Case Study: Stephenson Real Estate Recapitalization

Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robertson 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 corporation. 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 $42.50 per share.

Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $50 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephensons annual pretax earnings by $12 million in perpetuity. Kim Weyand, the companys new CEO, has been put in charge of the project. Kim has determined that the companys current cost of capital is 12.5%. She feels that the company would be more valuable if it included debt in his 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 8%. From her analysis, she also believes that a capital structure in the range of 70% equity / 30% debt would be optimal. If the company goes beyond 30% 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% corporate tax rate (state and federal).

Questions:

4. Which method of financing maximizes the total market value and the per-share stock price of Stephensons equity?