Corporate Finance
12th Edition
ISBN: 9781259918940
Author: Ross, Stephen A.
Publisher: Mcgraw-hill Education,
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Textbook Question
Chapter 16, Problem 1MC
STEPHENSON REAL ESTATE RECAPITALIZATION
Stephenson Real Estate Company 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 alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity financed, with II million shares of common stock outstanding. The stock currently trades at $48.50 per share.
Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $45 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson’s annual pretax earnings by $10 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 10.5 percent. 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 entirely finance the project. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with a coupon rate of 7 percent. Based on her analysis, she also believes that a capital structure in the range of 70 percent equity 30 percent debt would be optimal. If the company goes beyond 30 percent 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 40 percent corporate tax rate (state and federal).
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.
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Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson.The company purchases real estate, including land and buildings, and rents the property totenants. The company has shown a profit every year for the past 18 years, and the shareholdersare satisfied with the company’s management. Prior to founding Stephenson Real Estate, Robertwas the founder and CEO of a failed alpaca-farming operation. The resulting bankruptcy madehim extremely averse to debt financing. As a result, the company is entirely equity financed, with12 million shares of common stock outstanding. The stock currently trades at $48.50 per share.Robert is evaluating a plan to purchase a huge tract of land in eastern Canada for $45 million.The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson’sannual pre-tax earnings by $11 million in perpetuity. Kim Weyand, the company’s newCFO, has been put in charge of the project. Kim has determined…
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increase in net income this year. On careful reading of the notes to the financial statements,
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Chapter 16 Solutions
Corporate Finance
Ch. 16 - MM Assumptions List the three assumptions that lie...Ch. 16 - Prob. 2CQCh. 16 - Prob. 3CQCh. 16 - MM Propositions What is the quirk in the tax code...Ch. 16 - Prob. 5CQCh. 16 - Prob. 6CQCh. 16 - Optimal Capital Structure Is there an easily...Ch. 16 - Financial Leverage Why is the use of debt...Ch. 16 - Homemade Leverage What is homemade leverage?Ch. 16 - Capital Structure Goal What is the basic goal of...
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