Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robe

Question

Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. 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 company’s management. Prior to founding Stephenson Real Estate, Robert was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a results, the company is entirely equity finance, with 18 million shares of common stock outstanding. The stock currently trades at $37.50 per share.

            Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $105 million. The land will subsequently be lease to tenant farmers. This purchase is expected to increase Stephenson’s annual pretax earnings by $21.5 million in perpetuity. Kim Weyand, the company’s new CFO, has been put in charge of the project. Kim has determined that the company’s current cost of capital is 10.5 percent. She feels that the company would be more valuable if it included debt in its capital structure, so 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 7 percent coupon rate. Based on her analysis, she also believes that a capital structure in the range of 70 percent equity/30 percent debt would be optimal. If the company goes beyond 30 percent debt, its bonds would carry a lower rating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporate tax rate (state and federal).

1. If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

2. Construct Stephenson’s market value balance sheet before it announces the purchase.

3. Suppose Stephenson decides to issue equity to finance the purchase.

a. What is the net present value of the project?

b. Construct Stephenson’s market value balance sheets after it announces that the firm will fiancé the purchase using equity. What would be the new price per share of the firm’s stock? How many shares will Stephenson need to issue in order to finance the purchase?

c. Construct Stephenson’s market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does Stephenson have outstanding? What is the price per share of the firm’s stock?

d. Construct Stephenson’s market value balance sheet after the purchase has been made.

4. Suppose Stephenson decides to issue debt in order to finance the purchase.

a. What will the market value of the Stephenson company be if the purchase if financed with debt?

b. Construct Stephenson’s market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firms stock?

5. Which method of financing maximizes the per-share stock price of Stephenson’s equity?

Explanation / Answer

Answer:1 If Stephenson wishes to maximize the overall value of the Firm, it should use debt to Finance the $105 million purchase. Since interest payments are tax deductible, debt in the Firm’s capital structure will decrease the Firm’s taxable income, creating a tax shield that will increase the overall value of the Firm.

Answer:2 Since Stephenson is an all-equity Firm with 18 million shares of common stock outstanding, worth $37.50 per share, the market value of the Firm is:

Market value of equity = $37.50(18,000,000)

Market value of equity = $675,000,000

So, the market value balance sheet before the land purchase is:

Market value balance sheet:

Answer:3 a. As a result of the purchase, the Firm’s pre-tax earnings will increase by $21.5 million per year in perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by:

Earnings increase = $21,500,000(1 – .40)

Earnings increase = $12,900,000

Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity, so the NPV of the purchase is:

NPV = –$105,000,000 + ($12,900,000 / .105)

NPV = $17857142.86

b.After the announcement, the value of Stephenson will increase by $17857142.86, the net present value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s equity will immediately rise to reflect the NPV of the project. Therefore, the market value of Stephenson’s equity after the announcement will be:

Equity value = $675000,000 + 17857142.86

Equity value = $692857142.86

Since the market value of the firm’s equity is $692857142.86 and the firm has 18 million shares of common stock outstanding, Stephenson’s stock price after the announcement will be:

New share price = $692857142.86/ 18,000,000

New share price = $38.49

Since Stephenson must raise $105 million to finance the purchase and the firm’s stock is worth $38.49per share, Stephenson must issue:

Shares to issue = $105,000,000 / $38.49

Shares to issue = 2727981.29

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