Problem Set 1

Advanced Corporate Finance

Problem 1 (20 points)

Gladstone is planning to repurchase shares of common stock with the pro-
ceeds 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. (9 points)
Earnings per share = (700 (1 - 0.40))/100 = $4.20 (3 points)
Stock Price = $4/(earnings) * $4.20 (earnings/share) = $16.8 / (share)
(3 points)
Market Value = 16.8 * 100 million = 1.68 billion (3 points)
2. Compute the company’s earnings per share, stock price and market value
after the debt issue and stock repurchase. (11 points)

VL = VU + tau*D = 1680 + 0.4 * (850) = 2,020 million (3 points)

Shareholder Net Income = (700 – 0.1 * 850) (1 – 0.40) = 369
Price = VL/Nold = 2,020/100 = 20.20 (4 points)
Nnew = 100 – 850/20.20 = 57.92 million
Price = E/Nnew = (2020 - 850) / 57.92 = 20.20
EPS = 369 / 57.92 = 6.37 (4 points)

Problem 2 (40 points)

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.
(20 points)
2) Determine the value-maximizing capital structure. (20 points)
You have the following data:

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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.

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1) Value for current capital structure
Discount Rate

AP V = N P V + T S − BC
The NPV is the Net Present Value of the Free Cash Flows discounted at the
unlevered expected return. The unlevered expected return is obtained from the
CAPM model:

E[RU ] = Rf + βU ∗ Risk Premium = 0.05 + 1.35 ∗ 0.07 = 14.45% (2 points)

Unlevered Cash Flows

The unlevered Free Cash Flows are given by the usual formula:

F CFt = (1 − rt )EBIT (1 − τ )
where rt is the reinvestment rate and τ is the tax rate. The following F CF
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 rate 0.10 0.10 0.10 0.10 0.10 0.09 0.08 0.07 0.06 0.05 0.05
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 rate 0.50 0.50 0.50 0.50 0.50 0.4688 0.4348 0.3977 0.3571 0.3125 0.3125
Terminal Value 58745
FCF 1873 2061 2267 2493 2743 3176 3650 4161 4708 64032

(5 points)
The terminal value is the value of a growing perpetuity:

T V = F CF11 /(E[RU ] − g) (3 points)

where g is the EBIT growth rate.

Unlevered Firm Value

We can now compute the value of unlevered assets:

VU = N P V (F CF, @E[RU ]) = 29820 (2 points)

Debt is assumed to be perpetual. We know that in this case the value of tax
shields is:

T S = τ D = 0.35 ∗ 10, 000 = 3, 500 (3 points)

Bankruptcy costs are 40% of the value of unlevered assets. The probability
of bankruptcy for a debt level of 10, 000 is 0.45%(or 0.30% for AA rating).

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 BC = proba ∗ VU ∗ 0.4 = 0.0045 ∗ 29820 ∗ 0.4 = 53.68 (3 points)

Or
BC = proba ∗ VU ∗ 0.4 = 0.003 ∗ 29820 ∗ 0.4 = 35.78
Finally, we compute the APV:

AP V = N P V + T S − BC = 29, 820 + 3, 500 − 53.68 = 33266 (2 points)

Or

AP V = N P V + T S − BC = 29, 820 + 3, 500 − 35.78 = 33284

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 Default Drop in Vu TS BC Firm

Debt Proba EBIT Value
2’500 <5000 0.01% 0.00 29,820 875 1 30,694
7’500 [5’000-10’000] 0.30% 0.00 29,820 2,625 36 32,409
12’500 [10’000-15’000] 0.45% 0.00 29,820 4,375 54 34,141
17’500 [15’000-20’000] 2.20% 0.00 29,820 6,125 263 35,682
22’500 [20’000-25’000] 4.80% 0.00 29,820 7,875 574 37,122
27’500 [25’000-30’000] 5.30% 0.05 28,329 9,625 602 37,353
32’500 [30’000-35’000] 13.80% 0.30 20,874 11,375 1,155 31,097
40’000 >35’000 23.80% 0.50 14,910 14,000 1,423 27,491

(Vu: 5 points; TS: 5 points; BC: 5 points; Firm value: 3 points)

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] (2
points). The idea of optimal capital structure is better illustrated by a graph!

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