Question

Mini Case:

STEPHENSON REAL ESTATE RECAPITALIZATION

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 8 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 $85 million. The land will subsequently be leased to tenant farmers. This purchase is expected

to increase Stephenson’s annual pretax earnings by $14.125 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 an 6 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 23 percent corporate tax rate

(state and federal).

QUESTIONS

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 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?

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 to finance the purchase.

a. What will the market value of the Stephenson company be if the purchase is 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 firm’s stock?

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

Explain.

Answer 1

here the full answer of the question.

• Answer of Question

1

If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $60 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 of Question

2

Since Stephenson is an all-equity firm with 20 million shares of common stock outstanding, worth $35.50 per share, the market value of the firm is:

Market value of equity = $35.50(20,000,000)

Market value of equity = $710,000,000

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

Market value balance

sheet Assets $710,000,000 Equity $710,000,000

------------------- ----------------------

Total assets $710,000,000    Debt & Equity $710,000,000

• answer of question

3 (a)

As a result of the purchase, the firm’s pre-tax earnings will increase by $14 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 = $14,000,000(1 – .40)

Earnings increase = $8,400,000

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 = –$60,000,000 + ($8,400,000 / .125)

NPV = $7,200,000

• answer of question

3 (b)

After the announcement, the value of Stephenson will increase by $7.2 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 after the announcement will be:

Equity value = $710,000,000 + 7,200,000

Equity value = $717,200,000

Market value balance sheet

Old assets $710,000,000

NPV of project 7,200,000 Equity $717,200,000

------------------- --------------------------

Total assets $717,200,000 Debt & Equity $717,200,000

Since the market value of the firm’s equity is $717,200,000 and the firm has 20 million shares of common stock outstanding, Stephenson’s stock price after the announcement will be:

New share price = $717,200,000 / 20,000,000

New share price = $35.86 Since Stephenson must raise $60 million to finance the purchase and the firm’s stock is worth $35.86 per share, Stephenson must issue:

Shares to issue = $60,000,000 / $35.86

Shares to issue = 1,673,173

• answer of question

3 (c)

Stephenson will receive $60 million in cash as a result of the equity issue. This will increase the firm’s assets and equity by $60 million. So, the new market value balance sheet after the stock issue will be:

Market value balance sheet

Cash $ 60,000,000

Old assets $710,000,000

NPV of project $7,200,000 Equity $777,200,000

------------------------- ----------------------

Total assets $777,200,000 Debt & Equity $777,200,000

The stock price will remain unchanged. To show this, Stephenson will now have:

Total shares outstanding = 20,000,000 + 1,673,173

Total shares outstanding = 21,673,173

So, the share price is:

Share price = $777,200,000 / 21,673,173

Share price = $35.86

• answer of question

3 (d)

The project will generate $14 million of additional annual pretax earnings forever. These earnings will be taxed at a rate of 40 percent. Therefore, after taxes, the project increases the annual earnings of the firm by $8.4 million. So, the aftertax present value of the earnings increase is:

PV_Project = $8,400,000 / .125

PV_Project = $67,200,000

So, the market value balance sheet of the company will be:

Market value balance sheet

Old assets $710,000,000

PV of project 67,200,000 Equity $777,200,000

-------------------- -----------------------

Total assets $777,200,000 Debt & Equity $777,200,000

• answer of question

4 (a)

Modigliani-Miller Proposition I states that in a world with corporate taxes:

V_L = V_U + t_CB

As was shown in Question 3, Stephenson will be worth $777.2 million if it finances the purchase with equity. If it were to finance the initial outlay of the project with debt, the firm would have $60 million worth of 8 percent debt outstanding. So, the value of the company if it financed with debt is:

V_L = $777,200,000 + .40($60,000,000)

V_L = $801,200,000

• answer of question

4 (b)

After the announcement, the value of Stephenson will immediately rise by the present value of the project. Since the market value of the firm’s debt is $60 million and the value of the firm is $801.2 million, we can calculate the market value of Stephenson’s equity. Stephenson’s market-value balance sheet after the debt issue will be:

Market value balance sheet

Value unlevered $777,200,000 Debt $ 60,000,000

Tax shield 24,000,000 Equity 741,200,000

-----------------    --------------------

Total assets $801,200,000 Debt & Equity $801,200,000

Since the market value of the Stephenson’s equity is $741.2 million and the firm has 20 million shares of common stock outstanding, Stephenson’s stock price after the debt issue will be:

Stock price = $741,200,000 / 20,000,000

Stock price = $37.06

• answer of question

5

If Stephenson uses equity in order to finance the project, the firm’s stock price will remain at $35.86 per share. If the firm uses debt in order to finance the project, the firm’s stock price will rise to $37.06 per share. Therefore, debt financing maximizes the per share stock price of a firm’s equity.

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