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).

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 ($)