Mini Case

CHAPTER 16

STEPHENSON REAL ESTATE RECAPITALIZATION

1. If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $45 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. Since Stephenson is an all-equity firm with 12 million shares of common stock outstanding, worth $48.50 per share, the market value of the firm is:

Market value of equity = $48.50(12,000,000)

Market value of equity = $582,000,000

So, the market value balance sheet before the land purchase is:

Market value balance sheet |

| Assets | $582,000,000 |   | Equity | $582,000,000 |

  | Total assets | $582,000,000 |   | Debt & Equity | $582,000,000 |

3. a. As a result of the purchase, the firm’s pre-tax earnings will increase by $11 million per year in perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by:

Earnings increase = $11,000,000(1 – .40)

Earnings increase = $6,600,000

Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity, so the NPV of the purchase is:

NPV = –$45,000,000 + ($6,600,000 / .115)

NPV = $12,391,304

b. After the announcement, the value of Stephenson will increase by $12,391,304, the net present value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s equity will immediately rise to reflect the NPV of the project. Therefore, the market value of Stephenson’s equity after the announcement will be:

Equity value = $582,000,000 + 12,391,304

Equity value = $594,391,304

Market value balance sheet |

| Old assets | $582,000,000 |   | | |

  | NPV of project | 12,391,304 |   | Equity |...