Stephenson Real Estate Recapitalization Solution

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 $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.

Since Stephenson is an all-equity firm with 20 million shares of common stock outstanding, worth

$35.50 per share, the market value of the firm is:

Market value of equity = $35.50(20,000,000)

Market value of equity = $710,000,000

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

Assets

Total assets

3.

a.

Market value balance sheet

$710,000,000

Equity

$710,000,000

Debt & Equity

$710,000,000

$710,000,000

As a result of the purchase, 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. Therefore, after taxes, the purchase

increases the annual expected earnings of the firm by:

Earnings increase = $14,000,000(1 – .40)

Earnings increase = $8,400,000

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 = –$60,000,000 + ($8,400,000 / .125)

NPV = $7,200,000

b.

After the announcement, the value of Stephenson will increase by $7.2 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 after the announcement will be:

Equity value = $710,000,000 + 7,200,000

Equity value = $717,200,000

Old assets

NPV of project

Market value balance sheet

$710,000,000

7,200,000

Equity

Total assets

$717,200,000

Debt & Equity

$717,200,000

$717,200,000

Since the market value of the firm’s equity is $717,200,000 and the firm has 20 million shares

of common stock...