EBK FUNDAMENTALS OF CORPORATE FINANCE A
EBK FUNDAMENTALS OF CORPORATE FINANCE A
10th Edition
ISBN: 9780100342613
Author: Ross
Publisher: YUZU
Question
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Chapter 16, Problem 3M

a)

Summary Introduction

Case synopsis:

Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys real estate and rents it to the tenants. The firm has a profit each year. Before the foundation of Company S, Person R was a CEO and the founder of Company A, which is a farming operation. Company A was a failure as a firm, which ended up with bankruptcy. This situation made Person R extremely averse towards debt financing.

Hence, the company is completely financed through equity. Company S is assessing a plan to buy a huge tract of land, which would be leased to tenant farmers. This purchase is predicted to raise the annual earnings before tax in perpetuity. Person J is the new CFO (chief financial officer) of Company S, who has determined the present capital cost of the company.

Person J felt that the company will be very valuable if it adds debt in its capital structure. While evaluating whether the company could issue debt to completely finance the project, she found that it can issue bonds at a par value with the coupon rate. She found an optimal range of capital structure between 70% equity and 30% debt.

Characters in the case:

  • Company S
  • Company A
  • Person S
  • Person J

Adequate information:

  • If Company S moves beyond the 30% debt, the bonds issued by the company will have a lower rating and a greater coupon as the possibility of financial distress and the associated cost will increase.
  • Company S also has a corporate rate of tax.

To compute: The NPV of the project.

a)

Expert Solution
Check Mark

Answer to Problem 3M

The NPV (net present value) of the project $14,117,647.06.

Explanation of Solution

Given information: Company S has an outstanding stock of 12 million shares, while financed completely through equity. The present trade of the stock is $31.40 for one share. The purchase price of the huge tract of land is $80 million. The expected increase in the earnings through the land purchase is $16 million.

The present capital cost of the company is 10.2%. The company will have an optimal capital structure if it is between 70% equity and 30% debt. The corporate rate of tax is 40%.

Explanation:

The purchase of land will result in an increase in the earnings of the company by $16 million in a year, in perpetuity. Such earnings are taxed at 40%. Hence, after taxes, the land purchase will increase the yearly-expected earnings of the company.

Formula to calculate the increase in the earnings:

Earnings increase=Increase in purchase before tax(1Rate of tax)

Calculate the increase in the earnings:

Earnings increase=Increase in purchase before tax(1Rate of tax)=$16,000,000(10.40)=$9,600,000

Hence, the increase in the earnings after tax is $9,600,000.

As Company S is an all-equity company, the appropriate rate of discount is the company’s unlevered cost of equity. Hence, the NPV of the purchase is as follows:

Formula to calculate the NPV:

NPV=Increase in the earnings after-taxCurrent cost of capitalInitial cost

Calculate the NPV:

NPV=Increase in the earnings after-taxCurrent cost of capitalInitial cost=$9,600,0000.102$80,000,000=$14,117,647.06

Hence, the NPV is $14,117,647.06.

b)

Summary Introduction

Case synopsis:

Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys real estate and rents it to the tenants. The firm has a profit each year. Before the foundation of Company S, Person R was a CEO and the founder of Company A, which is a farming operation. Company A was a failure as a firm, which ended up with bankruptcy. This situation made Person R extremely averse towards debt financing.

Hence, the company is completely financed through equity. Company S is assessing a plan to buy a huge tract of land, which would be leased to tenant farmers. This purchase is predicted to raise the annual earnings before tax in perpetuity. Person J is the new CFO (chief financial officer) of Company S, who has determined the present capital cost of the company.

Person J felt that the company will be very valuable if it adds debt in its capital structure. While evaluating whether the company could issue debt to completely finance the project, she found that it can issue bonds at a par value with the coupon rate. She found an optimal range of capital structure between 70% equity and 30% debt.

Characters in the case:

  • Company S
  • Company A
  • Person S
  • Person J

Adequate information:

  • If Company S moves beyond the 30% debt, the bonds issued by the company will have a lower rating and a greater coupon as the possibility of financial distress and the associated cost will increase.
  • Company S also has a corporate rate of tax.

To construct:

The balance sheet of Company S with its market value after its announcement that the company will use equity finance for the purchase. Calculate the new price for one share of the company’s stock and the number of shares to be issued by the company in order to finance the purchase.

b)

Expert Solution
Check Mark

Answer to Problem 3M

The new price per share after the announcement of land purchase is $32.58 and the number of shares Company S needs to be issued is $2,547,770.70.

