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 12 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 south eastern 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 $11 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 11.5 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).

Case: Stephenson Real Estate (SRE) Recapitalization

Address the following questions regarding SRE’s proposed investment and potential move from an all-equity (unleveraged) capital structure to one employing enough debt to finance the new land acquisition:

Based on the perspectives provided in this chapter, what do you believe (before performing the detailed analysis to follow) should be the best approach for SRE to raise the required $45 million necessary to finance the land acquisition? Provide some perspective on your expectations.

Construct a simplified market value-based balance sheet for SRE reflecting its condition before making the land acquisition.

What is the NPV of SRE’s proposed project?

Now suppose that SRE has announced this project to financial markets with an intention to finance it with all equity capital.

Construct SRE’s market-value balance sheet following this announcement but prior to actually making the investment. (Hint: The market should credit SRE with the increased shareholder value projected for this project.) What will SRE’s share price be at this point? Fill in the Part a of the Part 5 tab.

How many shares will SRE have to issue to finance the project?

Assume now that SRE has issued the new shares but has not yet bought the land. Construct SRE’s market-value balance sheet and estimate the share price at this point in

Now assume that SRE has made the purchase of the land. Construct SRE’s market-value balance sheet in Part d of the Part 5 tab. (Hint: The market value of the land is now the PV (not NPV) of the project’s future CF.) Enter your estimate of the share price now.

Now let’s analyze how things will look if SRE uses debt to finance the project.

Using the M&M Proposition I formula (with taxes) and your estimate of SRE’s market value as an all-equity firm, what would you project SRE’s total market value to be if the project is financed entirely with debt?

Construct two versions of SRE’s market-value based balance sheet ‘

What should SRE’s common stock price be after financing with debt?

Given this analysis, how would you recommend that SRE finance the project? Are there any factors that we have not considered in this analysis that might change or at least temper your conclusion(s)?