Hoosier Rentals, Inc., another company founded by Gail McCornell in Richmond, In

Question

Hoosier Rentals, Inc., another company founded by Gail McCornell 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). You have just been hired by Gail as the financial manager of the company. You are expected to look for the answers to all of the key questions, as stated below, that might be brought up for discussion in the next board meeting.

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

Ans 1 Market Value of the firm is a function of future cashflows and discount rate used to discount the future cash flows. Since the equity bears the residual risk , expected return would be more and cost of capital would be high incase of firm fully financed with equity. Where as in case of an optimum capital structure , as cost of debt is lower compared to equity , it will leverage the valuaation of the firm. Details Amount Amount Ans 2 Market value Balance Sheet Investment Property and net current assets 162,50,000.00 Total Assets 162,50,000.00 Equity 162,50,000.00 Total Equity and outsider Liability 162,50,000.00 Ans 3 Increase in annual Pre-Tax earnings     42,00,000.00 Less Tax @35%     14,70,000.00 Increase in annual Post-Tax earnings     27,30,000.00 Discount rate 15% Present Value of cash inflows 182,00,000.00 Less Initial investment 123,50,000.00 NPV     58,50,000.00 Ans 4 Investment Property and net current assets 286,00,000.00 Total Assets 286,00,000.00 Equity 286,00,000.00 Total Equity and outsider Liability 286,00,000.00

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