Chapter 14 Closing Case
Professor: Darrell Early
October 8, 2011
1. If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain. 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 decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm. 2. Construct Stephenson’s market value balance sheet before it announces the purchase. Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding, worth $34.50 per share, the market value of the firm is: Market value of equity = $34.50(15,000,000)
Market value of equity = $517,500,000
So, the market value balance sheet before the land purchase is: Assets $517,500,000 Debt -Equity $517,500,000
Total assets $517,500,000 Debt &Equity $517,500,000
3. Suppose Stephenson decides to issue equity to finance the purchase. a. What is the net present value of the project?
As a result of the purchase, the firm’s pre-tax earnings will increase by$23 million per year in perpetuity. These earnings are taxed at a rate of40 percent. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by: Earnings increase = $23,000,000(1– .40)
Earnings increase = $13,800,000
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: NPV= – $95,000,000 + ($13,800,000 / .125)NPV = $15,400,000 b. Construct 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 in order to finance the purchase? After the announcement,...