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Date Submitted: 04/04/2012 05:49 PM
Stephenson Real Estate Recapitalization
Ch 16 1. If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $100 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.
Issuing debt will create a tax shield that will decrease taxes payable and increase the overall value of the firm.
2. Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding, worth $35.20 per share, the market value of the firm is $528 million (= 15 million shares * $35.20 per share).
Stephenson’s market-value balance sheet before the announcement of the land purchase is:
3. a. As a result of the purchase, the firm’s pre-tax earnings will increase by $27 million per year in perpetuity. These earnings are taxed at a rate of 40%. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by $16.2 million {($27 million)(1 - 0.40)}.
Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity capital (r0), which is 12.5%.
NPV(Purchase) = - $110,000,000 + {($27,000,000)(1 – 0.40) / 0.125}
= - $110,000,000 + ($16.2 million / 0.125)
= $19,600,000
Therefore, the net present value of the land purchase is $19.6 million.
b. After the announcement, the value of Stephenson will increase by $19.6 million, 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 will be $547.6 million (= $528 million + $19.6 million) after the firm’s announcement.
Stephenson s...