Nicolet Real Estate Company was founded 25 years ago by the current CEO, Steven Nicolet. 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 18 years, and the shareholders are satisfied with the company’s management. Prior to founding Nicolet Real Estate, Steven was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity financed, with 12 million shares of common stock outstanding. The stock currently trades at $31.40 per share.

Nicolet is evaluating a plan to purchase a huge tract of land in the southeastern Canada for $80 million. The land will subsequently be leased to a developer who plans to build a gated community for the Canadian snowbird market. This purchase is expected to increase Nicolet’s annual pre-tax earnings by $16 million in perpetuity. Scarlett Wright, the company’s new CFO, has been put in charge of the project. Scarlett has determined that the company’s current cost of capital is 10.2 percent.

She feels that the company would be more valuable if it included debt in its capital structure, so she is evaluating whether the company should issue debt to entirely finance the project. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with an 6 percent coupon rate. From her analysis, she also believes that a capital structure in the range of 70 percent equity/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. Nicholet has a 40 percent corporate tax rate (state and federal).

Questions

1. If Nicolet wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

2. Construct Nicolet’s market value statement of financial position before it announces the purchase.

3. Suppose Nicolet decides to issue equity to finance the purchase.

a. What is the net present value of the project?

b. Construct Nicolet’s market value statement of financial position after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm’s stock? How many shares will Nicolet need to issue to finance the purchase?

c. Construct Nicolet’s market value statement of financial position after the equity issue but before the purchase has been made. How many shares of common stock does Nicolet have outstanding? What is the price per share of the firm’s stock?

d. Construct Nicolet’s market value statement of financial position after the purchase has been made.

4. Suppose Nicolet decides to issue debt to finance the purchase.

a. What will the market value of the Nicolet company be if the purchase is financed with debt?

b. Construct Nicolet’s market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm’s stock?

5. Which method of financing maximizes the per-share stock price of Nicolet’s equity?