2. STEPHENSON REAL ESTATE RECAPITALIZATION Robert Stephenson founded Stephenson

Question

2. STEPHENSON REAL ESTATE RECAPITALIZATION Robert Stephenson founded Stephenson Real Estate Company years ago and is its current CEO. 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 result, the company is entirely equity financed, with 9 million shares of common stock outstanding. The stock currently trades at $42.50 per share. Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $50 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $12 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 12.5 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 an 8 percent coupon rate. From 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) a. If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain. b. Construct Stephenson's market value balance sheet before it announces the purchase. . Suppose Stephenson decides to issue equity to finance the purchase. i. What is the net present value of the project? ii. Construct Stephenson's market value balance sheet after it announces that the firm will finance 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 to finance the purchase? li. 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 d. Suppose Stephenson decides to issue debt to finance the purchase. i. What will the market value of the Stephenson Company be if the purchase is financed with debt? ii. Construct Stephenson's market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm's stock? e. Which method of financing maximizes the per-share stock price of Stephenson's equity?

Explanation / Answer

a. As the true cost of debt is the after-tax cost, having a right balance of debt in the capital structure maximises value of firm -- as the overall weighted average cost of capital decreases when debt funds are included--thus maximising the market price of the firm's stock. Moreover,interest expenses on debt are tax deductible & hence cash is retained in the business to the extent of the lesser tax burden. So, value of an unlevered firm goes up by this tax-shield amount ,when it becomes levered(that is when debt is added to its capital structure) b. Market value balance sheet Liabilities Millions Assets Millions Equity Common stock O/s 9mln.*42.5 382.5 Assets 382.5 c. Finance fully with Equity i. NPV=-50+(12*(1-40%)/0.125) 7.6 millions ii.Upon announcement Market value balance sheet Liabilities Millions Assets Millions Equity Common stock O/s 390.1 Existing Assets 382.5 NPV as above 7.6 Total 390.1 390.1 New price per share= 390100000/9000000= 43.34 No.of shares to issue to finance the purchase= 50000000/43.34= 1153669 Shares iii. MV B/S after Equity before purchase Project NPV   =0 Share price=382500000/9000000= 42.5 So, no.of new shares = 50000000/42.5 1176471 Total no.of shares o/s will be (9000000+1176471) 10176471 $ Equity=382500000+50000000= 432500000 Balance Sheet Assets Cash 50000000 Existing assets 382500000 NPV of the project 7600000 Total 440100000 Liabilities Equity 440100000 Total 440100000 MV B/S after Equity & after purchase Project NPV = 7600000 Share price=390100000/9000000= 43.34 42.5 So, no.of new shares = 50000000/43.34 1153669 Total no.of shares o/s will be (9000000+1153669) 10153669 $ Equity=390100000+50000000= 440100000 Balance Sheet Assets Existing assets 382500000 Project PV(12000000*(1-40%)/12.5%) 57600000 Total 440100000 Liabilities Equity 440100000 Total 440100000 d. Decide to issue debt to finance the purchase i. Value of levered firm V(L)= Value of Unlevered Firm V(U)+Tax Rate*Debt V(L)=440100000+(40%*50000000) 460100000 ii. Market value Balance sheet Assets Unlevered value 440100000 Tax shield40%*50000000 20000000 Total assets 460100000 Liabilities Debt 50000000 Equity 410100000 Total Liabilities 460100000 Stock price 460100000/9000000= 51.12 e. Debt financing maximises the stock price

Related Questions

Navigate

• Browse (All)
• Browse 2
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.