debt or equity financing : stephenson real estate recapitalization case study

Stephenson Real Estate

Recapitalization

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

Introduction (Shahin)

STEPHENSON Real Estate

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 share

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

Case Overview

Purchase track of land in of land in the southeastern USA for USD 60 million

Lease it for the tenant farmers

Increases the earnings by USD 14 million on pre-tax basis

He was the founder and CEO of a failed alpaca farming

operation. The resulting bankruptcy made him

extremely averse to debt financing!!!

Robert, CEOPlanning for a new project!

Case Overview

Based of my conversations with investment banks

We should issue bonds with 8%

coupon rate

Based on my analysis

Capital structure of 70% of equity

and 30% of debt is the most profitable

for the company

Kim, The new CFO

“I think it would be more valuable if we include debt in company’s capital structure , so we should finance this

project using debt structure…”

If 30% dept:• much higher

coupon rate• bonds would carry

a lower rate• financial distress

and associated costs

Question 1

If Setephenson wishes to maximize its total market

value, would you recommend that it issue debt or equity

to finance the land purchase? Explain.

Debt vs Equity Financing

60 million Land Purchase

Maximize Stephenson Real Estate total market value

EquityDebt

Equity Financing

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

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

Question 1 Answer

Stephenson should use debt to finance the $60 million purchase!

1. interest payments are tax deductible

2. debt in capital structure will decrease the firm’s taxable income

3. 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 2

Since Stephenson is an all-equity firm with 20 million shares of

common stock outstanding, worth $35.50 per share, the market

value of the firm is:

Market value of equity = $35.50 x 20,000,000

Market value of equity = $710,000,000

Question 3a & 3b

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 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 EstateBalance Sheet

(Upon Announcement of Equity Issue to New Project)Old Asset (20m x $35.50)= $710,000,000

NPV of plant $ 7,200,000

Equity $717,200,000

Total Asset $717,200,000

New Price per share= $717,200,000 / 20,000,000 shares = $35.86 per share

Number of shares to issue to finance the purchase = $60,000,000 / $35.86 = 1,673,173 shares

The Price is Risen to reflect the news concerning the new

project

Question 3c & 3d

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 !

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 = $770.000.000

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

Non-profitable project:

Profitable project:

Upon Issuance of Equity, before Purchase

Stephenson Real EstateBalance Sheet

(Upon Issuance of Equity, before Purchase)Cash = $ 60,000,000Old Asset (20m x $35.50)= $710,000,000

NPV of plant $ 7,200,000

Equity $777,200,000

Total Asset $777,200,000

Upon Completion of Purchase

Stephenson Real EstateBalance Sheet

(Upon Completion of Purchase)Old Asset (20m x $35.50)= $710,000,000

PV of project $ 67,200,000

Equity $777,200,000

Total Asset $777,200,000

PV Project = $8,400,000 / .125

PV Project = $67,200,000

Question 4

Suppose Stephenson decides to issue debt to finance 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

Eq-uity

Tax

Unlevered Firm

Eq-uity

Debt

Tax

Levered Firm

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 Debt

= + BModigliani-Miller Proposition I in a world with corporate taxes

= $777,200,000 + .40 ( $60,000,000 )= $801,200,000

= Present Value of Levered Firm = Present Value of Unlevered Firm = Corporate Tax RateB = Amount of Debt

from the previous calculation, = $777,200,000

Balance Sheet & Stock Price

Stock price = Value of Equity / Number of Shares Outstanding

Stock price = $741,200,000 / 20,000,000

Stock price = $37.06

Question 5

Which method of financing maximizes the per-share stock price

of Stephenson’s equity?

Debt vs 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

New share price = $717,200,000 / 20,000,000

New share price = $35.86

Debt Capital

Stock price = $741,200,000 / 20,000,000

Stock price = $37.06

Thank You