex? Explain and construct the market value balance sheet. (10 points)
6. If HR decides to issue debt (i.e. borrow money by selling the 7 percent bonds) to pay for the shopping complex, (a) what will be the market value of the firm? (10 points) (b) how will the firm’s market value balance sheet look like after both the debt issue and the purchase of the shopping complex? Explain and construct the market value balance sheet. (15 points) (c) what will the price per share of the firm’s stock be after both the debt issue and the shopping complex purchase? (10 points)
7. Which method of financing (equity versus debt) maximizes the per-share stock price of HR’s equity? Briefly explain. (10 points)
Explanation / Answer
1.
If HR would like to maximize its total market value, should it issue debt or equity to pay for the shopping complex because interest payments on debt instruments are tax deductible. Thus, using debt in the capital structure shall decrease the firm’s taxable income which will ultimately increase the overall value of the firm.
2.
Common stock outstanding = 250,000 shares
Market value per share = $65 per share
Market value of equity = 250,000 shares *$65 = $16,250,000
Market value balance sheet
Assets
$16,250,000
Equity
$16,250,000
Total Assets
$16,250,000
Total Debt & Equity
$16,250,000
3.
Net present value of the project
Initial outflow = Cost of the complex = $12,350,000
Annual earnings = $4,200,000
Post tax annual earnings = $4,200,000 (1 – 0.35) = $2,730,000
Net present value = -$12,350,000 + $2,730,000/0.15 = $5,850,000
4.
Market value balance sheet
Old Assets
$16,250,000
Equity
$22,100,000
NPV of complex
$5,850,000
Total Assets
$22,100,000
Total Debt & Equity
$22,100,000
5.
(a) New price per share = $22,100,000 / 250,000 = $88.40
(b) Shares need to be issued to finance the purchase = $12,350,000/$88.40 = 139,706 shares
(c)
Market value balance sheet
Old Assets
$16,250,000
Equity
$34,450,000
Cash
$12,350,000
NPV of complex
$5,850,000
Total Assets
$34,450,000
Total Debt & Equity
$34,450,000
(d) No. of shares outstanding = 250,000 + 139,706 = 389,706
(e) Price per share of firm’s stock = $34,450,000/389,706 = $88.40 per share
(f)
Present value of complex = $4,200,000(1-0.35)/0.15 = $18,200,000
Market value balance sheet
Old Assets
$16,250,000
Equity
$34,450,000
PV of complex
$18,200,000
Total Assets
$34,450,000
Total Debt & Equity
$34,450,000
6.
(a) Value of firm = Value of all equity firm + value of tax shield from debt = $34,450,000 + $12,350,000*0.35 = $38,772,500
(b)
Market value balance sheet
Value of all equity
$34,450,000
Equity
$26,422,500
Tax shield
$4,322,500
Debt
$12,350,000
Total Assets
$38,772,500
Total Debt & Equity
$38,772,500
(c) Price per share of the firm’s stock = $26,422,500 / 250,000 = $105.69
7. Price per share under equity financing = $88.40 per share
Price per share under debt financing = $105.69 per share
Hence, debt method of financing maximizes the per-share stock price HR’s Equity.
Market value balance sheet
Assets
$16,250,000
Equity
$16,250,000
Total Assets
$16,250,000
Total Debt & Equity
$16,250,000
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