BREHIMA KOUMARE (20-342-267)

DESPOINA TSAKIRIDOU (19-309-582)

ROLAND DE PURY VARGAS (15-311-608) Genève, 5 octobre 2021
ZILDETE LANDIM CRAUSAZ (18-308-528)

University of Geneva Prof. BORIS NIKOLOV

GSEM Asst. HONGZHE SHAN
Asst. YE ZHANG

OBJET : Problem set 1, Advanced Corporate Finance

PROBLEM 1. Gladstone
Initial situation of the firm: No debt, share outstanding=95 million, P/E
ratio=3.75, pretax operationg income (EBIT)=600 million, rE = 23%, Equity
beta=βE = 1.8, company’s tax rate = τC = 35%, All Cash Flows are level perpe-
tuities.
The project. The firm is planning to issue a debt of 675 million at the
interest rate of rD = 9%, in order to repurchase shares of common stock.
1) We have:
EBIT × (1 − τc ) 600 × (1 − 0.35) 78
earnings per share = = = ≃ 4.105 $
share outstanding 95 19

share price
P/E ratio = 3.75 ⇒ = 3.75 $
earnings per share
78 585
⇒ share price = 3.75 × earnings per share = 3.75 × = ≃ 15.395 $
19 38

585
M arket value = share price × share outstanding = × 95 = 1462.5 million $
38
2) The firm value after the debt issue is calculated as follows:

V L = V U + τc × D = 1462.5 + 0.35 × 675 = 1698.75 million $

 The new share price is :
1698.75
S= ≃ 17.882 $
95
And the market value of Equity of the leverate firm will be:

E = V L − D = 1698.75 − 675 = 1023.75 million $

After repurchase, the new share outstanding is

675
95 − = 57.251656 million
S
After the debt issue, the earning per share will be
T otal earnings
earnings per share =
new share outstanding
(EBIT − Debt × Interest rate) × (1 − τC )
=
new share outstanding
(600 − 675 × 0.09) × (1 − 0.35)
= ≃ 6.122 $
57.251656
The share price after debt issue and share repurchase is
1023.75
share price = ≃ 17.882 $
57.251656

PROBLEM 2. Gladstone Corporation

The probability distribution of Gladstone value is given below:

firm value 150 135 95 80

proba 1/4 1/4 1/4 1/4

Risk free interest rate = r = 5%

Bankrupcy costs = 25% of the firm’s assets
a) Assume that Glastone is all equity financed. The fact that the risk of the
project is diversifiable implies that the discount rate is the risk free interest rate.

2
And the value of equity is
( )
1 1 1 1 1
E = × 150 + × 135 + × 95 + × 80
1+r 4 4 4 4
( )
1 1 1 1 1
= × 150 + × 135 + × 95 + × 80
1 + 0.05 4 4 4 4
115
= ≃ 109.524
1.05
b) Suppose Gladstone has zero coupon debt with 100 million face value.
The initial value D of Gladstone debt is calculated as follows:
( )
1 1 1 1 1
D = × 100 + × 100 + × 95 × (1 − 0.25) + × 80 × (1 − 0.25)
1 + 0.05 4 4 4 4
6625
= ≃ 78.869
84
c) The yield to maturity of the debt is
100
Y TM = − 1 = 0.2679 = 26.79%
78.869
d) What is the initial value of Gladstones levered equity? What is Gladstones
total value with leverage?
The initial value of Gladstone’s levered equity is
( )
1 1 1 1 1
E = × (150 − 100) + × (135 − 100) + × 0 + × 0
1 + 0.05 4 4 4 4
425
= ≃ 20.238
21
The total value with leverage is
425 6625 2775
VL =E+D = + = ≃ 99.107
21 84 28
e) Suppose Gladstone has 10 million shares outstanding and no debt at the
start of the year.
The share price is given by

VU 109.524
share price = ≃ ≃ 10.952
share outstanding 10

3
 f ) The share price of the Gladstone’s stock after the debt issuance will be
VL 99.107
share price = = ≃ 9.911
share outstanding 10
This answer differs from that in part e), because with a debt issuance of
100 million $ due next year (to repurchase shares), Gladstone will default in the
states of nature where its EBIT is 95 or 80 million $, and the bancrupcy costs
will outweigh the tax benefits, resulting in a lower share price.

