Stephenson Real EstateRecapitalization Corporate Finance Case Study Shahin Firouztash 1111200071 Jevgenijs Lesevs 1111200131 Khatereh Azarnoor 1101600315 Yoong Khai Hung 1111200139 Aliakbar Bahrpeyma1091200261 Uun Ainurrofiq 1111200141 Poon Wai Chuen 1111200122
Case OverviewIntroduction (Shahin) Founded 25 years ago by current CEO, Robert Stephenson Purchase real state, building and rents property to tenants. Has shown profit for the last 18 years The company has 20 million shares outstanding Last traded price was USD 35.50 per shareSTEPHENSON Real Estate The company has virtually no debt The current cost of capital of the company is 12.5% The company is subject to 40% corporation tax rate
Case Overview He was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing!!! Increases the earnings by USD 14 million on pre-tax basisRobert, CEOPlanning for a Lease it for thenew project! tenant farmers Purchase track of land in of land in the southeastern USA for USD 60 million
Case Overview If 30% dept: • much higher Kim, The new CFO coupon rate“I think it would be more valuable if we include debt in • bonds would carry acompany’s capital structure , so we should finance this lower rate project using debt structure…” • financial distress and associated Based of my costs conversations with Based on my analysis investment banks Capital structure We should issue of 70% of equity bonds with 8% and 30% of debt is coupon rate the most profitable for the company
Question 1 If Setephenson wishes to maximize its total marketvalue, would you recommend that it issue debt or equity to finance the land purchase? Explain.
Debt vs Equity Financing 60 million Land Purchase Debt EquityMaximize Stephenson Real Estate total market value
Equity FinancingAdvantages You can use your cash and that of your investors when you start up (no large loan payments) If business fails you don’t need to return money to investors. Investors may offer valuable business assistance that you may not have.Disadvantages investors own a piece of your business you are expected to act in investors best interests
Debt FinancingAdvantages Allows you to have control of your own destiny The lender(s) from whom you borrow money do not share in your profits You can apply for a loan that has more favorable terms. If you finance your business using debt, the interest you repay on your loan is tax-deductible.Disadvantages Large loan payments Credit rating can be spoiled
Question 1 AnswerStephenson should use debt to finance the $60million purchase!1. interest payments are tax deductible2. debt in capital structure will decrease the firm’s taxable income3. It creates a tax shield that will increase the overall value of the firm.
Question 2 Construct Stephenson’s market value balance sheet before it announces the purchase.
Question 2Since Stephenson is an all-equity firm with 20 million shares ofcommon stock outstanding, worth $35.50 per share, the marketvalue of the firm is:Market value of equity = $35.50 x 20,000,000Market value of equity = $710,000,000
Question 3a & 3bSuppose Stephenson decides to issue equity tofinance 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 with equity. What would be the new price per share of the firm’s stock? How many shares will Stephenson need to issue?
NPV of the Project Initial Outlay = $60,000,000 Annual pretax earnings = $14,000,000 Earnings after tax = $14,000,000 x (1-0.40) = $ 8,400,000 NPV(project) = -$60,000,000 + ($8,400,000/0.125) = $7,200,000
Upon Announcement of Equity Issue to New Project Stephenson Real Estate Balance Sheet (Upon Announcement of Equity Issue to New Project)Old Asset (20m x $35.50)= $710,000,000 Equity $717,200,000NPV of plant $ 7,200,000 The Price is Risen to reflect the news concerning the newTotal Asset $717,200,000 projectNew Price per share= $717,200,000 / 20,000,000 shares = $35.86 per shareNumber of shares to issue to finance the purchase = $60,000,000 / $35.86= 1,673,173 shares
Question 3c & 3dc. 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 !
Non-profitable project:NPV of the project =$0Share price = 710.000.000/20.000.000 = $35.5 per shareNumber of shares = 60.000.000 / 35.5 = 1.690.140Total number of share out standing = 21.690.140Equity = 710.000.000 +60.000.000 = $770.000.000Profitable project:NPV of the project = $ 7.200.00Share price = 717.200.000/20.000.000 = $35.86 per shareNumber of shares = 60.000.000 / 38.86 = 1.673.173Total number of share out standing = 21.673.173Equity = 717.200.000 +60.000.000 = $777.200.000
Upon Issuance of Equity, before Purchase Stephenson Real Estate Balance Sheet (Upon Issuance of Equity, before Purchase)Cash = $ 60,000,000 Equity $777,200,000Old Asset (20m x $35.50)= $710,000,000NPV of plant $ 7,200,000Total Asset $777,200,000
Upon Completion of PurchasePV Project = $8,400,000 / .125PV Project = $67,200,000 Stephenson Real Estate Balance Sheet (Upon Completion of Purchase)Old Asset (20m x $35.50)= $710,000,000 Equity $777,200,000PV of project $ 67,200,000Total Asset $777,200,000
Question 4Suppose Stephenson decides to issue debt tofinance the purchase.a. What will the market value of the Stephenson company?b. Construct Stephenson’s market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm stock?
Tax Shield The reduction in income taxes that results from taking an allowable deduction from taxable income Exp of Non Taxable Income : • debt interest • mortgage interest, • medical expenses, • charitable donations, • amortization • and depreciation.
Capital Structure under Corporate Tax Unlevered Firm Levered Firm0% 0% Debt Tax Tax Equity Debt Equity The levered firm pay less taxes because debt interest is non taxable income. Thus the sum of the debt + equity of levered firm is greater than the unlevered (all equity) firm
Financing by DebtModigliani-Miller Proposition Iin a world with corporate taxes
Balance Sheet & Stock PriceStock price = Value of Equity / Number of Shares OutstandingStock price = $741,200,000 / 20,000,000Stock price = $37.06
Question 5 Which method of financing maximizes the per-share stock price of Stephenson’s equity?
Equity Financing (review)Advantages You can use your cash and that of your investors when you start up (no large loan payments) If business fails you don’t need to return money to investors. Investors may offer valuable business assistance that you may not have.Disadvantages investors own a piece of your business you are expected to act in investors best interests
Debt Financing (review)Advantages Allows you to have control of your own destiny The lender(s) from whom you borrow money do not share in your profits You can apply for a loan that has more favorable terms. If you finance your business using debt, the interest you repay on your loan is tax-deductible.Disadvantages Large loan payments Credit rating can be spoiled
Calculation on Price per Share Equity Capital Debt Capital New share price = Stock price = $717,200,000 / 20,000,000 $741,200,000 / 20,000,000 New share price = $35.86 Stock price = $37.06