"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 15 million shares of common stock outstanding. The stock currently trades at $34.50 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 ex- pected to increase Stephenson’s annual pretax earnings by $23 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 in- cluded 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. Based on 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)."

To determine whether Stephenson Real Estate Company should issue debt to finance the purchase of the land, we can calculate the weighted average cost of capital (WACC) for the company under two scenarios: an all-equity financing and a 70% equity/30% debt financing.

1. All-Equity Financing:
- The current cost of capital for Stephenson Real Estate is given as 12.5%.
- Since the company is entirely equity financed with 15 million shares of common stock outstanding, we can calculate the equity value as follows:
Equity Value = Number of Shares * Stock Price
Equity Value = 15 million * $34.50 = $517.5 million
- The WACC for an all-equity financing is equal to the cost of equity, which is the current cost of capital:
WACC (all-equity) = 12.5%

2. 70% Equity/30% Debt Financing:
- If the company decides to issue debt to finance the project, it will have a capital structure of 70% equity and 30% debt.
- Based on the conversation with investment banks, Stephenson can issue bonds at par value with an 8% coupon rate.
- Using the cost of debt formula, we can calculate the cost of debt:
Cost of Debt = Coupon Rate * (1 - Tax Rate)
Cost of Debt = 8% * (1 - 0.4) = 4.8%
- To calculate the equity value, we need to adjust the market value of equity for the additional funds raised from issuing debt. The additional funds raised can be calculated as follows:
Debt Proceeds = Cost of Land - Equity Portion
Debt Proceeds = $95 million - (0.30 * $95 million) = $95 million - $28.5 million = $66.5 million
Equity Value = Number of Shares * Stock Price + Debt Proceeds
Equity Value = 15 million * $34.50 + $66.5 million = $517.5 million + $66.5 million = $584 million
- The WACC for the 70% equity/30% debt financing can be calculated using the weighted average of the cost of equity and cost of debt:
WACC (70/30) = (Equity Proportion * Cost of Equity) + (Debt Proportion * Cost of Debt)
WACC (70/30) = (0.70 * 12.5%) + (0.30 * 4.8%)

By comparing the WACC for the all-equity financing and the 70% equity/30% debt financing, we can determine which capital structure is more optimal. If the WACC for the 70% equity/30% debt financing is lower, it indicates that this capital structure creates more value for the company.