Chapter 15 Minicase

MINI CASE

Stephenson real estate recapitalization

Stephenson Real Estate was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year for the past 18 years, and the shareholders are satisfied with the company’s management. Prior to founding Stephenson Real Estate, Robert was the founder and CEO of a failed sheep farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity-financed, with 15 million shares outstanding. The shares currently trade at £32.50 per share. Stephenson is evaluating a plan to purchase a huge tract of land in south-eastern England for £100 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson’s annual pre-tax earnings by £25 million in perpetuity. Kim Weyand, the company’s new CFO, has been put in charge of the project. Kim has determined that the company’s current cost of capital is 12.5 per cent. She feels that the company would be more valuable if it included debt in its capital structure, so she is evaluating whether the company should issue debt to finance the project entirely. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with an 8 per cent coupon rate. Based on her analysis, she also believes that a capital structure in the range of 70 per cent equity/30 per cent debt would be optimal. If the company goes beyond 30 per cent debt, its bonds would carry a lower rating and a much higher coupon, because the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 28 per cent corporate tax rate. 1 If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain. 2 Construct Stephenson’s...