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

IF TOO MUCH DEBT INVOLVED INTEREST PAYMENTS TO COMPANIES SO TOO MUCH DEBT MAY MAKE COMPANY INSOLVENT IN LONGER TIME.

TOO MUCH EQUITY ALSO CAUSES RISKS FOR COMPANIES BECAUSE TOO MUCH EQUITY MAY LEAD TO HIGHER EXPECTATIONS FROM SHAREHOLDERS WHICH DEMAND HIGHER RETURNS THAN DEBT AND OWNERSHIP ISSUES MAY LEAD TO ACQUISITION. SO TOO MUCH EQUITY ALSO NOT GOOD FOR COMPANY.

THERE IS NEED OF OPTIMAL CAPITAL STRUCTURE SO THAT OVERALL COST CAN BE REDUCED AND MARKET VALUE OF COMPANY AND RETURN ON EQUITY CAN BE RAISED. REAL ESTATE SECTOR IS FULL OF UNCERTAINTIES SO TOO MUCH DEBT BEYOND 30% WOULD CAUSE EXCESSIVE INTEREST PAYMENTS AND ALSO SEND WRONG SIGNALS TO MARKET SO 70% EQUITY AND 30% DEBT IS VERY GOOD MIXTURE OF CAPITAL STRUCTURE FOR REAL ESTATE SECTOR. I WOULD SUGGEST 30% DEBT AND 70% EQUITY IS QUITE NICE STRUCTURE SHOULD CONTINUE WITH THAT BECAUSE DEBT IS ALSO GOOD BECAUSE IT IS BENEFICIAL IN TAX STRUCTURE. CONTINUE SAME STRUCTURE SEND GOOD SIGNALS IN MARKET WHICH MAY EFFECT SHARE VALUE OF COMPANY.