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. 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

No. of Shares	Mln.			9.00
Value per share	USD			37.80
Mkt Value of Equity	USD Mn			340.20
Cost of Land	USD Mn			95.00
Additional Pre tax Earnings	USD Mn			18.75
If leveraged 100% by Debt
Debt Amount	USD Mn			95.00
Interest Cost PA	@6%			5.70
PBT	USD Mn			13.05
Tax Amount	@40%			5.22
PAT	USD Mn			7.83
WACC of capital
Debt Value- USD Mn	95	22%
Equity Value- USD Mn	340.20	78%
Cost of Debt	8%
1- tax rate	60.0%
Cost of Debt	1.05%
Cost of Equity	7.97%
WACC	9.02%
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.	the Company should use Debt for new financing as the cost of debt is lower than cost of equity
2. What is the value of firm if the firm uses equity financing?	340.20	USD Mn
3. What is the value of firm if the firm uses debt financing?	435.20	USD Mn
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?	9.02%

Thanks