PROBLEM 3. Midcap corporation

a) The Free cash Flows are 90 (1 − 0.2) = 72, 180 (1 − 0.2) = 144 or 225 (1 − 0.2) =
180, with equal probabilities. This distribution is given in the table below:
FCF 72 144 180 Total
1 1 1
proba 3 3 3
1
The current value of M C equity:
1 1
E = × × (90 (1 − 0.2) + 180 (1 − 0.2) + 225 (1 − 0.2))
1 + 0.2 3
1 1
= × × (72 + 144 + 180) = 110
1.2 3
b) Suppose that MC chooses the debt with the 60 million promised payment.
From de previous question, we have the unlevered firm value:
V U = E = 110
We deduce the levered firm value:
V L = V U + T ax Shield − Bankupcy Cost
60 × 0.2
= 110 + = 120
1 + 0.2
The current debt value :
( )
1 1 1 1
D= × 60 + × 60 + × 60 = 50 million $
1 + 0.2 3 3 3
The value of equity :
E = V L − D = 120 − 50 = 70 million $

4
 Other computation of the equity value :
1 1
E = × ((90 − 60) (1 − 0.2) + (180 − 60) (1 − 0.2) + (225 − 60) (1 − 0.2))
1.2 3
1 1
= × (24 + 96 + 132) = 70 million $
1.2 3
After the debt issue the share price become
120
Share price = = 12 $
10
The number of shares repurchased is
D 50
= million ≃ 4.167 million
share price 12
After the debt issue and equity repurchase the share price will be
E 70
= = 12 $
new share outstanding 10 − 4.167
c) Suppose now that MC chooses the debt with the 120 million promised
payment.
Recall that the unlevered firm value is

V U = 110

We deduce the levered firm value:

V L = V U + T ax Shield − Bankupcy Cost

1 1 1 1
= 110 + × (90 × 0.2 + 120 × 0.2 + 120 × 0.2) − × × (90 × 0.8)
1.2 3 1.2 3
= 108.33

The current debt value :

( )
1 1 1 1
D = × 90 × (1 − 0.8) + × 120 + × 120
1 + 0.2 3 3 3
= 71.667 million $

The value of equity :

E = V L − D = 108.33 − 71.667 = 36.667 million $

5
 Other computation of the equity value :
1 1
E = × (0 + (180 − 120) (1 − 0.2) + (225 − 120) (1 − 0.2))
1.2 3
1 1
= × (0 + 48 + 84) = 36.667 million $
1.2 3
After the debt issue the share price become
108.33
Share price = = 10.833 $
10
The number of shares repurchased is
D 71.667
= million ≃ 6.615385 million
share price 10.833
After the debt issue and equity repurchase the share price will be
E 36.667
= = 10.833 $
new share outstanding 10 − 6.615385

d) The firm’s optimal choice is a debt with a face value of 60 million $, because
it corresponds to the highest value of the firm, say 120 million $. By choosing
a debt with a face value of 60 million $, the firm will earn tax shields, without
any risk of default, without incurring bankrupcy costs. In the other alternative
(debt with a face value of 120 million), the firm will default in the state of nature
where its EBIT is 90 million $, and the bankrupcy costs will exceed the tax gains,
resulting in a lower enterprise value.

PROBLEM 4. Investment bank

1) Estimation of the value of the bank if it sticks to the current capital struc-
ture.
We start by determining de Free Cash Flows of the firm. The calculations are
given in the following tables.

6
 Years 0 1 2 3 4 5
growth rate
10% 10% 10% 10% 10% 10%
in EBIT
Tax rate 35% 35% 35% 35% 35% 35%
EBIT 5240 5764 6340.4 6974.4 7671.9 8439.1
EBIT(1 − t) 3406 3746.6 4121.3 4533.4 4986.7 5485.4
Depreciation 700 770 847 931.7 1024.9 1127.4
Capital
2355.4 2591 2850 3135 3448.5 3793.3
expenditure
NW C 524 576.4 634.04 697.44 767.19 843.91
∆N W C 47.636 52.4 57.64 63.4 69.75 76.72
ROC 20% 20% 20% 20% 20% 20%
Reinvestment
g 50% 50% 50% 50% 50% 50%
rate = ROC
FCF 1703 1873.3 2060.6 2266.7 2493.4 2742.7
Terminal value

Years 6 7 8 9 10 11
growth rate
9% 8% 7% 6% 5% 5%
in EBIT = g
Tax rate 35% 35% 35% 35% 35% 35%
EBIT 9198.6 9934.5 10629.9 11267.7 11831.1 12422.6
EBIT(1 − t) 5979.1 6457.4 6909.4 7324 7690.2 8074.7
Depreciation 1228.8 1327.1 1420.0 1505.2 1580.5 1659.5
Capital
3955.6 4061.1 4098.5 4057.1 5927.3 4123.7
expenditure
NW C 919.86 993.45 1062.99 1126.77 1183.11 1242.26
∆N W C 75.95 73.59 69.54 63.78 56.34 59.15
ROC 19.2% 18.4% 17.6% 16.8% 16% 16%
Reinvestment
g 46.875% 43.478% 39.773% 35.714% 31.25% 31.25%
rate = ROC
FCF 3176.4 3649.8 4161.3 4708.3 5287.0 5551.4
Terminal value 53636.7

