STEPHENSON REAL ESTATE RECAPITALIZATION

Question No. 1

If Stephenson wishes to maximize its total market value then I would recommend to issue debt finance for land purchase.
As dividend paid to equity holders are not tax deductible where as interest are tax deductible and would decrease the
taxable income for Stephenson, it would decrease its tax liability adding up to the overall value of the firm. Further
Stephenson is unlevered currently and adding debt portion to its structure wouldn't increase the cost of debt dramatically
so it would be a cheaper source of finance as well.

Question No. 2

The Market Value of Stephenson equity is 12 mil X $48.5 = $582 milllion

So the balance sheet before the purchase would look like

Stephenson Real Estate Company

Balance Sheet
Assets $582,000,000 Equity $582,000,000
Total assets $582,000,000 Debt & Equity $582,000,000

Question No. 3 (A)

After tax annual earning increase 11,000,000 X (1 - 40%)

After tax annual earning increase 6,600,000.00

If Stephenson decides to issue equity to finance the project then the NPV Of the project is

NPV = -$45,000,000 + ($6,600,000 / .115)

NPV = 12,391,304.35

Question No. 3 (B)

After Stephenson annouces that the firm will finance the purchase using equity then in unlevered firm the
value of firm would increase equivalent to the NPV of the project in case of efficient market. Hence the market
value of Stephenson would be

The Market Value of Stephenson equity will be $582 milllion + 12,391,304.35

Market Value of Equity = 594,391,304.35

So the balance sheet before the purchase would look like

 Stephenson Real Estate Company
Balance Sheet
Old Assets $582,000,000.00 Equity $594,391,304.35
NPV of Project $12,391,304.35
Total assets $594,391,304.35 Debt & Equity $594,391,304.35

Market Value of Share 594,391,304.35

No. of share outstanding 12,000,000.00
New Share Price 49.53

Stephenson needs to raise $ 45 million finance so,

No. of share he needs to issue would be 45,000,000/ 49.53
No. of share he needs to issue would be 908,493.00

Question No. 3 (C)

Stephenson will have to raise $45 million to finance the new project via issue of new equity, so the market value balance
sheet after the issue looks like

Stephenson Real Estate Company

Balance Sheet
Old Assets $582,000,000.00 Equity $639,391,304.35
Cash $45,000,000.00
NPV of Project $12,391,304.35
Total assets $639,391,304.35 Debt & Equity $639,391,304.35

Total Outstanding Share 12,000,000 + 908493

Total Outstanding Share 12,908,493.00
So, the share price is 49.53

Question No. 3 (D)

Stephenson’s annual pretax earnings by $11 million in perpetuity
After tax annual earning increase 11,000,000 X (1 - 40%)
After tax annual earning increase 6,600,000.00

PV of the project is 6,600,000 / 11.5%

PV of the project is 57,391,304.35

So the balance sheet after the purchase would look like

Stephenson Real Estate Company

Balance Sheet
Old Assets $582,000,000.00 Equity $639,391,304.35
PV of Project $57,391,304.35
Total assets $639,391,304.35 Debt & Equity $639,391,304.35
Question No. 4 (a)
According to Modigliani–Miller Propositions with Corporate Taxes

VL = VU + D X T

The value of company if financed by debt is

VL = 639,391,304.35 + 45,000,000 X 40%

VL = 657,391,304.35

Question No. 4 (b)

The balance sheet after the purchase if financed by debt would look like

Stephenson Real Estate Company

Balance Sheet
Value Unlevered $639,391,304.35 Debt $45,000,000
Tax Saving $18,000,000 Equity $612,391,304.35
Total assets $657,391,304.35 Debt & Equity $657,391,304.35

Stock price would be 612,391,304.35 / 12,000,000

Stock price would be 51.03

Question No. 5
If Stephenson uses equity to finance the project,
Stock Price would be 49.53

If Stephenson uses debt to finance the project,

Stock Price would be 51.03

Hence, debt financing is instrumental in increasing the stock price of Stephenson’s equity.