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 12 million shares of common stock outstanding. The stock currently trades at $ 31.40 per share. Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $ 80 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson’s annual pretax earnings by $ 16 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 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).
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. 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? 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? d. Construct Stephenson’s market value balance sheet after the purchase has been made. 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? 5. Which method of financing maximizes the per- share stock price of Stephenson’s equity?
No
1. To maximize total market value, it is recommended that Stephenson Real Estate Company issues debt to finance the land purchase. This is because the company's CEO, Robert Stephenson, has an aversion to debt financing due to a previous bankruptcy in a different venture. By issuing debt, the company can take advantage of the tax shield provided by interest payments, which can increase the firm's value.
2. Market Value Balance Sheet before the purchase announcement:
Assets:
- Land and buildings: ?
- Cash: ?
- Total assets: ?
Liabilities and Equity:
- Shareholders' equity: ?
- Total liabilities and equity: ?
3. If Stephenson decides to issue equity to finance the purchase:
a. The net present value (NPV) of the project would be the present value of the expected earnings increase of $16 million per year in perpetuity. Given the 10.2% cost of capital, the NPV can be calculated using the formula: NPV = (Earnings Increase / Cost of Capital).
b. Market Value Balance Sheet after equity financing announcement:
Assets:
- Land and buildings: $80 million
- Cash: 0 (assuming all funds will be raised through the equity issue)
- Total assets: $80 million
Liabilities and Equity:
- Shareholders' equity: ?
- Total liabilities and equity: ?
The new price per share of the firm's stock cannot be determined without knowing the number of shares Stephenson will issue to finance the purchase.
c. Market Value Balance Sheet after equity issue (before the purchase):
Assets:
- Land and buildings: $80 million
- Cash: 0 (assuming all funds will be raised through the equity issue)
- Total assets: $80 million
Liabilities and Equity:
- Shareholders' equity: ?
- Total liabilities and equity: ?
The number of shares of common stock outstanding and the price per share of the firm's stock cannot be determined without additional information.
d. Market Value Balance Sheet after the purchase:
Assets:
- Land and buildings: $80 million
- Cash: 0 (assuming all funds were used for the land purchase)
- Total assets: $80 million
Liabilities and Equity:
- Shareholders' equity: ?
- Total liabilities and equity: ?
4. If Stephenson decides to issue debt to finance the purchase:
a. The market value of the Stephenson company would depend on the impact of the debt issue on the company's overall cost of capital. Without additional information, it is difficult to determine the precise market value.
b. Market Value Balance Sheet after debt issue and land purchase:
Assets:
- Land and buildings: $80 million
- Cash: ?
- Total assets: ?
Liabilities and Equity:
- Debt: ?
- Shareholders' equity: ?
- Total liabilities and equity: ?
The price per share of the firm's stock cannot be determined without additional information.
5. To determine the method of financing that maximizes the per-share stock price of Stephenson's equity, a comparison would need to be made between the market value per share after equity financing (from 3b) and after debt financing (from 4b). The method of financing that results in a higher market value per share would be the one that maximizes the per-share stock price.
1. To determine whether Stephenson should issue debt or equity to finance the land purchase, we need to compare the effect of each financing option on the total market value of the company.
If Stephenson issues debt, it will have a lower cost of capital due to the tax shield provided by the interest expense on the debt. This means that the project's net present value (NPV) will be higher if debt is used to finance it. However, going beyond a 30 percent debt level will result in higher borrowing costs due to the increased risk of financial distress.
On the other hand, issuing equity will not have the tax shield benefit and will result in a higher cost of capital. This means that the project's NPV will be lower if equity is used to finance it.
Therefore, to maximize total market value, it is recommended that Stephenson issue debt to finance the land purchase.
2. Before the land purchase, Stephenson's market value balance sheet would include the following:
Assets:
- Land and buildings (current) = ?
- Cash (current) = ?
- Common stock = 12 million shares
- Stock price = $31.40 per share
Liabilities:
- Debt = $0
Equity:
- Retained earnings = ?
To determine the market value of the assets and retained earnings, more information is needed.
3. If Stephenson decides to issue equity to finance the purchase:
a. The net present value of the project is given as $16 million per year in perpetuity. To calculate the NPV, we need to discount the future cash flows at the company's cost of capital. Assuming the cost of capital is 10.2 percent, we can use the formula:
NPV = (Annual cash flow) / (Cost of capital)
NPV = $16 million / 0.102 = $156.86 million
b. After announcing the equity financing, the market value balance sheet would be as follows:
Assets:
- Land and buildings (current) = $80 million
- Cash (current) = ?
- Common stock = 12 million + (Amount raised from equity issuance / Stock price)
- Stock price = $31.40 per share
Liabilities:
- Debt = $0
Equity:
- Retained earnings = ?
To determine the new price per share and the number of shares Stephenson needs to issue, we need the amount raised from the equity issuance. This amount can be calculated as:
Amount raised from equity issuance = $80 million - NPV = $80 million - $156.86 million = -$76.86 million (negative as it represents the cash outflow from the company)
Using this information, we can calculate the new price per share and the number of shares to be issued.
c. Before the purchase, but after the equity issue, the market value balance sheet would be as follows:
Assets:
- Land and buildings (current) = $80 million
- Cash (current) = Amount raised from equity issuance
- Common stock = 12 million + (Amount raised from equity issuance / Stock price)
- Stock price = $31.40 per share
Liabilities:
- Debt = $0
Equity:
- Retained earnings = ?
To determine the number of shares outstanding and the price per share, we need to know the amount raised from equity issuance.
d. After the purchase has been made, the market value balance sheet would be updated with the land and buildings value, and the number of shares outstanding would remain the same as in part c.
4. If Stephenson decides to issue debt to finance the purchase:
a. To determine the market value of the company with debt financing, we need to calculate the present value of the interest tax shield provided by the debt. This can be done using the formula:
Interest tax shield value = (Debt amount) x (Tax rate)
Interest tax shield value = (Debt amount) x (Tax rate) x (Cost of debt)
The market value of the company with debt financing can be calculated as:
Market value = Market value without debt + Interest tax shield value
b. After both the debt issue and the land purchase, the market value balance sheet would include the land and buildings value, the debt amount, and the new market value of the company. By using this information, we can calculate the price per share of the firm's stock.
5. To determine which financing method maximizes the per-share stock price, we need to compare the stock price after equity financing (part c) and the stock price after debt financing (part b). The method that results in a higher stock price would maximize the per-share stock price.