Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robe
ID: 2799093 • 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).
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) Use the table below and construct Stephenson’s market value balance sheet before it announces the purchase.
Market value balance sheet
Assets $ Equity $ Total assets $ Debt and equity $
3) Suppose Stephenson decides to issue debt to finance the purchase.
What will the market value of the Stephenson company be if the purchase is financed
with debt?
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?
Value unlevered Tax shield
Total assets
Market Value Balance Sheet
$ Debt
$ Equity
$ Debt and equity
$ $ $
Explanation / Answer
(1) Common Stock Outstanding = 9 million and Current Stock Price = $37.8. Cost of Capital =10.2 %
Cost of Land = $95 million (Amount of financing required)
If $95 million is equity financed then number of shares to be issued = amount of required financing / current stock price = 95 /37.8 = 2.51 million
Increment in annual pre tax earnings = $18.75 million to perpetuity
Annual Incremental Post Tax Earnings = 18.75 x (1-0.4) = $11.25 million (Tax Rate =40%)
Therefore, additional value generated by land purchase = Incremental after tax earnings / Cost of Capital
= ( 11.25/.102) = $110.29 million
Therefore, Total Value of the firm = Initial Market Capitalization ( and not firm value as firm is entirely equity financed) + Incremental Value created by land purchase = Common stock outstanding x Current Stock Price + Incremental value created by land purchase = 9 x 37.8 + 110.29 = 340.2 + 110.29 =$ 450.49 million
In case of Debt Financing, Amount of Debt Required = $95 million
Company Equity Value = Current Stock Price x Common Stock Outstanding = 37.8 x 9 = $ 340.2 million
Book (and not implied/ fair market value) of the firm = Debt Raised + Company Equity Value = 340.2 + 95 =$ 435.2 million
Therefore, Debt to Value Ratio = Debt Raised / Book Value of Company = 95 / 435.2 = 0.218 and Equity to Value Ratio = 1- 0.218 = 0.782.
Cost of Debt = Bond Coupon Rate = 6% and Cost of Equity = Cost of Capital of all Equity Financed Firm =12%
Therefore, Weighted Average Cost of Capital = WACC = After Tax Cost of Debt x Debt to Value Ratio + Cost of Equity x Equity to Value Ratio = (1-0.4) x 6 x 0.218 + 10.2 x 0.782 = 8.76 %
Opportunity Cost of Capital = Pre tax Cost of Debt x Debt to Value Ratio + Cost of Equity x Equity to Value Ratio
= 6 x 0.218 + 10.2 x 0.782 = 9.28 %
Incremental Pre Tax Earnings = $ 18.75 million
Incremental Annual Earnings post interest expense = 18.75 - (95 x 0.06) = $ 13.05
Incremental Earnings post Taxes = 13.05 x (1-tax rate) = 13.05 x 0.6 = $7.83 million
Value created by post tax earnings (without incorporating tax shields) = Incremental Earnings post tax / Opportunity Cost of Capital = 7.83 / 0.0928 = $84.375 million
Annual Tax Shields = Debt X Coupon Rate X Tax Rate = 95 x 0.06 x 0.4 = $ 2.28 million
Unlevered Value of Tax Shield = Tax Shields / Cost of Debt = 2.28 / 0.06 = $ 38 million (as debt is constant at $95 million, the cost of debt is used as discounting rate)
Therefore, total incremental value created, Unlevered value of tax shields + Value created by incremental post tax earnings = 84.375 + 38 =$ 122.375 million
Therefore, Total Market Value of Firm = Market Capitalization (before raising debt) + Total Incremental Value Created = 340.2 + 122.375 = $462.575 million
As debt financing creates more value for Stephenson's it makes more sense to go for debt instead of equity financing.
(2) Market Value balance sheet pre purchase
Asset = Equity = Current Stock Price x Common Stock Outstanding = 37.8 x 9 = $ 340.2 million
Debt = 0 $
Total Assets = Total Debt and Equity = $340.2 million
(3) Market Value of Balance sheet post purchase:
Debt = $ 95 million and Equity = Firm Value - Debt = 462.575 - 95 = $ 367.575 million
Total Assets = Market Value of Firm = $ 462.575 million
Value of Unlevered Tax Shield = $ 122.375 million
Market Value of Equity = $367.575 million and Common Stock Outstanding = 9 million
Therefore, Stock Price post debt issue and purchase = Market Value of Equity / Common Stock Outstanding = 367.575 / 9 = $40.84 per share
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