CHAPTER 16 C-1
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 $45
2. Since Stephenson is an all-equity firm with 11 million shares of common stock outstanding, worth
$48.50 per share, the market value of the firm is:
So, the market value balance sheet before the land purchase is:
Market value balance sheet
3. a. As a result of the purchase, the firm’s pre-tax earnings will increase by $10 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:
Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost
of equity, so the NPV of the purchase is:
b. After the announcement, the value of Stephenson will increase by $12,142,857, the net present
value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s
equity will immediately rise to reflect the NPV of the project. Therefore, the market value of
Stephenson’s equity after the announcement will be:
Market value balance sheet
CHAPTER 16 C-2
Since the market value of the firm’s equity is $545,642,857 and the firm has 11 million shares
of common stock outstanding, Stephenson’s stock price after the announcement will be:
Since Stephenson must raise $45 million to finance the purchase and the firm’s stock is worth
$49.60 per share, Stephenson must issue:
c. Stephenson will receive $45 million in cash as a result of the equity issue. This will increase the
firm’s assets and equity by $45 million. So, the new market value balance sheet after the stock
issue will be:
Market value balance sheet
Cash $ 45,000,000
The stock price will remain unchanged. To show this, Stephenson will now have:
Total shares outstanding = 11,000,000 + 907,187
d. The project will generate $10 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 $6 million. So, the aftertax present value of the earnings increase
is:
So, the market value balance sheet of the company will be:
Market value balance sheet
Old assets $533,500,000
CHAPTER 16 C-3
4. a. Modigliani-Miller Proposition I states that in a world with corporate taxes:
As was shown in Question 3, Stephenson will be worth $590,642,857 if it finances the purchase
with equity. If it were to finance the initial outlay of the project with debt, the firm would have
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 debt is $45 million and the value of the firm is
$608,642,857, we can calculate the market value of Stephenson’s equity. Stephenson’s market-
value balance sheet after the debt issue will be:
Market value balance sheet
Since the market value of Stephenson’s equity is $563,642,857 and the firm has 11 million
shares of common stock outstanding, Stephenson’s stock price after the debt issue will be:
5. If Stephenson uses equity in order to finance the project, the firm’s stock price will remain at $49.60