Question

Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. 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 Stephen-son 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. Assuming this annual pretax earnings of $18.75 million is perpetuity, Jennifer estimates that the value of the firm will be increased by $110,294,118 (the present value of the perpetuity at the cost of capital of 10.2 percent).

Jennifer 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 borrow at a 6 percent interest rate with the cost of debt being 8%. Stephenson has a 40 percent corporate tax rate.

QUESTIONS

1. If Stephenson wishes to maximize its exiting stock price, would you recommend that it issue debt or equity to finance the land purchase? Explain.
2. What is the value of firm if the firm uses equity financing?
3. What is the value of firm if the firm uses debt financing?
4. What is the WACC if Stephenson finances the purchase with only equity?
5. What is the WACC if Stephenson finances the purchase with only debt?

Answer 1

1. Value of the firm if firm uses equity financing only:

Operating income (EBIT)	18750000
Interest	0
Equity Earning	18750000
Cost of Equity	0.102
Market Value of Equity(A)	183823529
Cost of Debt	0
Market value of debt(B)	0
Market value of firm (A)+(B)	183823529
Average cost of capital	0.102

2. Value of firm if the firm uses debt financing:

Operating Income (EBIT)	18750000
Interest	5700000
Equity Earning	13050000
Cost of Equity	0.102
Market Value of Equity(A)	127941176
Cost of Debt	0.08
Market value of debt(B)	71250000
Market value of firm (A)+(B)	199191176
Average cost of capital	0.0941

3. WACC if Stephenson finances the purchase with only equity

= 100%*(0.102)+0%(0.08)(1-0.40)

=0.102 = 10.20%

4. WACC if Stephenson finances the purchase with only Debt

= 0%*(0.102)+100%(0.08)(1-0.40) = 0+0.048

=0.048 = 4.80%