Problem Set 1

Advanced Corporate Finance

Due date: October 6
Submit via Moodle before class starts!!!
Problem 1

Gladstone is planning to repurchase shares of common stock with the proceeds of a $675 million
debt issue. The interest rate on the debt is expected to be 9%. Currently, Gladstone is unlevered
with 95,000,000 common shares outstanding. The price-earnings ratio of the common shares is
3.75 based on pre-tax operating income of $600 million. The equity has a required rate of return
of 26.67% based on an equity beta of 1.8. Assuming the company’s tax rate is 35%, there are no
personal taxes and all cash flows are level perpetuities, answer the following questions.

1) Compute the company’s earnings per share, stock price and market value before the debt
issue and stock repurchase.
Solution:
Earnings per share = (600 (1 - 0.35))/95 = $4.105
Stock Price = $3.75/(earnings) * $4.105 (earnings/share) = $15.39/((share)
Market Value = 15.39* (95,000,000) = 1.4625 billion

2) Compute the company’s earnings per share, stock price and market value after the debt
issue and stock repurchase.
Solution:
VL = VU + tau*D = 1462.5 + 0.35* (675) = 1698.75 million
Shareholder Net Income = (600 - 0.09* (675))* (1 - 0.35) = 350.51 million
Price = VL/Nold = 1698.75 /95 = 17.88
Nnew = 95 - 675/17.88= 57.25 million
Price = E/Nnew = (1698.75 - 675) / 57.25 = 17.88
EPS = 350.51 / 57.25 = 6.12

Problem 2

Gladstone Corporation is about to launch a new product. Depending on the success of the new
product, Gladstone may have one of four values next year: $150 million, $135 million, $95 million,
or $80 million. These outcomes are all equally likely, and the risk of the project is diversifiable.
Suppose the risk-free interest rate is 5% and that, in the event of default, 25% of the value of
Gladstone’s assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as
taxes.)

a) Assume that Gladstone is all equity financed. What is the value of equity?
Now suppose Gladstone has zero-coupon debt with a $100 million face value due next year.

b) What is the initial value of Gladstone’s debt?

c) What is the yield-to-maturity of the debt?
d) What is the initial value of Gladstone’s levered equity? What is Gladstone’s total value
with leverage?

Suppose Gladstone has 10 million shares outstanding and no debt at the start of the year.

e) If Gladstone does not issue debt, what is its share price?

f) If Gladstone issues debt of $100 million due next year and uses the proceeds to repurchase
shares, what will its share price be? Why does your answer differ from that in part (e)?

Solution:
a) 0.25*(150 + 135 + 95 + 80) / (1 + 0.05) = $ 109.52 million
b) 0.25*(100 + 100 + 95*0.75 + 80*0.75) / (1 + 0.05) = $ 78.87 million
c) 100/78.87 – 1 = 26.79%
d) 0.25*(50+35+0+0)/(1+0.05) = $ 20.24 million
Firm value = 78.87 + 20.24 = $ 99.11 million
e) 109.52/10 = $ 10.95 /share
f) 99.11/10 = $ 9.91 / share
Bankruptcy cost lowers share price.
Note that Gladstone will raise $78.87 million from the debt, and repurchase 78.87/9.91 = 7.96 million
shares. Its equity will be worth $20.24 million, for a share price of 20.24/(10-7.96) =$9.91 after the
transaction is completed.

Problem 3

Midcap Corporation (MC) will cease to operate in one year. The firm is currently all-equity
financed, and has 10 million shares outstanding. In one year, MC’s projects will generate earnings
before interest and taxes of $90 million, $180 million or $225 million with equal probabilities (in
the Bad, Medium and Good states respectively). Assume that the physical assets are completely
worthless in all three states of the world at that time. The risk is all idiosyncratic, and so all cash
flows can be discounted at the same riskfree rate of 20%. The corporate tax rate is 20%.

(a) What is the current value of MC equity and its price per share?

Solution:
The after-tax earnings of the firm are EBIT(1−tc), which are 90(1−0.20) = 72, 180(1 − 0.20) =
144, and 225(1 − 0.20) = 180 in the bad, medium and good states respectively. The firm (and
unlevered equity) is worth
 V = E = [72/3 + 144/3 + 180/3]/1.20 = 110

The price per shares is therefore 110/10= 11.

