Introduction
Many companies gain funds both by equity and bond issuing, maintaining a low debt-to-equity ratio. The latter helps them to avoid higher interest rates and benefits them in the future when seeking additional funding (Maverick, 2021). RRE currently relies on equity financing and considers adding some debt to its capital structure (30:70), expecting to increase its market value. The current total market value of the company is 302,400,000, and it needs to raise 85 million for the land purchase. The new debt-to-equity ratio would be 22:78, where the debt ratio is lower than 30%; thus, the interest rate of 6% remains. The company’s CFO believes that it may be a great idea. For that reason, two finance options will be analyzed further to provide final recommendations for the firm.
In general, equity and debt financing are two main methods enterprises use to raise money for their business needs, such as purchasing an asset or building a new facility. Finance through equity requires a company to sell a part of its assets in exchange for the capital it wants to acquire. On the contrary, debt financing does not involve selling an enterprise’s equity, as a company raises capital by borrowing money from lenders with the obligation to repay it under particular interest (Maverick, 2021). There is no ideal and safe option to choose from since both of them have specific risks and advantages. For instance, finance through equity helps a company to avoid repayment obligation, while a business owner loses control of the part of his/her business (Maverick, 2021). Finance through debt does not grant lender any ownership but may constrain a firm’s ability to grow soon, especially in case of an economic crisis.
Equity Financing
To decide which finance option to choose, the company should identify the total market value for both of them. The total market value formula says that it is equal to the total shares multiplied by the market value of shares. The latter can be found by dividing total earnings by total shares outstanding (Köseolu, 2019). It was estimated that earnings after tax (23%) is 10,876,250 and existing earnings is 30,844,800; hence, the total earnings of RRE would be 41,721,050.
Table 1: Market Value Balance Sheet after Announcement
Since company requires to raise 85 million and its current shares trade at 37.80 the number of shares to be issued = 85,000,000 / 37.80 = 2,248,678 shares. To find the total shares outstanding, one needs to add 8 million shares of common stock outstanding to newly issued shares, what equals 10,248,678 shares. Now the earnings per share can be calculated by dividing total earnings by total share outstanding = 41,721,050/10,248,678 = $4.07087. The case study provides the cost of capital that is 10.2%. To calculate the market value per share, earnings per share should be divided by the cost of capital (Köseolu, 2019). Thus, the new price per share of the firm’s stock = 4.07087 per share/10.2%=39.9105. Finally, the total market value if the company decides to finance through equity would be 10,248,678*39.9105 =409,029,863.
Table 2: Market Value Balance Sheet after Issue of Shares and Purchase of Commercial Real Estate
In order to calculate the net present value (NPV) of the project, the cash outflows should be subtracted from present value perpetuity inflows. The value of perpetuity earnings = earnings after-tax / cost of capital = 10,876,250 / 10.2%= 106,629,900. The value of perpetuity must be discounted to year zero since RRE would earn profits at the end of the first year (Fernando, 2021). For that reason, the present value of perpetuity would be 9,676,030. Next NPV can be easily calculated by subtracting 8,500,000 from 9,676,030, which is equal to 1,176,034. The positive number indicates the potential profitability of the investment that would not result in a net loss since earnings are higher than anticipated costs.
Debt Financing
If choosing other finance options, the company will have to issue bonds worth 85,000,000 and pay 5,100,000 of interest under a 6% coupon rate. To calculate total earnings to equity shareholders existing earnings should be added to earnings after interest and tax = 30,844,800 + 6,949,250 = 37,794,050 (Köseolu, 2019). This result makes possible further calculation of earnings per share, dividing it by 8 million the firm currently has in stock (4.724 per share). The company’s market value can be identified using the same formula applied in the case of equity financing. Thus, the market value of RRE when finance of the new project made through bond equals 370,528,000.
Table 3: Market Value Balance Sheet after Announcement of Debts
The new price per share of the firm’s stock calculation requires earnings per share divided by the current cost of capital. Hence, the price per share would be 4.724/10.2% = $46.316. This result is higher than was determined for equity financing ($39.9105 per share), leading to the conclusion that the debt method maximizes share price. It means that investors would perceive the company as one more ready to grow and yield profits in the near future, while its management would enjoy higher compensation (Fernando, 2021). The firm’s higher share price may signify its successful operation and attract more investors soon.
Table 4: Market Value Balance Sheet after Issue of Bonds and Purchase of Commercial Real Estate
Conclusion
Since RRE plans and strives to increase its market value, the company should concentrate on equity financing instead of debt financing. Calculations revealed that Raylynne’s idea to issue bonds at par value to purchase a segment of land leads to the lower market value of the company compared to another finance method. If the enterprise aims to boost its equity value, the better option will be to finance the purchase through debt. The calculation proved that debt financing maximizes the per-share stock price of RRE’s equity. Market value is more critical in this case; thus, the recommendation would be to issue equity to finance the land purchase increasing the latter.
References
Fernando, J. (2021). Net Present Value (NPV). Investopedia. Web.
Köseolu, S. D. (2019). Valuation challenges and solutions in contemporary businesses. IGI Global.
Maverick, J. B. (2021). Equity financing vs. debt financing: What’s the difference? Investopedia. Web.