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

Since, there are multiple parts to the question with part c having multiple sub-parts, I have answered the first three parts (a to c).

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Part a)

Stephenson should use debt to finance its $50 million requirement. It is because use of debt will result in tax deductible interest expense which in turn will cause a reduction in the taxable income for the company (resulting in lower taxes). In other words, inclusion of debt will provide tax shield which will result in lesser tax related cash outflow, thereby, increasing the market value of the firm.

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Part b)

The market value balance sheet is prepared as below:

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Part c)

1)

The net present value is calculated as below:

Net Present Value = Cash Outflow + Cash Inflow/Discount Rate

Here, Cash Outflow = -$50,000,000, Cash Inflow = Increase in Earnings*(1-Tax Rate) = 12,000,000*(1-40%) = $7,200,000 and Discount Rate = 12.5%

Using these values in the above formula for NPV, we get,

NPV = -50,000,000 + 7,200,000/12.5% = $7,600,000

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2)

The market value balance sheet is prepared as follows:

The new share price is calculated as below:

New Share Price = Total Value of Equity/Number of Shares = 390,100,000/9,000,000 = $43.34

The number of shares to be issued to finance the purchase is determined as follows:

Number of Shares = Total Fund Requirement/New Share Price = 50,000,000/43.34 = 1,153,668.66 or 1,153,669 shares (there can be a slight difference in final answer on account of rounding off values)

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3)

The market value balance sheet is provided as below:

The total number of revised shares outstanding is calculated as below:

Revised Shares Outstanding = 9,000,000 + 1,153,669 = 10,153,669 shares

The share price will remain same as determined below:

Share Price = Total Value of Equity/Revised Number of Shares = 440,100,000/10,153,669 = $43.34

Market Value Balance Sheet Assets 382,500,000 Equity (9,000,000*42.50) 382,500,000 Total Assets $382,500,000 Debt and Equity $382,500,000

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