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 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).

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?

Explanation / Answer

The question is really long and it has multiple sub-parts for question 3 and 4. I will try to answer as many as I can withing the time available.

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Part 1)

If the objective is to maximize the overall value of the firm, it is advisable to use use debt to finance the purchase. It is so because the company is liable to make interest payments on debt which is a tax deductible expense resulting in a lower taxable income. Thus, it helps in creating a tax-shield for the company which would ultimately result in an increase in the market value of the firm.

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Part 2)

Stephenson's balance sheet before tha announcement of purchase would comprise of only equity, since it has no debt in its capital structure as of now.

Balance Sheet:

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Part 3)

A)

NPV is the difference between the present value of cash flows and present value of cash inflows. The formula for calculating NPV is:

NPV = -Present Value of Cash Outflows + Present Value of Cash Inflows

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Here, the cash inflows occur in perpetuity, that is the amount of pre-tax savings will occur indefinately. The present value of a perepetuity can be calculated as follows:

Present Value of Cash Inflows = Pretax Savings*(1-Tax Rate)/Cost of Capital = 18750000*(1-40%)/10.2%

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Net Present Value = -95,000,000 + 18750000*(1-40%)/10.2% = $15,294,117.65

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B)

The value of the firm would by $15,294,117.65 (NPV) after the announcement. This increase will get adjusted in the current market value. The balance sheet after the announcement would, therefore, appear as follows:

Balance Sheet:

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Stock Price after Announcement = Total Revised Value of Equity/Total Common Stock Outstanding = 355,494,117.65/9,000,000 = $39.50

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Number of Shares = Amount to be Raised/Stock Price after Announcement = 95,000,000/39.50 = 2,405,063.29 shares or 2,405,063 shares

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C)

An amount of $95,000,000 million will be received by Stephenson in cash from stock issue. This will result in an increase in the asset value and total equity value.

Balance Sheet:

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Total Number of Outstanding Shares after Issue = Current Common Stock + Number of New Shares Issued (as calculated in Part 3 (B)) = 9,000,000 + 2,405,063 = 11,405,063 shares

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Stock Price after equity issue remains to be $39.50 (450,494,117.65/11,405,063)

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D)

We will report the present value of the project earnings in the balance sheet as project would result in an increase in the annual earnings of the firm. The present value of the project is = 18,750,000*(1-40%)/10.2% =

Stephenson Real Estate Balance Sheet Assets 340,200,000 Debt 0 Equity (9,000,000*37.80) 340,200,000 Total Assets $340,200,000 Total Debt and Stockholder's Equity $340,200,000

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