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Stephenson Real Estate Recapitalization

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

To maximise its total market value, it should use debt to finance the $110 million purchase.

As interest payments are tax deductable, Taxable income will decrease with debt in the

capital structure, creating a tax shield to increase the overall value of the firm.

2. Construct Stephenson’s market value balance sheet before it announces the purchase.

Market value of equity = $35.20(15,000,000) = $528,000,000

Market value balance sheet

Assets $528,000,000  Equity  $528,000,000

Total assets $528,000,000  Debt & Equity  $528,000,000

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 in

order 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?
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d. Construct Stephenson’s market value balance sheet after the purchase has been

made.

a. Earnings increase = $27,000,000(1 – .40) = $16,200,000

As Stevenson is an all-equity based firm, At firm’s unlevered cost of equity, the NPV of

the purchase is = –$110,000,000 + ($16,200,000 / .125) = $19,600,000

b. After Stephenson announces that the firm will finance the purchase using equity, the value

of Stephenson will increase by $20 million, the NPV of purchase.

According to efficient market hypothesis, the market value of Stephenson’s equity will

rise to reflect the NPV of the project.Hence, the market value of Stephenson’s equity

after the announcement will be:

Equity value = $528,000,000 + 19,600,000

Equity value = $507,500,000

Market value balance sheet

Old assets $528,000,000  
  NPV of project 19,600,000   Equity $507,500,000

  Total assets $547,600,000   Debt & Equity $547,600,000

Now,

Market value of the firm’s equity is $547,600,000

Shares of common stock outstanding=15 million

New share price = $547,600,000 / 15,000,000

New share price = $36.51

Since, Stephenson has to raise $110 million to finance the purchase, it should issue:

Shares to issue = $110,000,000 / $36. = 3,013,148

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c. Stephenson will receive $110 million in cash as a result of the equity issue. This will

increase the firm’s assets and equity by $110 million. So, the new market value

balance sheet after the stock issue will be:

Market value balance sheet

Cash $110,000,000  
  Old assets 528,000,000  
  NPV of project 19,600,000   Equity $657,600,000

  Total assets $657,600,000   Debt & Equity $657,600,000

Total shares outstanding = 15,000,000 + 3,031,148

Total shares outstanding = 18,013,148

So, the share price is:

Share price = $657,600 / 18,013,148

Share price = $36.51

d. After taxes, the project increases the annual earnings of the firm by $16.2 million.

PVProject = $16,200,000 / .125= $129,600,000

Market value balance sheet

Old assets $528,000,000  
  PV of project 129,600,000   Equity $648,000,000
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Debt &
  Total assets $657,600,000   Equity $657,600,000

4. a. Modigliani-Miller Proposition with respect to corporate taxes:

VL = VU + tCB

The value of the company if it financed with debt is:

VL = $657,600,000 + .40($110,000,000)

VL = $701,600,000

b.

Market value balance sheet

Value unlevered $657,600,000   Debt $110,000,000

  Tax shield 44,000,000   Equity 591,600,000

  Total assets $701,600,000   Debt & Equity $701,600,000

Stock price = $591,600,000 / 15,000,000

Stock price = $39.44

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

equity?

If Stephenson uses equity to finance the project,

Stock price= $36.51

If Stephenson uses debt to finance the project,

Stock price = $39.44

Hence, debt financing is instrumental in increasing the stock price of Stephenson’s

equity.