Calculations and explanations require

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 companys 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 12 million shares of common stock outstanding. The stock currently

trades at $53.80 per share.

Stephenson is evaluating a plan to purchase a tract of land in the southeastern United

States for $49 million. The land will subsequently be leased to tenant farmers. This purchase

is expected to increase Stephensons annual pretax earnings by $11.5 million in perpetuity.

Kim Weyand, the companys new CFO, has been put in charge of the project. Kim has determined

that the companys current cost of capital is 10.5 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 coupon

rate of 7 percent. Based on her analysis, she also believes that a capital 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 lower rating and a much higher coupon because the possibility

of financial distress and the associated costs would rise sharply. Stephenson has a 21 percent

corporate tax 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 Stephensons market value balance sheet before it announces the purchase.

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

a. What is the net present value of the project?

b. Construct Stephensons 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

firms stock? How many shares will Stephenson need to issue to finance the

purchase?

c. Construct Stephensons 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 firms stock?

d. Construct Stephensons market value balance sheet after the purchase has been made.

4. Suppose Stephenson decides to issue debt to finance the purchase.

a. What will the market value of Stephenson be if the purchase is financed with debt?

b. Construct Stephensons market value balance sheet after both the debt issue and the

land purchase. What is the price per share of the firms stock?

5. Which method of financing maximizes the per-share stock price of Stephensons equity?