Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robe
ID: 2790139 • 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 result, the company is entirely equity financed, with 9 million shares of common stock outstanding. The stock currently trades at $37.80 per share.
Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $95 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson’s annual pretax earnings by $18.75 million in perpetuity. Jennifer Weyand, the company’s new CFO, has been put in charge of the project. Jennifer has determined that the company’s current cost of capital is 10.2 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 6 percent coupon rate. From her analysis, she also believes that a capital structure in the range of 70 percent equityy30 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).
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? (10)
Which method of financing maximizes the per-share stock price of Stephenson’s equity? (10)
Explanation / Answer
a. Computation of Stephenson’s market value balance sheet after both the debt issue and the land purchase:
Given that financing by debt, With the help of Modigliani- miller proposition 1:
Present value of levered firm = Present value of unlevered firm + tax rate* amount of debt
Present value of unlevered firm = Assets + NPV of the project + cash
= 9million shares * $37.80 + (-95,000,000) + (18,750,000*0.6/ 0.102)
= 340,200,000 -95,000,000 + 110,294,118 + 95,000,000
= 450,494,118
Therefore, Present value of levered firm = 450,494,118 + 40%* 95,000,000
= 488,494,118
Market value Balance sheet:
Value unlevered
$450,494,118
Debt
$95,000,000
Tax shield
38,000,000
Equity
393,494,118
Total assets
$488,494,118
Debt and equity
$488,494,118
Stock price = Value of equity / number of shares outstanding
= 393,494,118 / 9million shares
= $43.72
b. To decide the method of financing maximizes the per-share stock price of Stephenson’s equity, we need to compare the stock price with debt and without debt
Let us first see, if we have equity capital , then our price = $37.80
And at the Debt capital it is $43.72
We can clearly see that price under debt capital is more beneficial than equity capital.
Thus, we can choose debt capital to maximize the per-share stock price.
Value unlevered
$450,494,118
Debt
$95,000,000
Tax shield
38,000,000
Equity
393,494,118
Total assets
$488,494,118
Debt and equity
$488,494,118
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