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 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. 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 equityy30 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).
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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.
What is the net present value of the project?
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?
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?
Construct Stephenson’s market value balance sheet after the
purchase has been made.
4. Suppose Stephenson decides to issue debt to finance the
purchase.
What will the market value of the Stephenson company be if the
purchase is financed with debt?
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?