capital structure (finance)

Project Description:

capital structure

pharaoh real estate inc. purchases real estate, including land and buildings, and rents the property to tenants. the company has been very profitable in the past. however, the company also saw some drawbacks in the past when some of its investments went bankrupt and made the company very averse to debt financing. for that reason, the company is 100 percent equity financed with 12 million shares of common stock outstanding. the stock is currently trades at 31.40 le (egyptian pound).
pharaoh real estate is evaluating a plan to purchase a huge land in upper egypt for 80 million le in anticipation of increase in tourism in the area. once the land is purchased, the company will start putting its structures immediately and in a year they expect to start getting their earnings. the company expects the project to increase its annual pretax earnings by 16 million le in perpetuity. (you may think “perpetuity” cash flow is unrealistic. yet, it greatly simplifies your calculations without compromising the intuition you would get from the problem!)
you, as newly hired mba, are part of the team that is in charge of the project and will directly report your findings to the cfo of the company. you determine that the cost of pharaoh real estate is 10.2 percent. you also feel that the company would be more valuable if it included debt in its capital structure. for that reason, you are evaluating whether the company should issue debt to entirely finance the project. based on some discussion with investment banks, you think that the company can issue bonds at par value with a 6 percent coupon rate. from the analysis, you also believe that a capital structure in the range of 70 percent equity and 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. pharaoh real estate has a 40 percent corporate tax rate.

questions:
1. if you wish to maximize the total market value of the firm, would you recommend that pharaoh real estate issue debt or equity to finance the proposed land purchase? why?

2. construct pharaoh real estate’s market value balance sheet before the purchase.

3. suppose you recommend that the company issues equity to finance the purchase.
a. what is the net present value of the project?
b. construct the company’s market value balance sheet after it announces that the company will finance the purchase with equity. what would be the new price per share of the company’s stock? how many shares will the company need to issue to finance the purchase?
c. construct the company’s market value balance sheet after the equity issue but before the purchase has been made. how many shares of common stock does the company have outstanding? what is the price per share of the company’s stock?
d. construct the company’s market value balance sheet after the purchase has been made?

4. suppose you recommend that the company issues debt to finance the purchase.
a. what will the market value of pharaoh real estate inc. be if the purchase is financed with debt?
b. construct the company’s market value balance sheet after both the debt issue and the land purchase. what is the price per share of the company’s stock?

5. which method of financing maximizes the per-share stock price of pharaoh real estate’s equity?
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