Stephenson Real Estate Recapitalization

Stephenson Real Estate Recapitalization

BUS 650 – Managerial Finance

1. Stephenson should use debt to finance the purchase of the land if it wants to maximize its total market value. Because interest is tax deductible, the firm’s debt will decrease its taxable income, which will create a tax shield that will increase the overall value of the firm.

2. Stephenson is an all-equity firm with 15 million shares of common stock outstanding. Each share is worth $34.50. The market value of the firm is:

Market value of equity = ($34.50)(15,000,000)

Market value of equity = $517,500,000

The market value balance sheet before the land is purchased is:

Assets $517,500,000 Debt -

Equity $517,500,000

Total Assets $517,500,000 Debt & Equity $517,500,000

3.

a. After the purchase of the property, the firm’s annual pretax earnings are expected to increase by $23 million in perpetuity. The firm has a corporate tax rate of 40 percent. The purchase will increase the annual expected earnings after taxes for the firm by:

Earnings increase = ($23,000,000)(1-0.40)

Earnings increase = $13,800,000

Stephenson is an all-equity firm. Thus, the appropriate discount rate is the firm’s unlevered cost of equity. The NPV of the purchase will be:

NPV = -$95,000,000 + ($13,800,000 / 0.125)

NPV = $15,400,000

b. Once Stephenson makes the announcement of the purchase, the firm’s value will increase by $15,400,000, which is the NPV of the purchase. According to the efficient-market hypothesis, the market value of the firm’s equity will immediately increase to reflect the NPV of the purchase. The market value of the firm’s equity after the announcement will be:

Equity value = $517,500,000 + $15,400,000

Equity value = $532,900,000

Market value balance sheet:

Old Assets $517,500,000 Debt -

NPV of Project $15,400,000 Equity $532,900,000

Total Assets $532,900,000 Debt & Equity $532,900,000

The market...