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 16 million shares of common stock outstanding. The stock currently trades at $41.50 per share.

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 Stephensons annual pretax earnings by $20.2 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 10.5 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 7 percent coupon rate. Based on 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 40 percent corporate tax rate (state and federal).

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. As part of your answer, be sure to discuss the advantages and disadvantages of using debt as part of your capital structure.

2. Why would the market value of the firm be higher using a mix of 70% equity and 30% debt, as opposed to 100% equity?
3. Assuming that things went well using 30% debt, is there any reason for them not to continue the process of increasing the debt level to a much higher percentage? What would you predict would happen (in detail) at high levels of debt?