PROBLEM 1

● Debt issue (D) = 675 m

● Shares outstanding (SHO) = 95 m
● Pre-tax income = 600 m
● ! = 0.35
● !! = 0.09
● !" = 0.23
● "" = 1.8
● Price-earnings ratio (P/E) = 3.75

1. Compute the company’s earnings per share, stock price, and market value
before the debt issue and stock repurchase.

#$%&'(%)* ,-./0& 456

- Earnings Per Share (EPS) = 123
= 57
= $4.105

o After-tax income = Pre-tax income × (1 - !) = 600 × (1 - 0.35) = 390

- Stock Price (P) = P/E × EPS = 3.75 × 4.105 = $15.39/share

- Market Value before debt issue = + 8 = SHO × P

= 95000000 × 15.39 = 1.462 billion

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

- Market Value after debt issue = + 9 = + 8 + PV(Interest tax shield)

= 1462 + 236.25 = 1698.25 m
o PV(Interest tax shield) = , × D = 0.35 × 675 = 236.25 m

:! ;<5=.?7
- Stock Price = 123
= 57
= $17.88

@&% ABCDEF 476.7;

- Earnings Per Share = -&G HI)'&H /J%H%)-K,-L
= 7M.?7
= $6.12

o New shares outstanding = SHO – shares repurchased

= 95 – (675 / 17.88) = 57.25 m
o Net income to Shareholders = [pre-tax income – (!! × Debt)] × (1 - ,)
= [600 – (0.09 × 675)] × (1 – 0.35) = 350.51

:! – O ;<5=.?7 – <M7
- Stock Repurchase = PFQ RST
= 7M.?7
= $17.88
 PROBLEM 2

● V = 150 m, 135 m, 95 m or 80 m with a probability of 25% for each

● 1$ = 0.05
● Bankruptcy costs = 0.25

A. Assume that Gladstone is all equity financed. What is the value of equity?
V 0.25 × (150 + 135 + 95 + 80)
V" = 1 + X = 1.05
= $109.52 million
#

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?

With a debt of $100 million, there are 2 outcomes in which the debt exceeds the
earnings:

• 100 > 95 → Bankruptcy costs = 95 × 0.25 = $23.75 million

• 100 > 80 → Bankruptcy costs = 80 × 0.25 = $20 million

, 6.?7 × [100 + 100 + (95 – 23.75) + (80 – 20)]

Ø D = ; \ '$
= ;.67
= $78.87 million

C. What is the yield-to-maturity of the debt?

;66
YTM = M=.=M – 1 = 26.79%

D. What is the initial value of Gladstone’s levered equity? What is

Gladstone’s total value with leverage?

• E; = (150 - 100) × 0.25 = 50 × 0.25 = 12.5

• E? = (135 - 100) × 0.25 = 35 × 0.25 = 8.75
• E4 =0
• E_ =0
;?.7 \ =.M7 + 0 + 0)
ð E = ;.67
= $20.24

Ø + 9 = E + D = 20.24 + 78.87 = $99.11 million

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?

:% 109.52
Share Price = @` 123
= ;6
= $10.95/share

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)?

:! 55.;;
Share Price (after repurchasing) = Pa RST
= ;6
= $9.91/share

ð The share price is lower due to bankruptcy costs.

M=.=M
• D = $78.87m → Gladstone will repurchase 5.5;
= 7.96 million shares
?6.?_
• E = $20.24m → After the repurchase, the share price is ;6 – M.5< = 9.91
 PROBLEM 3

● All-equity financed
● SHO = 10 m
● EBIT = 90 m, 180 m or 225 m with equal probability for each project = ⅓
● 1$ = 0.2
● !. = 0.2

A. What is the current value of MC equity and its price per share?
M? × ⅓ \ ;__ × ⅓ \ ;=6 × ⅓
- E = +8 = ; \ 6.?
= 110

• After-tax earnings = EBIT × (1 – !. )

§ Weak State: 90 × (1 – 0.2) = 72 millions

§ Medium State: 180 × (1 – 0.2) = 144 million
§ Strong State: 225 × (1 – 0.2) = 180 millions

:% ;;6
- Price per share = 123
= ;6
= 11

__________________________________________________________________

DATA

● One-year debt contract

● Debt payment: $60 or $120
● Bankruptcy frictions = 80% of the available money
● Payment of debt 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?

<6 × ⅓ \ <6 × ⅓ \ <6× ⅓

- C = ; \ 6.?
= 50
 ?_ × ⅓ \ 5< × ⅓ \ ;4? × ⅓
- D = ; \ 6.?
= 70

• Taxable profits (debt deducted from EBIT → EBIT – D)

§ Weak State : 90 – 60 = 30
§ Medium State : 180 – 60 = 120
§ Strong State: 225 – 60 = 165

• After corporate taxes

§ Weak State: 30 × (1 – !. ) = 30 × (1 – 0.2) = 24
§ Medium State: 120 ×(1 – !. ) = 120 × (1 – 0.2) = 96
§ Strong State: 165 × (1 – !. ) = 165 × (1 – 0.2) = 132