The firm is considering a debt issue whose proceeds will be used to repurchase some of its equity.
Two sizes are being considered for this one-year debt contract: a promised payment of $60 million
or a promised payment of $120 million. If MC defaults on its debt, it is anticipated that 80% of the
available money will be lost to bankruptcy frictions (e.g., legal costs). To simplify calculations,
assume that the entire payment on the debt (not just the interest payment) is tax deductible.

(b) Suppose that MC chooses the debt with the $60 million promised payment. After the debt
issue and equity repurchase, what is the value of the debt, the value of the equity, and the
total value of the firm? Also, what is the price per share, and how many shares are
repurchased?

Solution:
When a payment is made on the debt, this payment serves to reduce the taxable profits of the
firm. The firm’s earnings are large enough to afford the promised payment of 60 in all three
states, and thus

D = [60/3 + 60/3 + 60/3]/1.20 = 50

These debt payments reduce the firm’s taxable profits to 90 − 60 = 30, 180 − 60 = 120, and
225 − 60 = 165 in the bad, medium and good states respectively. After (corporate) taxes,
shareholders receive 30(1−0.20) = 24, 120(1−0.20) = 96, and 165(1−0.20) = 132 in these
states. Their equity is therefore worth

E = [24/3 + 96/3 + 132/3]/1.20 = 70

The firm’s value is V = D + E = 50 + 70 = 120. Upon the announcement of the debt issue, the
value of the firm goes up to 120, which is $12 per share. This means that the firm will
repurchase $50 million/$12= 4.17 million shares.

(c) Suppose instead that MC chooses the debt with the $120 million promised payment. After
the debt issue and equity repurchase, what is the value of the debt, the value of the equity,
and the total value of the firm? Also, what is the price per share, and how many shares are
repurchased?

Solution:
When the face value of the debt is 120, the firm defaults in the bad state as the 90 that its
operations generate is not sufficient to cover the promised payment on the debt. In that state,
the debtholders receive only 90(1 −0.80) = 18 after the bankruptcy costs are paid. They
receive a full 120 in the medium and good states. Therefore, their debt is worth
 D = [18/3 + 120/3 + 120/3]/1.20 = 71.67

These debt payments reduce the firm’s taxable profits to zero, 180 − 120 = 60, and 225 − 120
= 105 in the bad, medium and good states respectively. After (corporate) taxes, shareholders
receive zero, 60(1 − 0.20) = 48, and 105(1 − 0.20) = 84 in these states. Their equity is
therefore worth

E = [0/3 + 48/3 + 84/3]/1.20 = 36.67

The firm’s value is V = D + E = 71.67+36.67 = 108.33. Upon the announcement of the debt
issue, the value of the firm goes down to 108.33, which is $10.83 per share. This means that
the firm will repurchase $71.67 million/$10.83 = 6.62 million shares.

(d) What is the optimal financing of the firm (no debt, debt with a $60 million face value, or
debt with a $120 million face value)? Intuitively explain why (in 2-3 sentences).

Solution:
The firm will choose the debt with a face value of $60 million, as its value is maximized
with such a capital structure. Intuitively, the firm benefits from tax shields as it increases
the debt from zero to D = 50 (i.e., the debt with a face value of 60), as this debt allows it to
shield profits from taxes without forcing it to default and incur bankruptcy costs. When the
debt is increased too much, however, the firm must default in the bad state of the world.
Although the tax shields get larger, the large bankruptcy costs associated with default more
than offset the tax shield benefits.

Problem 4

At the end of your Bachelor’s program you are hired by an investment bank. Your boss asks you
to evaluate a firm using the APV method. Your assignment is to:

1) Estimate the value of the firm if it sticks to the current capital structure.

2) Determine the value-maximizing capital structure.

You have the following data:

You have in addition the following information:

- Historical market risk premium: 8%

- The risk-free rate is 4.95%
- The debt is perpetual
- The beta of unlevered assets is 1.3
- Bankruptcy costs represent 35% of the value of unlevered assets
- The drop in EBIT is to apply to the EBIT the firm would have had without debt. If for
example EBIT is 100 without debt, a firm with a leverage ratio between 40% and 45%
would have an EBIT reduced by 13% that is EBIT = 87.
The process of rating is given by the table below.

