MINICASE Stephenson Real Estate Recapitalization Stephenson Real Estate Company was founded 25 years ago be more valuable if it included debt in its capital structure, by the current CEO, Robert Stephenson. The company pur- so she is evaluating whether the company should issue debt chases real estate, including land and buildings, and rents the to entirely finance the project. Based on some conversations property to tenants. The company has shown a profit every with investment banks, she thinks that the company can issue year for the past 18 years, and the shareholders are satisfied bonds at par value with a 6 percent coupon rate. From her with the company's management. Prior to founding Stephenanalysis, she also believes that a capital structure in the range son Real Estate, Robert was the founder and CEO of a failed of 70 percent equity/30 percent debt would be optimal. If the alpaca farming operation. The resulting bankruptey made him company goes beyond 30 percent debt, its bonds would carry extremely averse to debt financing. As a result, the company a lower rating and a much higher coupon because the possi- is entirely equity financed, with 9 million shares of common bility of financial distress and the associated costs would rise stock outstanding. The stock currently trades at $37.80 per sharply. Stephenson has a 40 percent corporate tax rate (state Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $95 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $18.75 million in perpetuity. Jennifer Weyand, the company's new CFO, has been put in charge of the proj- ect. Jennifer has determined that the company's current cost of capital is 10.2 percent. She feels that the company would QUESTIONS 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 Stephenson's market value balance sheet before it announces the purchase