1441466501

8/13/2019 1441466501

http://slidepdf.com/reader/full/1441466501 1/5

CHAPTER 16

STEPHENSON REAL ESTATE

RECAPITALIZATION1.  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 firm’s capital structure willdecrease the firm’s taxable income, creating a tax shield that will increase the overall value of thefirm.

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:

 Market value balance sheet  

Assets  $710,000,000  Equity $710,000,000 

Total assets  $710,000,000  Debt & Equity $710,000,000 

3.  a.  As a result of the purchase, the firm’s 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 purchaseincreases 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 firm’s unlevered costof equity, so the NPV of the purchase is:

 NPV = – $60,000,000 + ($8,400,000 / .125) NPV = $7,200,000

8/13/2019 1441466501

http://slidepdf.com/reader/full/1441466501 2/5

 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 firm’sequity will immediately rise to reflect the NPV of the project. Therefore, the market value ofStephenson’s equity after the announcement will be: 

Equity value = $710,000,000 + 7,200,000

Equity value = $717,200,000

 Market value balance sheet  

Old assets  $710,000,000 

 NPV of project 7,200,000  Equity $717,200,000 

Total assets  $717,200,000  Debt & Equity $717,200,000 

Since the market value of the firm’s equity is $717,200,000 and the firm has 20 million sharesof common stock outstanding, Stephenson’s 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 firm’s stock is worth$35.86 per share, Stephenson must issue:

Shares to issue = $60,000,000 / $35.86Shares to issue = 1,673,173

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

 Market value balance sheet  

Cash  $ 60,000,000 

Old assets  710,000,000 

 NPV of project 7,200,000  Equity $777,200,000 

Total assets  $777,200,000  Debt & Equity $777,200,000 

The stock price will remain unchanged. To show this, Stephenson will now have:

Total shares outstanding = 20,000,000 + 1,673,173Total shares outstanding = 21,673,173

So, the share price is:

Share price = $777,200,000 / 21,673,173Share price = $35.86

8/13/2019 1441466501

http://slidepdf.com/reader/full/1441466501 3/5

d.  The project will generate $14 million of additional annual pretax earnings forever. Theseearnings will be taxed at a rate of 40 percent. Therefore, after taxes, the project increases theannual earnings of the firm by $8.4 million. So, the aftertax present value of the earningsincrease is:

PVProject = $8,400,000 / .125PVProject = $67,200,000

So, the market value balance sheet of the company will be:

 Market value balance sheet  

Old assets  $710,000,000 

PV of project 67,200,000  Equity $777,200,000 

Total assets  $777,200,000  Debt & Equity $777,200,000 

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

VL = VU + tCB

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 firmwould have $60 million worth of 8 percent debt outstanding. So, the value of the company if itfinanced 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 firm’s de bt is $60 million and the value of the firm is$801.2 million, we can calculate the market value of Stephenson’s equity. Stephenson’smarket-value balance sheet after the debt issue will be:

 Market value balance sheet  

Value unlevered  $777,200,000  Debt  $ 60,000,000 

Tax shield 24,000,000  Equity 741,200,000 

Total assets  $801,200,000  Debt & Equity $801,200,000 

Since the market value of the Stephenson’s equity is $741.2 million and the firm has 20 millionshares of common stock outstanding, Stephenson’s stock price after the debt issue will be: 

Stock price = $741,200,000 / 20,000,000Stock price = $37.06

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

8/13/2019 1441466501

http://slidepdf.com/reader/full/1441466501 4/5

CHAPTER 17

McKENZIE CORPORATION’S CAPITAL

BUDGETING

1.  We assume the $8.4 million is spent over the course of the year so we can ignore time value ofmoney considerations. If we include the time value of money, the numerical solutions will changeslightly, but the analysis will remain the same. The expected value of the company in one yearwithout 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 company’s 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 expansionis $9,000,000. If the required investment is $8.4 million, the expansion creates a positive increase inexpected value for current shareholders. However, as further analysis will show, stockholders areactually worse off.

2.  The value of the company’s debt with low economic growth is the value of the company because thecompany 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 company’s debt in one year with expansion is: 

VD = .30($33,000,000) + .50($34,000,000) + .20($34,000,000)VD = $33,700,000

8/13/2019 1441466501

http://slidepdf.com/reader/full/1441466501 5/5

 3.  The value of the company’s 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 equitywith normal growth or high growth is the value of the company minus the $34 million face value ofdebt. 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 ofdebt. So, with expansion, the company’s bondholders gain: 

Bondholder gain = $33,700,000 –  32,800,000Bondholder gain = $900,000

And the value expected for stockholders is:

Stockholder gain = $12,000,000 –  3,900,000Stockholder gain = $8,100,000

The stockholder value increases by $8.1 million, but the expansion was funded entirely by equity, sothe expected NPV of expansion for stockholders is actually:

Stockholder NPV = – $8,400,000 + 8,100,000Stockholder NPV = – $300,000

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

5.  If they don’t expand, nothing will happen since it is already priced into the bond. If the companyannounces the expansion, they signal they are willing to sacrifice for the bondholders, so thecompany 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 isfinanced with cash on hand. If the company issues new equity, the expected loss in stock value isshared proportionally by the new investors, so the current stockholders will not bear the entire loss instock value alone. By expanding with cash on hand, current stockholders are bearing the entire

expected loss in stock value.