Mini Case: Stephenson Real Estate Recaptalization

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MINI CASE: STEPHENSON REAL ESTATE RECAPTALIZATION Information * The company is entirely equity financed. * Common stock outstanding : 20 million shares currently trades at $35.50 per share * Plan to purchase a land for $60 million. * Annual pretax earnings : $ 14 million in perpetuity * Cost of capital : 12.5 percent * Bond at par value : 8 percent coupon rate * Capital structure in the range of 70 percent equity/ 30 percent debt * Corporate tax rate : 40 percent | 1. If Stephenson wishes to maximize its total market value, would you recommend that it issues debt or equity to finance the land purchase? Explain. If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $60 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm. 2. Construct Stephenson’s market value balance sheet before it announce the purchase. The market value of the firm is: Market value equity = ($35.50)(20 000 000) = $710 000 000 Market value balance sheet | Asset | $710 000 000 | Equity | $710 000 000 | Total Asset | $710 000 000 | Debt and Equity | $710 000 000 | 3. Suppose Stephenson decide to issue equity to finance purchase a. What is the net present value of the project? When the purchase happen, the firm’s pre-tax earnings will increase by $14 million per year in perpetuity. These earnings are taxed at a rate of 40 percent. So, after the tax, the purchase will increase the annual expected earnings of the firm by-: Earnings increase = $14 000 000 (1-0.40) = $14 000 000 (0.60) = $8 400 000 NPV = -$60 000 000 + ($8 400 000/0.125) = $7 200 000 b. Construct

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