Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robe
ID: 2725855 • Letter: S
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
Solution:
1. If Stephenson wants to the maximize the value of the firm, it should finance the debt of $105 million purchase. Since the payment of interests are tax deductible, the debt decrease the taxable income by creating tax shield which will increase the value of the firm.
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 $675 million (= 18 million shares * $37.50 per share).
Stephenson’s market-value balance sheet before the announcement of the land purchase is:
Stephenson Real Estate
Assets
675,000,000
Debt
-
Equity
675,000,000
Total Assets
675,000,000
Total D + E =
675,000,000
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%. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by $12.9 million {($21.5 million) (1 - 0.40)}.
Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity capital (r0), which is 12.5%.
NPV (Purchase) = - $105,000,000 + {($21,500,000) (1 – 0.40) / 0.105}
= - $105,000,000 + ($12.9 million / 0.125)
= $17,857,143
Therefore, the net present value of the land purchase is $17,857,143
b) After the announcement, the value of Stephenson will increase by $17,857,143 million, 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 will be $532.9 million (= $675 million + $17,857,143 million) after the firm’s announcement.
Stephenson s market-value balance sheet after the announcement is:
Market Value Balance Sheet
Old Assets
675,000,000
NPV of project
17,857,143
Equity
692,857,143
Total Assets
692,857,143
Total D + E =
692,857,143
Since the market value of the firm’s equity is $692,857,143 and the firm has 18 million shares of common stock outstanding, Stephenson’s stock price after the announcement will be $38.49 per share (= $692,857,143 / 18 million shares).
Stephenson’s stock price after the announcement is $38.49 per share.
Since Stephenson must raise $105 million to finance the purchase and the firm’s stock is worth $38.49 per share, Stephenson must issue 2,727,981 shares (= $105 million / $38.49 per share) in order to finance the purchase.
Stephenson must issue 2,727,981 shares in order to finance the initial outlay for the purchase.
c. Stephenson will receive $105 million (=issue 2,727,981 shares * $38.49 per share) in cash as a result of the equity issue. This will increase the firm’s assets and equity by $105 million.
Stephenson’s market-value balance sheet after the equity issue is:
Market Value Balance Sheet
Old Assets
675,000,000
Cash
105,000,000
NPV of project
17,857,143
Equity
797,857,143
Total Assets
797,857,143
Total D + E =
797,857,143
Since Stephenson issued 2,727,981 shares in order to finance the purchase, the firm now has 20,727,981 (= 18,000,000 + 2,727,981) shares outstanding.
Stephenson will have 20,727,981 shares of common stock outstanding after the equity issue.
Since the market value of the firm’s equity is $797,857,143 million and the firm has 20,727,981 shares of common stock outstanding, Stephenson’s stock price after the equity issue will be $38.49 per share (= $797,857,143 / 20,727,981 million shares).
Stephenson’s stock price after the equity issue remains at $38.49 per share.
Stephenson Real Estate
Assets
675,000,000
Debt
-
Equity
675,000,000
Total Assets
675,000,000
Total D + E =
675,000,000
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