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Stephenson Real Estate Recapitalization - Assignment Example

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The author of the "Stephenson Real Estate Recapitalization" paper constructs Stephenson’s market value balance sheet before it announces the purchase and identifies which method of financing maximizes the per-share stock price of Stephenson’s equity…
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Stephenson Real Estate Recapitalization
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If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? ExplainTo maximize its total market value, it should use debt to finance the $110 million purchase. As interest payments are tax-deductible, Taxable income will decrease with debt in the capital structure, creating a tax shield to increase the overall value of the firm.Market value of equity = $35.20(15,000,000) = $528,000,000Market value balance sheetAssets $528,000,000  Equity  $528,000,000Total assets $528,000,000  Debt & Equity  $528,000,0003.

Suppose Stephenson decides to issue equity to finance the purchase.a. What is the net present value of the project?b. Construct Stephenson’s market value balance sheet after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm’s stock? How many shares will Stephenson need to issue in order to finance the purchase?c. Construct Stephenson’s market value balance sheet after the equity issue, but before the purchase has been made.

How many shares of common stock does Stephenson have outstanding? What is the price per share of the firm’s stock?d. Construct Stephenson’s market value balance sheet after the purchase has been made.a. Earnings increase = $27,000,000(1 – .40) = $16,200,000As Stevenson is an all-equity based firm, At firm’s unlevered cost of equity, the NPV of the purchase is = –$110,000,000 + ($16,200,000 / .125) = $19,600,000b. After Stephenson announces that the firm will finance the purchase using equity, the value of Stephenson will increase by $20 million, the NPV of purchase.

Equity value = $507,500,000Market value balance sheetOld assets$528,000,000  NPV of project 19,600,000 Equity $507,500,000 Total assets$547,600,000 Debt & Equity $547,600,000Now,The market value of the firm’s equity is $547,600,000Shares of common stock outstanding=15 millionNew share price = $547,600,000 / 15,000,000New share price = $36.51Since Stephenson has to raise $110 million to finance the purchase, it should issue:Shares to issue = $110,000,000 / $36.

= 3,013,148c. Stephenson will receive $110 million in cash as a result of the equity issue. This will increase the firm’s assets and equity by $110 million. So, the new market value balance sheet after the stock issue will be:Market value balance sheetCash$110,000,000  Old assets528,000,000  NPV of project 19,600,000 Equity $657,600,000 Total assets$657,600,000 Debt & Equity $657,600,000Total shares outstanding = 15,000,000 + 3,031,148Total shares outstanding = 18,013,148So, the share price is:Share price = $657,600 / 18,013,148Share price = $36.51d. After taxes, the project increases the annual earnings of the firm by $16.2 million.PVProject = $16,200,000 / .

125= $129,600,000Market value balance sheetOld assets$528,000,000  PV of project 129,600,000 Equity $648,000,000 Total assets$657,600,000 Debt & Equity $657,600,0004. a. Modigliani-Miller Proposition with respect to corporate taxes:VL = VU + tCBThe value of the company if it financed with debt is:VL = $657,600,000 + .40($110,000,000)VL = $701,600,000b. Market value balance sheetValue unlevered$657,600,000 Debt$110,000,000 Tax shield 44,000,000 Equity 591,600,000 Total assets$701,600,000 Debt & Equity $701,600,000Stock price = $591,600,000 / 15,000,000Stock price = $39.

44If Stephenson uses equity to finance the project,Stock price= $36.51If Stephenson uses debt to finance the project,Stock price = $39.44Hence, debt financing is instrumental in increasing the stock price of Stephenson’s equity.

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