debt or equity financing
TRANSCRIPT
Stephenson Real Estate
Recapitalization
Corporate Finance Case Study
Shahin Firouztash 1111200071
Jevgenijs Lesevs 1111200131
Khatereh Azarnoor 1101600315
Yoong Khai Hung 1111200139
Aliakbar Bahrpeyma1091200261
Uun Ainurrofiq 1111200141
Poon Wai Chuen 1111200122
Introduction (Shahin)
STEPHENSON Real Estate
Founded 25 years ago by current CEO, Robert Stephenson
Purchase real state, building and rents property to tenants. Has shown profit for the last 18 years
The company has 20 million shares outstanding
Last traded price was USD 35.50 per share
The company has virtually no debt
The current cost of capital of the company is 12.5%
The company is subject to 40% corporation tax rate
Case Overview
Case Overview
Purchase track of land in of land in the southeastern USA for USD 60 million
Lease it for the tenant farmers
Increases the earnings by USD 14 million on pre-tax basis
He was the founder and CEO of a failed alpaca farming
operation. The resulting bankruptcy made him
extremely averse to debt financing!!!
Robert, CEO
Planning for a
new project!
Case Overview
Based of my conversations with investment banks
We should issue bonds with 8%
coupon rate
Based on my analysis
Capital structure of 70% of equity
and 30% of debt is the most profitable for the company
Kim, The new CFO
“I think it would be more valuable if we include debt in
company’s capital structure , so we should finance this
project using debt structure…”
If 30% dept:• much higher coupon rate
• bonds would carry a lower rate
• financial distress and associated
costs
Question 1
If Setephenson wishes to maximize its total market
value, would you recommend that it issue debt or equity
to finance the land purchase? Explain.
Debt vs Equity Financing
60 million Land Purchase
Maximize Stephenson Real Estate total market value
EquityDebt
Equity Financing
Advantages
You can use your cash and that of your investors when
you start up (no large loan payments)
If business fails you don’t need to return money to
investors.
Investors may offer valuable business assistance that
you may not have.
Disadvantages
investors own a piece of your business
you are expected to act in investors best interests
Debt Financing
Advantages
Allows you to have control of your own destiny
The lender(s) from whom you borrow money do not
share in your profits
You can apply for a loan that has more favorable terms.
If you finance your business using debt, the interest you
repay on your loan is tax-deductible.
Disadvantages
Large loan payments
Credit rating can be spoiled
Question 1 Answer
Stephenson should use debt to finance the $60
million purchase!
1. interest payments are tax deductible
2. debt in capital structure will decrease the
firm’s taxable income
3. It creates a tax shield that will increase the
overall value of the firm.
Question 2
Construct Stephenson’s market value balance
sheet before it announces the purchase.
Question 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 x 20,000,000
Market value of equity = $710,000,000
Question 3a & 3b
Suppose Stephenson decides to issue equity to
finance the purchase.
a. What is the net present value of the project?
b. Construct Stephenson’s market value balance sheet after it
announces that the firm will finance the purchase with equity. What
would be the new price per share of the firm’s stock? How many
shares will Stephenson need to issue?
NPV of the Project
Initial Outlay = $60,000,000
Annual pretax earnings = $14,000,000
Earnings after tax = $14,000,000 x (1-0.40)
= $ 8,400,000
NPV(project) = -$60,000,000 + ($8,400,000/0.125)
= $7,200,000
Upon Announcement of Equity Issue to New Project
Stephenson Real EstateBalance Sheet
(Upon Announcement of Equity Issue to New Project)
Old Asset (20m x $35.50)= $710,000,000
NPV of plant $ 7,200,000
Equity $717,200,000
Total Asset $717,200,000
New Price per share= $717,200,000 / 20,000,000 shares = $35.86 per share
Number of shares to issue to finance the purchase = $60,000,000 / $35.86
= 1,673,173 shares
The Price is Risen to reflect the news concerning the new
project
Question 3c & 3d
c. Construct 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?
d. Construct Stephenson’s market value balance sheet after the purchase has been made !
NPV of the project = $ 0
Share price = 710.000.000/20.000.000 = $35.5 per share
Number of shares = 60.000.000 / 35.5 = 1.690.140
Total number of share out standing = 21.690.140
Equity = 710.000.000 +60.000.000 = $770.000.000
NPV of the project = $ 7.200.00
Share price = 717.200.000/20.000.000 = $35.86 per share
Number of shares = 60.000.000 / 38.86 = 1.673.173
Total number of share out standing = 21.673.173
Equity = 717.200.000 +60.000.000 = $777.200.000
Non-profitable project:
Profitable project:
Upon Issuance of Equity, before Purchase
Stephenson Real EstateBalance Sheet
(Upon Issuance of Equity, before Purchase)
Cash = $ 60,000,000Old Asset (20m x $35.50)= $710,000,000
NPV of plant $ 7,200,000
Equity $777,200,000
Total Asset $777,200,000
Upon Completion of Purchase
Stephenson Real EstateBalance Sheet
(Upon Completion of Purchase)
Old Asset (20m x $35.50)= $710,000,000
PV of project $ 67,200,000
Equity $777,200,000
Total Asset $777,200,000
PV Project = $8,400,000 / .125
PV Project = $67,200,000
Question 4
Suppose Stephenson decides to issue debt to
finance the purchase.
a. What will the market value of the Stephenson company?
b. Construct Stephenson’s market value balance sheet after both the
debt issue and the land purchase. What is the price per share of
the firm stock?
Tax Shield
The reduction in income taxes that results from
taking an allowable deduction from taxable income
Exp of Non Taxable Income :
• debt interest
• mortgage interest,
• medical expenses,
• charitable donations,
• amortization
• and depreciation.
Capital Structure under Corporate Tax
Equity
Tax
Unlevered Firm
Equity
Debt
Tax
Levered Firm
The levered firm pay less taxes because debt interest is non
taxable income. Thus the sum of the debt + equity of levered
firm is greater than the unlevered (all equity) firm
Financing by Debt
𝑽𝑳 = 𝑽𝑼 + 𝒕𝒄 B
Modigliani-Miller Proposition I in a world with corporate taxes
𝑽𝑳 = $777,200,000 + .40 ( $60,000,000 )
𝑽𝑳 = $801,200,000
𝑽𝑳 = Present Value of Levered Firm
𝑽𝑼 = Present Value of Unlevered Firm
𝒕𝒄 = Corporate Tax Rate
B = Amount of Debt
from the previous calculation, 𝑽𝑼 = $777,200,000
Balance Sheet & Stock Price
Stock price = Value of Equity / Number of Shares Outstanding
Stock price = $741,200,000 / 20,000,000
Stock price = $37.06
Question 5
Which method of financing maximizes
the per-share stock price of
Stephenson’s equity?
Debt vs Equity
Equity Financing (review)
Advantages
You can use your cash and that of your investors when
you start up (no large loan payments)
If business fails you don’t need to return money to
investors.
Investors may offer valuable business assistance that
you may not have.
Disadvantages
investors own a piece of your business
you are expected to act in investors best interests
Debt Financing (review)
Advantages
Allows you to have control of your own destiny
The lender(s) from whom you borrow money do not
share in your profits
You can apply for a loan that has more favorable terms.
If you finance your business using debt, the interest you
repay on your loan is tax-deductible.
Disadvantages
Large loan payments
Credit rating can be spoiled
Calculation on Price per Share
Equity Capital
New share price =
$717,200,000 / 20,000,000
New share price = $35.86
Debt Capital
Stock price =
$741,200,000 / 20,000,000
Stock price = $37.06
Thank You