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). Please answer the questions below with separate papers.

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. Market value balance sheet Assets    Equity      Total assets    Debt and equity  

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? Market value balance sheet Old assets       NPV of project   Equity      Total assets Debt and equity  

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? Market Value Balance Sheet Cash       Old assets          NPV of project   Equity      Total assets Debt and equity   d. Construct Stephenson’s market value balance sheet after the purchase has been made. Market Value Balance Sheet Old assets       PV of project      Equity      Total assets    Debt and equity  

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? Market Value Balance Sheet Value unlevered    Debt    Tax shield      Equity      Total assets    Debt and equity  

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

Answer 1

Question 1

The companies current cost of capital is 10.2%. The cost of debt if borrowed would be 6% X(1-40%) = 3.6%.

The weighted cost of capital(WACC) for the Company assuming it shifts to the 70% Equity 30% Debt capital structure would result in (10.2% X 70%) + (3.6% X 30%) = 8.22%.

The WACC is essentially the cost of funds for the Company. As the WACC reduces, the value of its returns and in turn the value of the Company itself increase. Hence it is advisable to issue debt in order to maximize the value fo the Company.

Question 2

The Market Value Balance sheet before the purchase would look like this:

Assets	340.2
Total Assets	340.2
Equity ( 9M X37.8)	340.2
Total Equity	340.2

Question 3

a. If the project is funded by Equity, the NPV of the project will be:

PV of Pertpetuity of 18.75 - Cost of Investment

18.75/10.2% - 95M = $88.82M

b. Once the firm announces the purchase to be financed using equity, the market price per equity share would adjust itself.The value of the project would be added to the value of firm eventually resulting in a total value of $429.024

Assuming that the Company finances the purchase by issuing equity at the pre-purchase price of 37.80, it would have to issue $95M/37.80 Shares = 2.51M shares.

The new Stock price would be 429.024M/(9M+2.51M) = $37.26 per share.

The market value balance sheet after the announcement but prior to the purchase, would look as follows:

Assets	335.340
Total Assets	335.340
Equity ( 9M X37.26)	335.340
Total Equity	335.340

c. The market value balance sheet post the issue but prior to the purchase would look as follows:

Assets	428.863
Total Assets	428.863
Equity ( 11.51M X37.26)	428.863
Total Equity	428.863

Essentially we would add the 2.51 newly issued share to the value of Equity and assets.

Question 4

If the purchase is financed with debt, the Company would have $95M in debt and (9M X 37.8) = 340.2 in equity

The debt % would be 95/(95+340.2) = 21.83%

The equity % would be 78.17%

Hence the WACC will be (21.83%*6%) + (78.17% * 10.2%) = 9.28%.

Hence the NPV of the project would be $18.75M/9.28 - 95 = $106.98

The market value balance sheet after the purchase would include the project value of 106.98 as well

Assets(340.2 + 106.97)	447.18
Total Assets	447.18
Equity	352.18
Debt	95.00
Total Equity and Debt	447.18

The value per equity share would be 352.18M/9M = $39.13

Question 5

From the above calculations it is clear that issuing debt would result in a per share value of $39.13 as compared to $37.26 per share in equity financing. Hence it is advisiable to issue debt to finance the project.