Chapter Case:

Stephenson Real Estate Recapitalization

Reference:

Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2023). Essentials of Corporate Finance (11th ed.). McGraw Hill LLC. P. 462

ISBN13: 9781264101573 (bound edition); ISBN 9781265412548 (ebook)

Problem scenario:

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 8.7 million shares of common stock outstanding. The stock currently trades at $46.50 per share. Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $65 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephensons annual pretax earnings by $14 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 12.5 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 8 percent. From 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).

Input area:

Shares outstanding	8,700,000
Share price	$ 46.50
Purchase price of land	$ 65,000,000
Perpetual earnings increase	$ 14,000,000
Current cost of capital	12.50%
Cost of new debt	8%
Optimal equity weight	70%
Optimal debt weight	30%
Tax rate	21%

Output area:

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)		Assets	?		Equity	?
		Total assets	?		Debt & Equity	?
3)	a)	Perpetual aftertax earnings	?
		NPV of purchase	?
	b)	Balance Sheet
		Old assets	?
		NPV of project	?		Equity	?
		Total assets	?		Debt & Equity	?
		New share price	?
		Shares to issue	?
	c)	Balance Sheet
		Cash	?
		Old assets	?
		NPV of project	?		Equity	?
		Total assets	?		Debt & Equity	?
		Total shares outstanding	?
		Share price	?
	d)	PV of earnings increase	?
		Balance Sheet
		Old assets	?
		PV of project	?		Equity	?
		Total assets	?		Debt & Equity	?
4)	a)	Value of levered company	?		Note*: TC = Tax rate
	b)	Balance Sheet
		Value unlevered	?		Debt	?
		Tax shield value	?		Equity	?
		Total assets	?		Debt & Equity	?
		Stock share price	?
5)		Which method of financing maximizes the per share stock price of Stephenson's equity?

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 8.7 million shares of common stock outstanding. The stock currently trades at $46.50 per share. Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $65 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $14 million in perpetuity. Kim Weyand, the company's new CFO, has been put in charge of the project. Kim has determined that the company's current cost of capital is 12.5 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 8 percent. From 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). Ross, S. A. Westerfield, R. W. \& Jordan, B. D. (2023). Essentials of Corporate Finance [11th ed.). McGraw Hil ISBN13: 9781264101573 (bound edition): ISBN 9781265412548 (ebook) 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 8.7 million shares of common stock outstanding. The stock currently trades at $46.50 per share. Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $65 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $14 million in perpetuity. Kim Weyand, the company's new CFO, has been put in charge of the project. Kim has determined that the company's current cost of capital is 12.5 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 8 percent. From 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). Ross, S. A. Westerfield, R. W. \& Jordan, B. D. (2023). Essentials of Corporate Finance [11th ed.). McGraw Hil ISBN13: 9781264101573 (bound edition): ISBN 9781265412548 (ebook)