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Case Study Questions and Answers

CaseStudy Questions and Answers

InstitutionAffiliation

  • If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

To maximize the overall market value of the company, it shouldfinance the $45 million land through debt. The company will have topay tax on the loan interest this will considerably reduceStephenson’s taxable income (Dubay, 2015). Debt finance is alsocheaper in terms of administration expenses. Equity financing is moreexpensive in the long run primarily due to consultation fees involved(Findlaw.com, 2016).

  • Review Stephenson`s market value balance sheet before it announces the purchase.

The value ofassets=48.5 per share * 12000000

=582,000,000

Stephenson Balance Sheet before the Purchase

Assets=

$582,000,000

Debt=

Equity=

$582,000,000

Total Assets=

$582,000,000

Total=

$582,000,000

  • Suppose Stephenson decides to issue equity to finance the purchase.

  1. What is the net present value of the project?

The first step is to calculate the earnings after tax. The pre-taxearnings will increase by 11 million in perpetuity, according to thecase. The tax rate is 40 percent. This means that the earnings aftertax will be:

11,000,000(1-0.4)

=$6,600,000

The NPV is the sum of the initial cost of land and the present valuesof cash flows that will come from the investment in future.

NPV=-45,000,000+6,600,000/0.115

=$12, 391,304.35

Stephenson Balance new Sheet

Assets=

$582,000,000

Debt

NPV=

$12, 391,304.35

Equity

$594,391,304.35

Total Assets

$594,391,304.35

Total D+E

$594,391,304.35

The firm’sequity is $594,391,304.35

  1. Review Stephenson`s market value balance sheet after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm`s stock? How many shares will Stephenson need to issue to finance the purchase?

Price per share

Stephenson’s should then determine a new stock price thatcorresponds to the equity value. The equity price is equal to theequity value divided by the number of shares.

Number of shares =12,000,000

Share price=$594,391,304.35/12,000,000

=$49.53

Number of shares to finance the purchase

After determining the new price per share, the firm will also have todetermine the number of shares needed for the equity financed landpurchase. It requires $45,000,000 to buy the land at a stock price of$49.53.

Amount needed= 45,000,000

New share price=49.53

Number of shares=45,000,000/49.53

=908,540.28

  1. Review 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?

After issuing the equity, Stephenson will receive $45,000,000 incash, thus the assets and equity will increase by the same amount,The new equity amount will be$45,000,000+594,391,304.35=$639,391,304.35

Stephenson Balance Sheet after Equity Issue

Assets

Cash

45,000,000

Old Assets

582,000,000

NPV of project

12, 391,304.35

Equity

639,391,304.35

Total Assets

639,391,304.35

Debt +Equity

639,391,304.35

Outstanding common stock shares

The new outstanding shares will be the old shares added to the newshares issued

Number of initial shares=12,000,000

Number of new shares=908,540.28

Sum= 12,908,540.28

Price per Share

Equity finance/Number of outstanding shares

=639,391,304.35/12,908,540.28

=$49.53

(The price does not change)

  1. Review Stephenson`s market value balance sheet after the purchase has been made.

Stephenson Balance Sheet after the Purchase

Assets

Initial assets

582,000,000

Debt=

PV of project

57,391,304.35

Equity=

639,391,304.35

Total Assets

639,391,304.35

Debt +Equity=

639,391,304.35

SupposeStephenson decides to issue debt to finance the purchase.

  • What will the market value of the Stephenson’s company be if the purchase is financed with debt?

Stephenson will need to calculate the market value as the leveredvalue with the formula below:

Levered value= Unlevered firm value + tax shield (Giddy, 2006).

(Equity + Debt) + (Debt *Tax)

VL= 639,391,304.35 + (0.4*45,000,000)

=$657,391,304.35

  • Review Stephenson`s market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm`s stock?

The firm’s new value=$657,391,304.35

The value of debt=45,000,000

The equity= Value of the firm –Debt

=$612, 391,304.35

The price per share

The total outstanding shares= 12,000,000

Price per share=612, 391,304.35/12,000,000

=$51.03

  • Which method of financing maximizes the per-share stock price of Stephenson`s equity?

If they decideto use equity to finance the project, the stock price will beconstant at $49.53 per share. However, if they use debt financing forthe project, the stock price will increase to $51.03 per share.

In conclusion,debt financing is the option that will help them maximize theper-share stock price of the company’s equity.

References

Dubay, C. S. (2015). Taxation of Debt and Equity: Setting theRecord Straight. Retrieved from&lthttp://www.heritage.org/research/reports/2015/09/taxation-of-debt-and-equity-setting-the-record-straight&gt

Findlaw.com (2016). Debt vs. Equity — Advantages andDisadvantages. Retrieved from&lthttp://smallbusiness.findlaw.com/business-finances/debt-vs-equity-advantages-and-disadvantages.html&gt

Giddy, I. (2006). Leverage and Equity Returns. Retrieved from&lthttp://people.stern.nyu.edu/igiddy/capstr.htm&gt