- + 9 = D + E = 50 + 70 = 120

:! ;?6
- Price per share = 123
= ;6
= $12/share

O 76
- Shares repurchased = cdeCF fFd ghidF
= ;?
= 4.17 million shares

C. Suppose 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?

;= × ⅓ \ ;?6 × ⅓ \ ;?6 × ⅓
- C = ; \ 6.?
= 71.67

o In the Weak State, the earnings are not sufficient to cover the due debt
payment (120 > 90), so the firm defaults.
§ After payment of Bankruptcy costs: 90 × 0.8 = $72 million are lost
§ Debtholders receive: 90 × (1 – 0.8) = $18 millions

o In Medium and Strong State, they receive $120 millions

6 × ⅓ \ _= × ⅓ \ =_ × ⅓
- D = ; \ 6.?
= 36.67

• Taxable profits (debt deducted from EBIT)

§ Weak State: 90 – 120 = -30 = 0
§ Medium State: 180 – 120 = 60
§ Strong State: 225 – 120 = 105

• After corporate taxes

§ Weak State: 0 × (1 – !. ) = 0 × (1 – 0.2) = 0
§ Medium State: 60 × (1 – !. ) = 60 × (1 – 0.2) = 48
§ Strong State: 105 × (1 – !. ) = 105 × (1 – 0.2) = 84
- + 9 = D + E = 71.67 + 36.67 = 108.33 million

:! ;6=.44
- Price per share = = = $10.83/share
123 ;6

O M;.<M
- Shares repurchased = cdeCF fFd ghidF
= ;6.=4
= 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).

The first objective of an enterprise is to maximize the value of the firm.

So from the previous results, it would be better for the firm to choose debt with
a $60 million face value because + 9 ($60m debt) > + 8 > + 9 ($120m debt).
As we can see at point B, we have a firm’s value of $120m which is better than
the value from the point A where the value is only $110m and better than the
one from point c which is equal to $108.33 m.

The difference between this values is due to the PV(Interest Tax Shield)
!
ð PV(Interest Tax Shield) = ,. × '
$

There is a tradeoff between tax shield and bankruptcy cost, and the objective is
to find the right mixture to maximize the firm’s value and take advantage of the
tax shield. However, even though the tax shield is bigger when the debt =
$120m, the bankruptcy costs associated with it are higher than the tax shield
benefits.
 PROBLEM 4

● Risk Premium = 8% = 0.08

● 1$ = 4.95% = 0.0495
● "8 = 1.3
● Bankruptcy costs (BC) = 35% = 0.35
● Debt = 10000 perpetual

ð + 9 = APV = + 8 + PV(Interest Tax Shield) – BC

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

Use the CAPM to compute the expected unlevered cost of capital

Ø D(1J ) = 1$ + "8 × (E[R j ] – rk ) = 4.95% + 1.3 × 8% = 15.35%

• ROC:
o From year 1 to year 5, ROC = 20%
?6% – ;<%
o Next 5 years, it declines linearly up to 16% →
7
= 0.8%
so, each year ROC declines by 0.8%
o Year 10, ROC = 16%

• Growth rate in EBIT = ROC × Reinvestment rate

o From year 1 to year 5, growth rate in EBIT = 20% × 50% = 10%
;6% – 7%
o Next 5 years, it declines linearly up to 5% which means
7
= 1%
declining each year
o Year 10, ROC10 × Reinvestment rate10 = 16% × 31.25% = 5%
o After year 10, growth rate = 5%

mnAo
• Reinvestment rate (1% ) = growth rate in pTq
;6%
o From year 1 to year 5, reinvestment rate = ?6%
= 50%
7%
o Year 10, reinvestment rate = ;<%
= 31.25%
 • FCF = (1 – reinvestment rate) × EBIT × (1 – ,)
o FCF1 = (1 – 50%) × 5764 × (1 – 35%) = 1874
o FCF11 = (1 – 31.25%) × 12423 × (1 – 35%) = 5552

rqr&& 777?
• Terminal Value = "('' ) – u
= ;7.47% – 7%
= 53643

Ø FCF10 = (1 – reinvestment rate10) × EBIT10 × (1 – ,;6 ) + Terminal Value

= (1 – 31.25%) × 11831 × (1 – 35%) + 53643 = 58930

2. Determine the value-maximizing capital structure.

rqr& rqr( rqr&)

+8 = ; \ "('' )
+ ; \ "('' )(
+ ...+ ; \ "('' )&)
= 1624 + 1549 + . . . + 14129 = 26854

• Bankruptcy costs = default probability × BC × + 8

= 0.01% × 35% × 26854 = 0.94 for an AAA rating
= 0.25% × 35% × 26854 = 23.50 for an AA rating
= 0.40% × 35% × 26854 = 37.6 for an A rating

• Tax shield benefit = , × D = 35% × 10000 = 3500

o PV(Interest Tax Shield) = Average debt × , = 2500 × 35% = 875
o PV(ITS) = Average debt × , = 7500 × 35% = 2625

• Adjusted Present Value (APV) = + 8 + PV(ITS) – Bankruptcy costs

= 26854 + 875 – 0.94 = 875 = 27728
= 26854 + 2625 – 23.5 = 29456
= 26854 + 4375 – 37.6 = 31191

The optimal capital structure is when we have a debt level between 25000 and 30000
as the value of the firm is maximized.