Explanation of Solution

The value of Company S will maximize by $14,117,647.06, which is NPV of the purchase, after the announcement. As per the efficient-market hypothesis, the firm’s market value will immediately increase to reflect the project’s NPV. Hence, the market value equity of Company S after the purchase announcement is as follows:

Formula to calculate the value of equity:

Equity value=Market value of equity+NPV

Calculate the value of equity:

Equity value=Market value of equity+NPV=$376,800,000+$14,117,647.06=$390,917,647.10

Hence, the equity value is $390,917,647.10.

Balance sheet showing the market value after its announcement of land purchase through equity finance:

Market value balance sheet
Equity $39,09,17,647 Old assets  $37,68,00,000
    NPV of project  $1,41,17,647
Debt and equity $39,09,17,647 Total assets $39,09,17,647

As the market value of the company’s equity is $390,917,647 and the company has an outstanding stock of 9 million shares, the stock price of Company S after the announcement will be the following:

Formula to calculate the new share price:

New share price=Market value of the firm's equityOutstanding shares

Calculate the new share price:

New share price=Market value of the firm's equityOutstanding shares=$390,917,647$12,000,000=$32.58

Hence, the new share price is $32.58.

Company S should increase $80 million to finance the purchase of land and the worth of the company’s stock is $32.58 for one share. Hence, Company S must issue the following amount:

Formula to calculate the shares to be issued:

Shares to issue=Increase in the financing amount for land purchaseNew share price

Calculate the shares to be issued:

Shares to issue=Increase in the financing amount for land purchaseNew share price=$80,000,000$32.58=$2,455,494.168

Hence, the shares to be issued are $2,455,494.168.

c)

Summary Introduction

Case synopsis:

Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys real estate and rents it to the tenants. The firm has a profit each year. Before the foundation of Company S, Person R was a CEO and the founder of Company A, which is a farming operation. Company A was a failure as a firm, which ended up with bankruptcy. This situation made Person R extremely averse towards debt financing.

Hence, the company is completely financed through equity. Company S is assessing a plan to buy a huge tract of land, which would be leased to tenant farmers. This purchase is predicted to raise the annual earnings before tax in perpetuity. Person J is the new CFO (chief financial officer) of Company S, who has determined the present capital cost of the company.

Person J felt that the company will be very valuable if it adds debt in its capital structure. While evaluating whether the company could issue debt to completely finance the project, she found that it can issue bonds at a par value with the coupon rate. She found an optimal range of capital structure between 70% equity and 30% debt.

Characters in the case:

  • Company S
  • Company A
  • Person S
  • Person J

Adequate information:

  • If Company S moves beyond the 30% debt, the bonds issued by the company will have a lower rating and a greater coupon as the possibility of financial distress and the associated cost will increase.
  • Company S also has a corporate rate of tax.

To construct:

The balance sheet of Company S, with its market value after the issue of equity prior to the purchase. Calculate the new price for one share of the company’s stock and the outstanding number of shares of the common stock that the company has.

c)

Expert Solution
Check Mark

Answer to Problem 3M

The outstanding number of shares of common stock that the company has is $14,547,770.70 and the price for one share of the company’s stock is $32.58.

Explanation of Solution

Company S will receive a cash of $80 million due to equity issues. This will raise the assets and equity of the firm by $80 million. Hence, the balance sheet with the new market value after the issue of stock will be as follows:

Balance sheet showing the market value before the land purchase after the issue of stock:

Market Value Balance Sheet
Equity $470,917,647 Cash $80,000,000
    Old assets  $376,800,000
    NPV of project  $1,41,17,647
Debt and equity $470,917,647 Total assets $470,917,647

The stock price will be unchanged. Hence, compute the total outstanding shares to show the constant stock price.

Formula to calculate the total outstanding shares:

Total shares outstanding=Outstanding shares+Number of shares to be issued

Calculate the total outstanding shares:

Total shares outstanding=Outstanding shares+Number of shares to be issued=$12,000,000+$2,455,494.168=$14,455,494.17

Hence, the total outstanding shares are $14,455,494.17.

Formula to calculate the share price:

Share price=EquityTotal shares outstanding

Calculate the share price:

Share price=EquityTotal shares outstanding=$470,917,647$14,455,494.17=$32.58

Hence, the share price is $32.58.

d)

Summary Introduction

Case synopsis:

Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys real estate and rents it to the tenants. The firm has a profit each year. Before the foundation of Company S, Person R was a CEO and the founder of Company A, which is a farming operation. Company A was a failure as a firm, which ended up with bankruptcy. This situation made Person R extremely averse towards debt financing.

