Case

Assume you are an analyst working at Stephenson Real Estate, founded 20 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 15 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 6 million shares of common stock outstanding. The stock currently trades at $50 per share.

Stephenson is evaluating a plan to purchase a huge tract of land in the south-eastern United States for $90 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephensons annual pre-tax earnings by $15 million in perpetuity. Jennifer Weyand, the companys new CFO, has been put in charge of the project. Jennifer has determined that the companys current cost of capital is 10 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 5 percent coupon rate. From her analysis, she also believes that a capital structure in the range of 60 percent equity/40 percent debt would be optimal. If the company goes beyond 40 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 25 percent corporate tax rate (state and federal).

Read the case above, answer the following questions using knowledge of FINAN200 and produce a report for your line manager.

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. (5 marks)

2. Construct Stephensons market value balance sheet before it announces the purchase. (10 marks)

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

1) What is the net present value of the project? (10 marks)

2) 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? (15 marks)

3) 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? (15 marks)

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

(15 marks)

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

What will the market value of the Stephenson Real Estate Company be if the

purchase is financed with debt? (10 marks)

Construct Stephensons market value balance sheet after both the debt issue and theland purchase. What is the price per share of the firms stock? (15 marks)

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