Stephenson Real Estate Company was founded 25 years ago by thecurrent CEO, Robert Stephenson. The company purchases real estate,including land and buildings, and rents the properties 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 founderand CEO of a failed alpaca farming operation. The resultingbankruptcy made him extremely averse to debt financing. As aresult, the company is entirely equity financed, with 9 millionshares of common stock outstanding. The stock currently trades at$37.80 per share.

Stephenson is evaluating a plan to purchase a huge tract of landin the southeastern United States for $95 million. The land willsubsequently be leased to tenant farmers. This purchase is expectedto increase Stephenson’s annual pre-tax earnings (EBIT) by $18.75million in perpetuity. Jennifer Weyand, the company’s new CFO, hasbeen put in charge of the project. Jennifer has determined that thecompany’s current cost of capital is 10.20%. She feels that thecompany would be more valuable if it included debt in its capitalstructure, so she is evaluating whether the company should issuedebt to entirely finance the project. Based on some conversationswith investment banks, she thinks that the company can issue bondsat par (face value) with a 6 percent coupon rate. From heranalysis, she also believes that a capital structure in the rangeof 70 percent equity/30 percent debt would be optimal. If thecompany goes beyond 30 percent debt, its bonds would carry a lowerrating and a much higher coupon because of the possibility offinancial distress and the associated costs would rise sharply.Stephenson has a 40 percent corporate tax rate.

What after-tax cash flow must Stephenson be currently producingper year, assuming that its current cash flows remain constant eachyear?

Construct Stephenson’s market value balance sheet before itannounces the purchase.

Market value balance sheet
				Debt
	Existing Assets			Equity
	Total assets			Total Debt + Equity

3)Suppose Stephenson decidedto issue equity to finance the purchase.

What is the net present value of the land acquisitionproject?

Construct Stephenson’s market value balance sheet after itannounces that the firm will finance the purchase using equity.(Assume that the value of the firm will immediately change toreflect the NPV of the new project.)

Market value balance sheet
	Old assets			Debt
	NPV of project			Equity
	Total assets			Total Debt + Equity

What would be the new price per share of the firm’s stock? Howmany shares will Stephenson need to issue to finance thepurchase?

      

Construct Stephenson’s market value balance sheet after theequity issue, but before the purchase has been made. How manyshares of common stock does Stephenson have outstanding? What isthe price per share of the firm’s stock?

Market Value Balance Sheet
	Cash
	Old assets			Debt
	NPV of project			Equity
	Total assets			Total Debt + Equity

e)What is Stephenson’s weighted average cost of capitalafter the acquisition? What after-tax cash flow will be producedannually after the acquisition? What is the present value of thisstream of after-tax cash flow? What is the stock price after theacquisition? Does this agree with your previous calculations?

Suppose Stephenson decides to issue debt to finance thepurchase.

What will be the market value of the Stephenson company be ifthe purchase is financed with debt?

Construct Stephenson’s market value balance sheet after both thedebt issue and the land purchase. What is the price per share ofthe firm’s stock?

      

Market Value Balance Sheet
	Value unlevered			Debt
	Tax shield			Equity
	Total assets			Total Debt + Equity

              

c)What is Stephenson’s cost of equity if it goesforward with the debt issue? (Do not round your answer.)

d)What is Stephenson’s weighted average cost of capitalif it goes forward with the debt issue? (Do not round youranswer.)

e)What total after-tax cash flow is being generated byStephenson after the acquisition?

f)What is the present value of this after-tax cashflow? What is the market value of equity? What is the stock price?Does this agree with your work from parts (a) and (b)?

Which method of financing maximizes the per-share price ofStephenson’s equity?

Does the resultant capital structure (with the land acquisitionfinanced by debt) satisfy Jennifer’s concerns about the negativeeffects of moving beyond the optimal capital structure?