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).

What is the net present value of the project? (10)

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? (15)

Explanation / Answer

Part a)

The net present value of the project is calculated as below:

Increase in Earnings after Tax = Annual Increase in Earnings*(1-Tax Rate) = 18,750,000*(1-40%) = $11,250.000

NPV = -Investment Cost + Increase in Earnings after Tax/Unlevered Cost of Equity = -95,000,000 + 11,250,000/10.20% = $15,294,117.65 or $15,294,118

_____

Part b)

The market value balance sheet is constructed as below:

_____

The stock price after announcement is determined as below:

Stock Price after Announcement = Total Value of Equity/Number of Shares = 355,494,118/9,000,000 = $39.50

_____

The number of shares to be issued is calculated as follows:

Number of Shares = Total Amount to be Raised/Stock Price = 95,000,000/39.50 = 2,405,103 shares

_____

Notes:

There can be a slight difference in final answer on account of rounding off values.

Market Value Balance Sheet Old Assets 340,200,000 NPV of Project 15,294,118 Equity (9,000,000*37.80 + 15,294,118) 355,494,118 Total Assets $355,494,118 Debt and Equity $355,494,118

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