Debt range Rating Default probability Drop in EBIT

<5’000 AAA 0.01% 0.00%
5’000-10’000 AA 0.25% 0.00%
10’000-15’000 A 0.40% 0.00%
15’000-20’000 BBB 2.05% 0.00%
20’000-25’000 BB 4.65% 0.00%
25’000-30’000 B 5.10% 5.00%
30’000-35’000 CC 12.90% 30.00%
>35’000 D 21.95% 50.00%
Solution:

1) Value for current capital structure

APV = NPV + TS - BC
The NPV is the Net Present Value of the Free Cash Flows discounted at the unlevered expected return.

Discount Rate
The unlevered expected return is obtained from the CAPM model:
E[RU ] = Rf + beta_u * Risk Premium = 0.0495 + 1.3 * 0.08 = 15.35%

Unlevered Cash Flows

The unlevered free cash flows are given by the usual formula:
FCFt = (1 - rt)*EBIT*(1 - tax rate )
where rt is the reinvestment rate. The following FCF are obtained:
0 1 2 3 4 5 6 7 8 9 10 11
tax rate 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35
EBIT growth 0.10 0.10 0.10 0.10 0.10 0.09 0.08 0.07 0.06 0.05 0.05
rate
EBIT 5240 5764 6340 6974 7672 8439 9199 9934 10630 11268 11831 12423
ROC 0.20 0.20 0.20 0.20 0.20 0.192 0.184 0.176 0.168 0.16 0.16
Reinvestment 0.50 0.50 0.50 0.50 0.50 0.4688 0.4348 0.3977 0.3571 0.3125 0.3125
rate
Terminal Value 53636
FCF 1873 2061 2267 2493 2743 3176 3650 4161 4708 58923

The terminal value is the value of a growing perpetuity:

TV = FCF11/(E[RU ] - g)
where g is the EBIT growth rate.

Unlevered Firm Value

We can now compute the value of unlevered assets:
VU = NPV (FCF, @E[RU ]) = 26,852

Debt is assumed to be perpetual. We know that in this case the value of tax shields is:
TS = tax rate * D = 0.35 * 10,000 = 3,500

Bankruptcy costs are 35% of the value of unlevered assets. The probability of bankruptcy for a debt level
of 10,000 is 0.40% (or 0.25% for AA rating).
BC = proba * VU * 0.35 = 0.0040 * 26,852 * 0.35 = 37.59
Or BC = proba * VU * 0.35 = 0.0025 * 26,852 * 0.35 = 23.50

Finally, we compute the APV:

APV = NPV + TS - BC = 26,852 + 3, 500 – 37.59 = 30314
Or APV = NPV + TS - BC = 26,852 + 3, 500 – 23.50 = 30328
2) Optimal Capital Structure

The optimal capital structure is defined by the amount of debt such that the value of the firm is
maximized. Finding the optimal capital structure requires performing the above analysis for various debt
levels. Then the optimal debt level is the one for which the value of the firm is the highest.

Mean Debt Debt Default Drop in Tax Bankruptcy Firm

outstanding outstanding probability EBIT Vu Shields costs Value
2,500 <5000 0.01% 0.00 26,852 875 1 27,726
7,500 [5'000-10'000] 0.25% 0.00 26,852 2,625 23 29,453
12,500 [10'000-15'000] 0.40% 0.00 26,852 4,375 38 31,189
17,500 [15'000-20'000] 2.05% 0.00 26,852 6,125 193 32,784
22,500 [20'000-25'000] 4.65% 0.00 26,852 7,875 437 34,290
27,500 [25'000-30'000] 5.10% 0.05 25,509 9,625 455 34,679
32,500 [30'000-35'000] 12.90% 0.30 18,796 11,375 849 29,322
40,000 >35'000 21.95% 0.50 13,426 14,000 1,031 26,394

The EBIT must be adjusted for each scenario. Indeed, it is assumed that the EBIT decreases when debt
increases. We observe that the optimal debt level is in the range of [25'000-30'000]. The idea of optimal
capital structure is better illustrated by a graph!