Reference no: EM132806992

Pacific company is a property developer. It is entirely equity financed with 20 million shares of common stock outstanding. The stock currently trades at $30 per share. It is evaluating a plan to purchase a building in the Kowloon for $52 million. The land will be leased to tenant. The deal is expected to increase its annual pretax earnings by $12 million in perpetuity. John Boss, the company's financial manager, has been put in charge of the project. John has determined that the company's current cost of capital is 11 percent. He feels that the company value will be higher if it included debt in its capital structure. Hence, he is considering whether the company should issue debt to finance the project. Based on his analysis, he believes that its optimal capital structure will be 70% equity and 30% debt. If the company goes beyond 30% debt, its company credit rating would be decreased because the possibility of financial distress and the associated costs would rise. It has a 25 percent corporate tax rate (state and federal).

Problem a) If the Pacific company wishes to maximize its total market value, should it issue debt or equity to finance the building purchase? Explain.

Problem b) Construct its market value balance sheet before it announces the purchase.