Hence, the company is completely financed through equity. Company S is assessing a plan to buy a huge tract of land, which would be leased to tenant farmers. This purchase is predicted to raise the annual earnings before tax in perpetuity. Person J is the new CFO (chief financial officer) of Company S, who has determined the present capital cost of the company.

Person J felt that the company will be very valuable if it adds debt in its capital structure. While evaluating whether the company could issue debt to completely finance the project, she found that it can issue bonds at a par value with the coupon rate. She found an optimal range of capital structure between 70% equity and 30% debt.

Characters in the case:

  • Company S
  • Company A
  • Person S
  • Person J

Adequate information:

  • If Company S moves beyond the 30% debt, the bonds issued by the company will have a lower rating and a greater coupon as the possibility of financial distress and the associated cost will increase.
  • Company S also has a corporate rate of tax.

To construct: The balance sheet of Company S after the purchase.

d)

Expert Solution
Check Mark

Explanation of Solution

The project will increase $16 million of extra pre-tax earnings yearly forever. Such earnings will be taxed at 40%. Hence, after taxes, the project will raise the yearly earnings of the firm by $9.6 million. Compute the present value of the increase in the earnings after-tax:

Formula to calculate the market value balance sheet:

Present value of the project=Increase in the yearly earnings of the firm Present capital cost

Calculate the market value balance sheet:

Present value of the project=Increase in the yearly earnings of the firm Present capital cost=$9,600,000$0.102=$94,117,647.06

Hence, the present value of the project is $94,117,647.06.

Balance sheet showing the market value after the land purchase after the issue of stock:

Market Value Balance Sheet
Equity $470,917,647.1 Old assets $376,800,000
    PV of project $94,117,647.06
Debt and equity $470,917,647.1 Total assets $470,917,647.1

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Chapter 16 Solutions

EBK FUNDAMENTALS OF CORPORATE FINANCE A

Ch. 16.4 - If we consider only the effect of taxes, what is...Ch. 16.5 - Prob. 16.5ACQCh. 16.5 - What are indirect bankruptcy costs?Ch. 16.6 - Can you describe the trade-off that defines the...Ch. 16.6 - What are the important factors in making capital...Ch. 16.7 - Prob. 16.7ACQCh. 16.7 - What is the difference between a marketed claim...Ch. 16.7 - What does the extended pie model say about the...Ch. 16.8 - Prob. 16.8ACQCh. 16.8 - Why might firms prefer not to issue new equity?Ch. 16.8 - Prob. 16.8CCQCh. 16.9 - Do U.S. corporations rely heavily on debt...Ch. 16.9 - What regularities do we observe in capital...Ch. 16.10 - Prob. 16.10ACQCh. 16.10 - Prob. 16.10BCQCh. 16 - Maximizing what will maximize shareholder value?Ch. 16 - What is most closely related to a firms use of...Ch. 16 - Give an example of a direct cost of bankruptcy.Ch. 16 - Prob. 16.7CTFCh. 16 - Prob. 1CRCTCh. 16 - Prob. 2CRCTCh. 16 - Optimal Capital Structure [LO1] Is there an easily...Ch. 16 - Observed Capital Structures [LO1] Refer to the...Ch. 16 - Financial Leverage [LO1] Why is the use of debt...Ch. 16 - Homemade Leverage [LO1] What is homemade leverage?Ch. 16 - Prob. 7CRCTCh. 16 - Prob. 8CRCTCh. 16 - Prob. 9CRCTCh. 16 - Prob. 10CRCTCh. 16 - Prob. 1QPCh. 16 - Prob. 2QPCh. 16 - Prob. 3QPCh. 16 - Prob. 4QPCh. 16 - Prob. 5QPCh. 16 - Prob. 6QPCh. 16 - Prob. 7QPCh. 16 - Prob. 8QPCh. 16 - Prob. 9QPCh. 16 - Prob. 10QPCh. 16 - Prob. 11QPCh. 16 - Prob. 12QPCh. 16 - Prob. 13QPCh. 16 - Prob. 14QPCh. 16 - Prob. 15QPCh. 16 - Prob. 16QPCh. 16 - Prob. 17QPCh. 16 - Prob. 18QPCh. 16 - Weighted Average Cost of Capital [LO1] In a world...Ch. 16 - Cost of Equity and Leverage [LO1] Assuming a world...Ch. 16 - Business and Financial Risk [LO1] Assume a firms...Ch. 16 - Stockholder Risk [LO1] Suppose a firms business...Ch. 16 - Prob. 1MCh. 16 - Prob. 2MCh. 16 - Prob. 3MCh. 16 - Prob. 4MCh. 16 - Prob. 5M
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