Module 2 Case

MBA 6365

Group 4

Case #1

Summary

In our first case study, we evaluated the decision of whether Johnson Real Estate Company should fund a land purchase with debt or with equity.  In our analysis, we’ve concluded that Johnson should issue debt to fund the purchase of land.  Key factors in this decision were the increase in earnings provided by leasing the land as well as the coupon rate of the bond, Johnson’s corporate tax rate and Johnson’s current cost of capital.  By issuing debt to fund the land purchase, Johnson takes advantage of the tax shield generated by the tax deductible interest payments.

In the second portion of the assignment, Johnson is again faced with the decision of whether to fund a new project.  This time, the company can not issue debt due to a covenant with their existing debt.  We analyzed the impact of issuing equity to fund the project on both the market value of the company and on the market value of the debt.  We found that the market value of the debt is less than the face value regardless of whether Johnson invests in the new project.  If the company does invest in the new project, the firm will be more valuable and bondholders will receive more money.  However, because the investment is funded by equity, the value per share for the company will be less if Johnson proceeds with the investment.

There are advantages and disadvantages to both equity and debt financing.  However, there is one significant advantage to debt financing; the main advantage to debt financing is the fact that the interest payments a firm makes are tax deductible. Since they are tax deductible, the debt in Johnson’s capital structure will actually decrease Johnson’s taxable income.  This decrease in taxable income is a tax shield in a sense, and will increase the total market value of Johnson.  For this reason, Johnson should issue debt to finance the land purchase.

Currently, Johnson is an all equity firm, with 14 million shares of common stock outstanding, at...