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 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?
(b) How many shares will HR need to issue?
(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? Construct the market value balance sheet.
(d) How many shares of common stock will be outstanding after the equity issue?
(e) What is the new price per share of the firm’s stock?
(f) How will the firm’s market value balance sheet look like after purchasing the shopping complex? Construct the market value balance sheet.
2. 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?
(b) how will the firm’s market value balance sheet look like after both the debt issue and the purchase of the shopping complex? Construct the market value balance sheet.
(c) what will the price per share of the firm’s stock be after both the debt issue and the shopping complex purchase?
3. Which method of financing (equity versus debt) maximizes the per-share stock price of HR’s equity?