Question

Johnson Real Estate Company was founded 25 years ago by the current CEO, David Johnson. 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 Johnson Real Estate, David was the founder and CEO of a failed camel 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. Johnson 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 Johnson's annual pretax earnings by $14.125 million in perpetuity. Abigail Burton, the company’s new CFO, has been put in charge of the project. Abigail 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. Johnson has a 23 percent corporate tax rate (state and federal). If Johnson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

Answer 1

In this case we must opt for the scenario which minimizes the Cost of Capital. Minimizing the Cost of Capital will in turn maximize the market value of the firm.

Option 1 –

Finance the land purchase by Equity only

Cost of land = $ 85 million.

Cost of Equity = 10.2 %

Hence, Cost of Capital (annual) = $ 85 million x 10.2% = $ 8.67 million

Option 2 –

Finance the land purchase by 70% Equity and 30% Debt

Cost of land = $ 85 million

Cost of Equity = 10.2%

Cost of Debt = 6% (coupon rate on bonds)

Tax rate = 23%

Hence,

Weight Average Cost of Capital (WACC) = Cost of Equity + [ Cost of Debt x (1- Tax Rate) ]

Note - coupon amount paid on Bonds is tax deductible. Hence it further reduces the actual cost of debt.

WACC = [ 70% x 10% ] + [ (30% x 6%) x (1 – 23%) ]

              = [ 0.7 x 0.1 ] + [ (0.3 x 0.06) x (0.77) ]

              = 0.07 + 0.0139

              = 0.0839 or 8.39 %

Hence, Weighted Average Cost of Capital (annual) = $ 85 million x 8.39% = $ 7.13 million

Since Option 2 minimizes the Cost of Capital, Johnson should recommend combination of Equity and Debt to finance the land purchases. (70% Equity, 30% Debt).