CHAPTER 14 C-1
CHAPTER 14
STEPHENSON REAL ESTATE
RECAPITALIZATION
1. If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $95
million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will
2. Since Stephenson is an all-equity firm with 16 million shares of common stock outstanding, worth
$41.50 per share, the market value of the firm is:
Market value of equity = $41.50(16,000,000)
CHAPTER 14 C-2
Since the market value of the firm’s equity is $684,428,571 and the firm has 16 million shares of
common stock outstanding, Stephenson’s stock price after the announcement will be:
New share price = $684,428,571/16,000,000
c. Stephenson will receive $95 million in cash as a result of the equity issue. This will increase the
firm’s assets and equity by $95 million. So, the new market value balance sheet after the stock
issue will be:
Cash
$95,000,000
Old assets
664,000,000
NPV of project
20,428,571
Equity
$779,428,571
Total assets
$779,428,571
Debt & Equity
$779,428,571
The stock price will remain unchanged. To show this, Stephenson will now have:
Total shares outstanding = 16,000,000 + 2,220,831
Total shares outstanding = 18,220,831
So, the share price is:
Share price = $779,428,571/18,220,831
Share price = $42.78
d. The project will generate $20.2 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 $12.12 million. So, the aftertax present value of the earnings
increase is:
PVProject = $12,120,000/.105
Old assets
$664,000,000
PV of project
115,428,571
Equity
$779,428,571
Total assets
$779,428,571
Debt & Equity
$779,428,571
CHAPTER 14 C-3
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 $779.4 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
$95 million worth of 7 percent debt outstanding. So, the value of the company if it financed with
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 $95 million and the value of the firm is
$817.4 million, we can calculate the market value of Stephenson’s equity. Stephenson’s market–
value balance sheet after the debt issue will be:
Value unlevered
$779,428,571
Debt
$95,000,000
Tax shield
38,000,000
Equity
722,428,571
Total assets
$817,428,571
Debt & Equity
$817,428,571
Since the market value of Stephenson’s equity is $722.4 million and the firm has 16 million
shares of common stock outstanding, Stephenson’s stock price after the debt issue will be:
Stock price = $722,428,571/16,000,000
Stock price = $45.15
5. If Stephenson uses equity in order to finance the project, the firm’s stock price will increase to $42.78
per share. If the firm uses debt in order to finance the project, the firm’s stock price will rise to $45.15
per share. Therefore, debt financing maximizes the per share stock price of a firm’s equity.