tephenson 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 7 million shares of common stock outstanding. The stock currently trades at $48.40 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 $14.65 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 10.2 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 6 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 23 percent corporate tax rate (state and federal). 1. If Stephenson wishes to maximize its total market value, would you recommend that it is debt or equity to finance the land purchase? Explain. 2. Construct Stephensons market value balance sheet before it announces the purchase. a. Hint: Create a basic balance sheet that includes the essentials: assets, equity and debt denominated in market values (rather than book values). 3. Suppose Stephenson decides to issue equity to finance the project a. What is the NPV of the project? i. Hint: To calculate the present value of the incremental cash flows, use the formula for the present value of a perpetuity. b. Construct Stephensons market value balance sheet after the announcement to use equity. What would the new price per share of the firms stock be? How many shares will Stephenson need to issue? i. Assumption: Capital markets are efficient, and the stock price will equal the value of equity per share. Stock prices will reflect any value increases immediately. In this case, when the firm takes on a project, the market value of equity will increase by the full amount of the NPV after the announcement has been made Construct Stephensons market value balance sheet after the equity issue, but before purchase has been made. How many common shares does the firm have outstanding? What is the price per share of the firms stock. i. Hint: Add the newly issued equity to the balance sheet, along with the cash received (as an asset). Include the NPV of the project as an asset. d. Construct Stephensons market value balance sheet after the purchase has been made. i. Hint: The difference between c. and d. is that in the latter case the cash is spent, and we replace the NPV by the present value of the land purchase. 4. Suppose Stephenson decides to issue debt to finance the project a. What will the market value of the Stephenson Real Estate company be if it finances the purchase with debt? i. Hint: Use Modigliani-Miller Proposition I with corporate taxes. b. Construct Stephensons market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firms stock? i. Hint: Remember to include the PV(Tax shield) as an asset. 5. Which method of financing maximizes the per-share stock price of Stephensons equity