Reference no: EM132825214

Stephen Real Estate Company was founded twenty years ago by the current CEO, Robert Stephen. Prior to founding Stephen Real Estate, Robert was the founder of a failed alpaca farming operation. The resulting bankruptcy made him quite averse to debt financing.

• The company has issued 7000 bonds with a 7.5% coupon rate, $1000 face value and a quoted price of $1080. The bonds have twenty years to maturity and the yield to maturity is 6.76%. The company also has 180 000 ordinary shares. The dividends have a growth rate of 6% indefinitely; the current share price is $60; and the dividend next year will be $2.80. The beta of the share is 0.9. Apart from the ordinary shares, the company also issues 8000 5.50% preference shares with a face value of $100 and selling at $94.
• Stephen is evaluating a plan to purchase a huge tract of land in the south-eastern Melbourne for $100 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase the company's annual earnings in the next five years. You have been just appointed as the company's new CFO.

To understand the cost of capital and capital structure decision, Robert has asked you to answer the below questions:

Problem (a) Suppose the expected return on the market is 12%, the risk-free rate is 5%, and the corporate tax rate is 30%, calculate the company's weighted average cost of capital.

Problem (b) If Stephen wishes to maximise firm's total market value, would you recommend him to use debt or equity to finance the land purchase? Explain your answer.

Problem (c) If Stephen is raising finance based on the pecking order theory of capital structure, what would be your recommendation?