Stephenson Real Estate Recapitalization - Corporate Finance - Ch 16 - Financial Leverage and Capital Structure Policy

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...