Problem Set 1

Advanced Corporate Finance

Due date: October 5
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Problem 1

Gladstone is planning to repurchase shares of common stock with the proceeds of a $850 million
debt issue. The interest rate on the debt is expected to be 10%. Currently, Gladstone is unlevered
with 100,000,000 common shares outstanding. The price-earnings ratio of the common shares is
4 based on pre-tax operating income of $700 million. The equity has a required rate of return of
25% based on an equity beta of 1.85. Assuming the company’s tax rate is 40%, 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.

2) Compute the company’s earnings per share, stock price and market value after the debt
issue and stock repurchase.

Problem 2

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: 7%

- The risk-free rate is 5%
- The debt is perpetual
- The beta of unlevered assets is 1.35
- Bankruptcy costs represent 40% 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 0.30% 0.00%
10’000-15’000 A 0.45% 0.00%
15’000-20’000 BBB 2.20% 0.00%
20’000-25’000 BB 4.80% 0.00%
25’000-30’000 B 5.30% 5.00%
30’000-35’000 CC 13.80% 30.00%
>35’000 D 23.80% 50.00%