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 properties 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 pre-tax earnings (EBIT) 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 10.20%. 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 (face value) with a 6 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 of the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporate tax rate.

What after-tax cash flow must Stephenson be currently producing per year, assuming that its current cash flows remain constant each year?

Construct Stephenson’s market value balance sheet before it announces the purchase.

Market value balance sheet
				Debt
	Existing Assets			Equity
	Total assets			Total Debt + Equity

3)Suppose Stephenson decided to issue equity to finance the purchase.

What is the net present value of the land acquisition project?

Construct Stephenson’s market value balance sheet after it announces that the firm will finance the purchase using equity. (Assume that the value of the firm will immediately change to reflect the NPV of the new project.)

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

      

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			Debt
	NPV of project			Equity
	Total assets			Total Debt + Equity

e)What is Stephenson’s weighted average cost of capital after the acquisition? What after-tax cash flow will be produced annually after the acquisition? What is the present value of this stream of after-tax cash flow? What is the stock price after the acquisition? Does this agree with your previous calculations?

Suppose Stephenson decides to issue debt to finance the purchase.

What will be 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?

      

Market Value Balance Sheet
	Value unlevered			Debt
	Tax shield			Equity
	Total assets			Total Debt + Equity

              

c)What is Stephenson’s cost of equity if it goes forward with the debt issue? (Do not round your answer.)

d)What is Stephenson’s weighted average cost of capital if it goes forward with the debt issue? (Do not round your answer.)

e)What total after-tax cash flow is being generated by Stephenson after the acquisition?

f)What is the present value of this after-tax cash flow? What is the market value of equity? What is the stock price? Does this agree with your work from parts (a) and (b)?

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

Does the resultant capital structure (with the land acquisition financed by debt) satisfy Jennifer’s concerns about the negative effects of moving beyond the optimal capital structure?

Answer 1

he company purchases real estate, including land and buildings, and rents the properties 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 pre-tax earnings (EBIT) 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 10.20%. 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 (face value) with a 6 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 of the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporate tax rate.