CHAPTER 16

STEPHENSON REAL ESTATE

RECAPITALIZATION
1.

If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $60
million purchase. Since interest payments are tax deductible, debt in the firms capital structure will
decrease the firms taxable income, creating a tax shield that will increase the overall value of the
firm.

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(20,000,000)
Market value of equity = $710,000,000
So, the market value balance sheet before the land purchase is:

Assets
Total assets
3.

a.

Market value balance sheet

$710,000,000
Equity
$710,000,000
Debt & Equity

$710,000,000
$710,000,000

As a result of the purchase, the firms pre-tax earnings will increase by $14 million per year in
perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase
increases the annual expected earnings of the firm by:
Earnings increase = $14,000,000(1 .40)
Earnings increase = $8,400,000
Since Stephenson is an all-equity firm, the appropriate discount rate is the firms unlevered cost
of equity, so the NPV of the purchase is:
NPV = $60,000,000 + ($8,400,000 / .125)
NPV = $7,200,000

b.

After the announcement, the value of Stephenson will increase by $7.2 million, the net present
value of the purchase. Under the efficient-market hypothesis, the market value of the firms
equity will immediately rise to reflect the NPV of the project. Therefore, the market value of
Stephensons equity after the announcement will be:
Equity value = $710,000,000 + 7,200,000
Equity value = $717,200,000

Old assets
NPV of project

Market value balance sheet

$710,000,000
7,200,000
Equity

Total assets

$717,200,000

Debt & Equity

$717,200,000
$717,200,000

Since the market value of the firms equity is $717,200,000 and the firm has 20 million shares
of common stock outstanding, Stephensons stock price after the announcement will be:
New share price = $717,200,000 / 20,000,000
New share price = $35.86
Since Stephenson must raise $60 million to finance the purchase and the firms stock is worth
$35.86 per share, Stephenson must issue:
Shares to issue = $60,000,000 / $35.86
Shares to issue = 1,673,173
c.

Stephenson will receive $60 million in cash as a result of the equity issue. This will increase the
firms assets and equity by $60 million. So, the new market value balance sheet after the stock
issue will be:

Cash
Old assets
NPV of project

Market value balance sheet

$ 60,000,000
710,000,000
7,200,000
Equity

Total assets

$777,200,000

Debt & Equity

$777,200,000
$777,200,000

The stock price will remain unchanged. To show this, Stephenson will now have:
Total shares outstanding = 20,000,000 + 1,673,173
Total shares outstanding = 21,673,173
So, the share price is:
Share price = $777,200,000 / 21,673,173
Share price = $35.86

d.

The project will generate $14 million of additional annual pretax earnings forever. These
earnings will be taxed at a rate of 40 percent. Therefore, after taxes, the project increases the
annual earnings of the firm by $8.4 million. So, the aftertax present value of the earnings
increase is:
PVProject = $8,400,000 / .125
PVProject = $67,200,000
So, the market value balance sheet of the company will be:

Old assets
PV of project
Total assets
4.

a.

Market value balance sheet

$710,000,000
67,200,000
Equity
$777,200,000

Debt & Equity

$777,200,000
$777,200,000

Modigliani-Miller Proposition I states that in a world with corporate taxes:

V L = V U + t CB
As was shown in Question 3, Stephenson will be worth $777.2 million if it finances the
purchase with equity. If it were to finance the initial outlay of the project with debt, the firm
would have $60 million worth of 8 percent debt outstanding. So, the value of the company if it
financed with debt is:
VL = $777,200,000 + .40($60,000,000)
VL = $801,200,000

b.

After the announcement, the value of Stephenson will immediately rise by the present value of
the project. Since the market value of the firms debt is $60 million and the value of the firm is
$801.2 million, we can calculate the market value of Stephensons equity. Stephensons
market-value balance sheet after the debt issue will be:

Value unlevered
Tax shield
Total assets

Market value balance sheet

$777,200,000
Debt
24,000,000
Equity
$801,200,000

Debt & Equity

$ 60,000,000
741,200,000
$801,200,000

Since the market value of the Stephensons equity is $741.2 million and the firm has 20 million
shares of common stock outstanding, Stephensons stock price after the debt issue will be:
Stock price = $741,200,000 / 20,000,000
Stock price = $37.06
5.

If Stephenson uses equity in order to finance the project, the firms stock price will remain at $35.86
per share. If the firm uses debt in order to finance the project, the firms stock price will rise to
$37.06 per share. Therefore, debt financing maximizes the per share stock price of a firms equity.

CHAPTER 17
McKENZIE CORPORATIONS CAPITAL
BUDGETING
1.

We assume the $8.4 million is spent over the course of the year so we can ignore time value of
money considerations. If we include the time value of money, the numerical solutions will change
slightly, but the analysis will remain the same. The expected value of the company in one year
without expansion is:
V = .30($30,000,000) + .50($35,000,000) + .20($51,000,000)
V = $36,700,000
And the expected value of the company in one year with expansion is:
V = .30($33,000,000) + .50($46,000,000) + .20($64,000,000)
V = $45,700,000
The companys stockholders appear to be better off with expansion since the expected NPV of the
project is positive. The difference in the expected value of the company with and without expansion
is $9,000,000. If the required investment is $8.4 million, the expansion creates a positive increase in
expected value for current shareholders. However, as further analysis will show, stockholders are
actually worse off.

2.

The value of the companys debt with low economic growth is the value of the company because the
company value is less than the face value of the debt. In both other economic states, the value of the
debt is the face value of the debt. So, the expected value of debt in one year without expansion is:
VD = .30($30,000,000) + .50($34,000,000) + .20($34,000,000)
VD = $32,800,000
And the value of the companys debt in one year with expansion is:
VD = .30($33,000,000) + .50($34,000,000) + .20($34,000,000)
VD = $33,700,000

3.

The value of the companys equity with low economic growth is zero both with and without
expansion since the company value will be less than the face value of the debt. The value of equity
with normal growth or high growth is the value of the company minus the $34 million face value of
debt. So, the expected value of the equity without expansion is:
VE = .30($0) + .50($1,000,000) + .20($17,000,000)
VE = $3,900,000
And the value of equity with expansion is:
VE = .30($0) + .50($12,000,000) + .20($30,000,000)
VE = $12,000,000
The value expected for bondholders from the expansion is the difference in the expected value of
debt. So, with expansion, the companys bondholders gain:
Bondholder gain = $33,700,000 32,800,000
Bondholder gain = $900,000
And the value expected for stockholders is:
Stockholder gain = $12,000,000 3,900,000
Stockholder gain = $8,100,000
The stockholder value increases by $8.1 million, but the expansion was funded entirely by equity, so
the expected NPV of expansion for stockholders is actually:
Stockholder NPV = $8,400,000 + 8,100,000
Stockholder NPV = $300,000

4.

Assuming bondholders are fully informed and they act rationally, they will expect the stockholders
to act in their best interest and not expand, so the price of the bonds will not change. If the expansion
is announced, the price of the bonds will increase.

5.

If they dont expand, nothing will happen since it is already priced into the bond. If the company
announces the expansion, they signal they are willing to sacrifice for the bondholders, so the
company will receive a lower interest rate in the future.

6.

It is a stronger signal that stockholders are not acting in their best interest if the expansion is
financed with cash on hand. If the company issues new equity, the expected loss in stock value is
shared proportionally by the new investors, so the current stockholders will not bear the entire loss in
stock value alone. By expanding with cash on hand, current stockholders are bearing the entire
expected loss in stock value.