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 makes 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 vast 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 millions 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 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 ).  If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain. Construct Stephenson's market value balance sheet before it announces the purchases?

Answer 1

a.)	Capital Structure	Debt & Equity (70:30)	Complete Equity
	Pretax Earning	1,10,00,000	1,10,00,000
	Less: Intt. On Bond	2,52,000	-
	Profit before tax	1,07,48,000	1,10,00,000
	Less: Tax@40%	42,99,200	44,00,000
	Profit after Tax	64,48,800	66,00,000
	Cost of capital	9.31%	11.50%
	Present Value of annuity inflow	6,35,34,975	5,73,91,304
	(profit after tax/ cost of capital)
	PV of outflow	4,50,00,000	4,50,00,000
	Net Present Value	2,42,67,454	1,23,91,304
	It is advisble to finance in form of Equity & Debt in ratio of 70:30 based on NPV.
	If the objective is to maximize the overall value of the firm, it is advisable to use use debt to finance the purchase. It is so because the company is liable to make interest payments on debt which is a tax deductible expense resulting in a lower taxable income. Thus, it helps in creating a tax-shield for the company which would ultimately result in an increase in the market value of the firm.
b.)	Market Value Balance sheet before purchase:-
	Stephenson's balance sheet before the announcement of purchase would comprise of only equity, since it has no debt in its capital structure as of now.
	Balance Sheet:
	Stephenson Real Estate Balance Sheet
	Assets	58,20,00,000	Debt	-
			Equity (12,000,000*48.50)	58,20,00,000
	Total Assets	58,20,00,000	Total Debt and Stockholder's Equity	58,20,00,000