Strozier Real Estate Refinancing

The current CEO, Robert Strozier, founded Strozier Real Estate Company 25 years ago. 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 companys management. Prior to founding Strozier Real Estate, Robert was 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 8.5 million shares of common stock outstanding. The stock currently trades at $44.50 per share.

Strozier is evaluating a plan to purchase a huge tract of land in the southeastern United States for $50 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stroziers annual pretax earnings by $11 million in perpetuity. Lynn Frasier the companys new CFO, has determined that the companys current cost of capital is 12.5%

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Cost of capital is the rate of return required to persuade the investor to make a given investment. She feels that the company would be more valuable if it included debt in its capital structure, therefore 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 a coupon rate of 8%. From her analysis, she also believes that a capital structure in the range of 70% equity/30% debt would be optimal. If the company goes beyond 30% debt, its bonds would carry a lower rating and a much higher coupon because the possibility of financial distress and its associated costs would rise sharply. Strozier has a 21% corporate tax rate (state and federal).

Follow the same format (instructions from Case Study One)

QUESTIONS

1. If Strozier wants to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase. Choose debt or equity (not a combination). Explain.

2. Construct Stroziers Market Value Balance Sheet before it announces the purchase.

Market Value Balance Sheet

AssetValue ($)		Equity ($)
Total assets		Debt & Equity ($)

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

1. What is the Net Present Value of the Project (NPV)

Earnings increase = projected new earnings (1 tax rate)

Discount rate = Stroziers unlevered cost of capital is the implied rate of return a company expects to earn on its assets, use Stroziers current cost of capital

NPV =Cost of the land + ( earnings increase/current cost of capital)

2. Construct Stroziers Market Value Balance Sheet after it announces that the firm will finance the land purchase using only equity. What would be the new price per share of Stroziers stock? How many shares will Strozier need to issue to finance the purchase?

Equity Value = Equity + NPV

Market Value Balance Sheet

Old Assets ($)	Equity
NPV	Debt + Equity
Total Assets

New share price = value of firms equity/shares outstanding

Shares to issue = purchase of land/stock price

3. Construct Stroziers Market Value Balance Sheet after the equity issue but before the land is purchased. Use same balance sheet format as above but add the cash Strozier has acquired from the sale of the stock. How many shares of common stock does Strozier have outstanding? What is the price per share of the firms stock now?

4. After the sale, what are Stroziers after-tax earnings? Using the unlevered cost of capital, determine the PV of the project.

The unlevered cost of capital represents the cost of a company financing the project itself without incurring debt. It provides an implied rate of return, which helps investors make informed decisions on whether to invest

4. Suppose Strozier decides to issue debt to finance the project.

1. What will be the market value of the company after taxes?

Old asset value + PV of project + tax rate($ value of debt used)

2. Construct Stroziers Market Value Balance Sheet after both the debt issue and the land purchase. What is the price per share of the firms stock?

Market Value Balance Sheet

Value of firm without use of debt	Debt
Tax Shield	Equity
Total Asset Value	Debt + Equity