Question

Stephenson Real estate Recapitalization

Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and buildings, andrents 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 averseto debt financing. As a result, the company is entirely equity financed, with 15 million shares of common stock outstanding. The stock currently trades at $41.50per share.

Stephenson is evaluating a plan to purchase a huge tract of land in the southern United States for $70 million. The land will subsequently be leased to tenantfarmers. This purchase is expected to increase Stephenson’s annual pretax earnings by $18 million in perpetuity. Kim Weyand, the company’s new CFO, has been put incharge 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 itincluded debt in its capital structure, so she is evaluating whether the company should issue debt to entirely finance the project. Based on some conversationswith 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 acapital 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 lowerrating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporatetax 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.



Market Value Balance Sheet
Assets
Equity
Total assets
Debt &Equity


3. Suppose Stephenson decides to issue equity to finance the purchase.

a. What is the net present value (NPV) of the project? (Hint: Calculate the after-tax increase in earnings as a result of the land purchase as a perpetuity.)



b. Construct Stephenson’s market value balance sheet after it announces the purchase
will be financed with equity. (Hint: The market value of equity increases by the
market value or NPV of the land purchase.)

Market Value Balance Sheet
Old assets

NPV of project Equity
Total assets
Debt &Equity

What would be the new price per share of the firm’s stock?


How many shares will Stephenson need to issue in order to finance the issue?



c. Construct Stephenson’s market value balance sheet after the equity issue, but
before the purchase has been made.


Market Value Balance Sheet
Cash
Old assets
NPV of project Equity
Total assets Debt &Equity


How many shares of common stock does Stephenson have outstanding after the
new equity issue?


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.

Market Value Balance Sheet
Old assets
PV of project Equity
Total assets Debt &Equity



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? (Hint: VL = VU + tCB.)


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 after thedebt issue?


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


5. Which method of financing maximizes the per-share stock price of Stephenson’s equity? Explain.

Answer 1

1.Purchase using equity would be recommended.


3. NPV of project (A) $28,600,000
Equity (B) $621,000,000
New market value of Stephen Real Estate Corporation (C) $649,600,000
B. Cost of New Asset (D) $125,000,000
Total Assets (E) $774,600,000
Market Value of Equity Shares (F= C/18,000,000) $36.09
No. of new Shares required to be issued (125,000,000/36.09) 3,463,670

The Net Present Value of proposed project (Land Acquisition) will be added to Market Value of the Corporation. Resultantly, the Market Value of theCorporation will be $649,600,000. On this Market Value, Stephen Real Estate Corporation shall issue new Equity Shares i.e. at the price of $36.09.

The value of land proposed to be acquired is $125,000,000. Therefore, the assets will be increased by $125,000,000.

The Company will issue new shares @ $36.09 to finance the proposed land acquisition. Therefore, the total no. of shares to be issued shall be3,463,670.