Company is currently: ? Entirely equity financed with 15 mil shares of common st

Question

Company is currently:
? Entirely equity financed with 15 mil shares of common stock outstanding
? Current per share price is $34.50

Company wants to make a land purchase in the amount of $95 mil.
? Expect an increase to annual pretax earnings of $23 mil in perpetuity
? Company’s current cost of capital is 12.5%

Company would like to determine if land purchase should be financed with debt or equity. Company believes they can:
? Issue bonds at par value with an 8% coupon rate
? Optimal ratio would be 70% equity/30% debt
? Corporate Tax rate is 40%

Is it in their best interest to finance the land purchase with debt or equity and what would the market value balance sheet look like before this purchase announcement?

Explanation / Answer

Equity

Bonds

In millions

In millions

Pre tax earnings

23

23

Interest 8%

0

7.6

Profit before tax

23

15.4

Tax 40%

9.2

6.16

Net profit

13.8

9.24

11.875

0

Retained earnings

1.925

9.24

Bonds

In millions

Pre tax earnings

23

Interest 8%

2.28

Profit before tax

20.72

Tax 40%

8.288

Net profit

12.432

Devidend 12.5%

8.3125

Retained earnings

4.1195

Equity

Bonds

In millions

In millions

Pre tax earnings

23

23

Interest 8%

0

7.6

Profit before tax

23

15.4

Tax 40%

9.2

6.16

Net profit

13.8

9.24

Devidend 12.5% (cost of capital)*

11.875

0

Retained earnings

1.925

9.24

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