Here is my question:

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 12 million shares of common stock outstanding. The stock currently trades at $48.50 per share.

Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $45 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $11 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 11.5 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 equity30 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 40 percent corporate tax rate (state and federal).

If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

Review Stephenson's market value balance sheet before it announces the purchase.

Suppose Stephenson decides to issue equity to finance the purchase.

o What is the net present value of the project?

o Review 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 to finance the purchase?

o Review 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?

o Review Stephenson's market value balance sheet after the purchase has been made.

Suppose Stephenson decides to issue debt to finance the purchase.

o What will the market value of the Stephenson company be if the purchase is financed with debt?

o Review Stephenson's market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm's stock?

Can you tell me if my answers are correct?

Land Purchase: Debt or Equity

In order for Stephenson to maximize the overall value of the firm the land purchase of $45 million should be purchased using debt to finance the purchase. The interest payments on the debt are tax deductible and therefore will decrease the firms taxable income. Stephensons long term success is another reason to finance with debt because borrowing can limit the businesss future obligation of repayment of the loan due to the fact that the lender does not receive an ownership share in the business. The final effect will result in a tax shield that will also increase the overall value of the firm. Finally, using debt to finance the land purchase is also cheaper in the long run than the time and consulting fees involved in selling equity in a company (Worth, 2015).

Equity Analysis of Land Purchase

Assets = 582,000,000 Equity = 582,000,000

Total Assets = 582,000,000 Total Debt & Equity = 582,000,000

Table 1-1

An analysis of the firms balance sheet prior to the purchase of the land indicates that 12,000,000 shares of common stock outstanding worth $48.50 per share results in total assets value of the firm equaling the total debt and equity of the firm, as shown in Table 1-1.

Net Present Value

In order to calculate the net present value or NPV, under the scenario of using equity to finance the land purchase, the firms after-tax earnings must be calculated first. Currently the firms pre-tax earnings are expected to increase by $11 million in perpetuity and are taxed at 40 percent. Therefore, the after-tax increase in earnings due to the purchase of land is calculated at annual earnings times one minus the tax rate, as shown in Table 1-2.

Pre-Taxed Earnings = 11,000,000 Tax Rate 0.40

Earnings 6,600,000

Table 1-2

Next, the net present value of the land purchase can be calculated by discounting the future cash flows by the firm's cost of capital, 11.5 percent. Stephenson recalls that net present value or NPV is the difference between the sum of the present values of future cash flows and the initial cost of the land purchase. After the purchase of the land, the equity value of the firm will rise by the net present value of this project.

NPV = -45,000,000 + 6,600,000/.115 + $12,391,304.35

Stephenson's New Stock Price

Assets

Old Assets 582,000,000 Debt

NPV of Project 12,391,304.35 Equity 594,391,304.35

Total Assets 594,391,304.35 Total Debt & Equity 594,391,304.35

Table 1-3

After reviewing the new market value balance sheet, as seen in Table 1-3, Stephenson determines a new stock price reflecting the change in the firm's value. The new market value of the firm's equity is $594,391,304.35 and the firm has 12,000,000 shares of common stock outstanding. The firm's new price per share will be equal to the market value of equity divided by the number of shares outstanding, as seen in Table 1-4.

New Price Per Share

Equity Finance outstanding shares 12,000,000

Equity 594,391,304.35

New Price per Share $49.53

Table 1-4

Number of Shares Needed To Finance Purchase

After analyzing the new price per share Stephenson will need to determine the number of shares needed to carry out this equity financed purchase of land. The company needs to raise $45,000,000 to purchase the land with the price per share of $49.53. The company needs to issue 908,540.28 in shares to finance the purchase of the land, as seen in Table 1-5.

Shares Needed to Finance Purchase of Land

Plan to Purchase Land 45,000,000

New Price per Share 49.53

Shares Needed 908,540.28

Table 1-5

Equity Issued Balance Sheet

After the equity is issued the firm will receive $45,000,000 in cash which will increase the company's assets and equity by $45 million as seen in the new balance sheet in Table 1-6. The stock price will remain unchanged.

Market Value Balance Sheet

Assets

Cash 45,000,000

Old Assets 582,000,000 Equity 639,391,304.35

NPV of Project 12,391,304.35

Total Assets 639,391,304.35 Total Debt & Equity 639,391,304.35

Table 1-6

This changes the number of shares outstanding. The new number of shares outstanding equals the number of old shares outstanding plus new shares issued. Table 1-7 shows the new number of shares outstanding equals 12,908,540.28.

New Shares Outstanding

Equity Finance Outstanding Old Shares 12,000,000

New Shares Issued 908,540.28

New Number of Shares Outstanding 12,908,540.28

Table 1-7

The price per share remains unchanged as recalculated in Table 1-8.

New Price Per Share

Total Stockholder's Equity 639,391,304.35

Number of new common shares outstanding 12,908,540.28

New Price Per Share $49.53

Table 1-8

After the land is financed using equity, Stephenson reviews the updated balance sheet now reflecting the $45 million land purchase, as seen in Table 1-9.

Market Value Balance Sheet

Assets Total Debt & Stockholder's Equity

Purchase of Land 45,000,000 Debt

Old Assets 582,000,000 Equity 639,391,304.35

NPV of Project 12,391,304.35 Total Debt & Equity 639,391,304.35

Table 1-9

Debt Analysis of Land Purchase

The board of directors has now requested a full analysis of the land purchase issuing debt to finance the cost of $45 million. Stephenson begins his analysis by determining the market value of the company using the formula for leveraged value. This formula states that the value of the leveraged firm equals the value of the unlevered firm plus the corporate tax rate multiplied by the debt. Therefore, the market value of the firm if it uses debt to finance the purchase is:

VL = VU + T x D

VL = 639,391,304.35 + (0.40 x 45000000)

VL = $657,391,304.35

Debt Issued New Value of Equity

Stephenson needs to review the balance sheet after both the debt issue and land purchase as well as recalculate the price per share of the firm's stock. First, the new value of equity must be reevaluated based on the knowledge of the value of debt of $45 million and the total value of the company equaling $657,391,304.35. As seen in Table 2-1 the new value of equity is $612,391,304.35.

New Value of Equity

Value of Firm 657,391,304.35

Value of Debt 45,000,000.00

Equity 612,391,304.35

Table 2-1

Debt Issued New Price Per Share

Next, the new price per share must be calculated to complete the analysis of financing the land purchase by way of issuing debt. Table 2-2 shows Stephenson's calculations and the new price per share of common stock.

Stock Price per Share

New Value of Equity 612,391,304.35

Number of Outstanding Shares 12,000,000

Price per Share $51.03

Table 2-2

New Debt Issued Balance Sheet

After determining the new value of equity and price per share the following is the new balance sheet showing the purchase of the land using debt as seen in Table 2-3.

Market Value Balance Sheet

Assets Total Debt & Stockholder's Equity

Unlevered Value 639,391,304.35 Debt 45,000,000

Tax Shield 18,000,000 Equity 612,391,304.35

Total Assets 657,391,304.35 Total Debt & Stockholder's Equity 657,391,304.35

Table 2-3

Conclusion

After analyzing both project one, issuing equity to finance, and project two, issuing debt to finance, Stephenson has prepared a final proposal for submission to the board for the purchase of land to expand the company's business. If the company uses equity to finance the purchase of the new land, the firm's stock price will remain at $49.53 per share. The analysis of project two results in the stock price rising to $51.03 per share. Therefore, the proposal to the board is to use debt financing to maximize the price per share of the firm's equity which will increase the overall value of the company.