Problem
Ariff real estate company was founded 10 years ago by the current CEO, Ariff. 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 10 years and the shareholders are satisfied with the company's management. Prior to founding Ariff real estate, Ariff was the founder and CEO of a failed alfafa farming operation. The resulting bankruptcy made Ariff extremely afraid to use debt financing. As a result, the company is entirely relying on equity financing with 10 million shares of common stock outstanding. The stock currently trades at RM 23.45 per share.
Ariff is evaluating a plan to purchase two acres of land in Perak for RM1,000,000. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Ariff's annual pretax earnings by RM15 million in perpetuity. Alex, the company's new CFO, has been put in charge of the project. Alex has determined that the company's current cost of capital is 10.5%. He feels that the company would be more valuable if it included debt in its capital structure, so he is evaluating whether the company should issue debt to entirely finance the project. Based on some conversations with investment banks, he thinks that the company can issue bond at par value witha 9% coupon rate. From his analysis, he also believes that a capital structure in the range of 60 percent equity/40 percent debt would be optimal. If the company goes beyond 40 percent debt, its bond will carry a lower rating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Ariff has a 35 percent corporate tax rate.
i. If Ariff wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.
ii. Which method of financing will maximize the per-share stock price of Ariff's equity?