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Given the assumptions of the problem, we have used de following formulas.
Formulas for the EBIT:
EBITt = 5240 × 1.1t , t = 0, ..., 5
EBIT6 = 5240 × 1.15 (1.09) ; EBIT7 = 5240 × 1.15 (1.09) (1.08) , ...
Formulas for the Net Working Capital :
N W Ct = EBITt × 0.1 for t = 1, 2, ..., 11
( W Ct − N W Ct−1
∆N W Ct = N ) , t = 1, ...,
( 11 )
∆N W C0 = EBIT0 − 1.1 × 0.1 = 5240 −
EBIT0 5240
1.1
× 0.1 = 47.636
Formulas for the Return on capital :
ROCt = .20, t = 0, ..., 5
ROCt = 0.20 − 0.008 (t − 5) , t = 6, ..., 10
ROCt = 0.16, t ≥ 10
Formulas for the capital Expenditure:
N etCapext = reinvest ratet × EBITt (1 − τ ) − ∆N W Ct
Capext = reinvest ratet × EBITt (1 − τ ) − ∆N W Ct + Depreciationst
Formulas for the Free Cash Flows :

F CFt = EBITt (1 − τ ) + Depreciationst − Capext − ∆N W Ct

= (1 − reinvestment rate) × EBITt (1 − τ )

The Terminal value at date 10 is calculated by the Shapiro formula:

F CF11
T erminal value =
E (RU ) − g

where E (RU ) is calculated by applying the CAPM formula:

E (RU ) = rf + βU (E (RM ) − rf ) = 0.0495 + 1.3 × 0.08 = 0.1535

Thus
F CF11 5551.4
T erminal value = = ≃ 53636.715
E (RU ) − g 0.1535 − 0.05

8
 We are now able to determine the value of the unlevered firm :
∑
9
F CFt F CF10 + T erminal V alue
U
V = t +
t=0 (1 + E (RU )) (1 + E (RU ))10
1873.3 2060.6 2266.7 2493.4
= 1703 + + 2 + 3 +
(1 + 0.1535) (1 + 0.1535) (1 + 0.1535) (1 + 0.1535)4
2742.7 3176.4 3649.8 4161.3
+ 5 + 6 + 7 +
(1 + 0.1535) (1 + 0.1535) (1 + 0.1535) (1 + 0.1535)8
4708.3 5287.0 + 53636.7
+ 9 + ≃ 28554.656 ≃ 28555
(1 + 0.1535) (1 + 0.1535)10
Estimation of the value of the levered firm by the AP V method, with default
probabity = 0.40% :

V L = V U + P V (T ax Shield) − P V (Bancrupcy Costs)

= V U + τ × D − Def ault probability × 0.35 × V U
0.4
≃ 28554.656 + 0.35 × 10000 − × 0.35 × 28554.656
100
≃ 32014.68 ≃ 32015

Estimation of the value of the levered firm by the AP V method, with default
probabity = 0.25% :

V L = V U + P V (T ax Shield) − P V (Bancrupcy Costs)

= V U + τ × D − Def ault probability × 0.35 × V U
0.25
≃ 28554.656 + 0.35 × 10000 − × 0.35 × 28554.656
100
≃ 32029.67 ≃ 32030

2) Determination of the value - maximizing capital structure

The optimal capital structure corresponds to the level of debt that maximizes
de levered value of the firm. To determine this optimal capital structure, we
apply the AP V method for different debt levels. We will identify the debt range
associated with the highest value of the firm.
For each debt range, and for simplicity, we choose de mean level, called Debt
mean.
We adjust the EBIT for each scenario. It is in fact assumed that the EBIT is
a decreasing function of the debt level.

9
 In addition, according to the relation F CFt = (1 − rt ) × EBITt × (1 − τ ) ,
the Free Cash Flows is proportional to the EBIT for the same period. We deduce
that the two aggregates, FCF and EBIT, have the same rate of growth. We can
therefore apply the following formulas :

V U = 28555 (1 − Drop in EBIT )

BC = P V (Bankrupcy Costs) = Def ault probability × 0.35 × V U
P V (T ax Shield) = 0.35 × Debt M ean
V L = V U + P V (T ax Shield) − BC

For example, if the debt is in the range [30000, 35000] , we have :

V U = 28555 × (1 − Drop in EBIT ) = 28555 × (1 − 0.30) = 19988.5

P V (T ax Shield) = 0.35 × Debt M ean = 0.35 × 30000+35000
2
= 0.35 × 32500 ≃ 11375
12.90
BC = Def ault probability × 0.35 × V U = × 0.35 × 19988.5 ≃ 902.481
100
V L = F irm V alue = V U + P V (T ax Shield) − BC
= 19988.5 + 11375 − 902.481 ≃ 30461.0
The calculations are given in the following table.

VL =
Drop P V (T ax
Debt range Debt Mean VU BC Firm
in EBIT Shield)
Value
<5000 2500 0.00% 28555 875 0.999425 29429.0
5000-10000 7500 0.00% 28555 2625 24.986 31155.0
10000-15000 12500 0.00% 28555 4375 39.977 32890.0
15000-20000 17500 0.00% 28555 6125 204.882 34475.1
20000-25000 22500 0.00% 28555 7875 464.733 35965.3
25000-30000 27500 5.00% 27127.3 9625 484.222 36268.1
30000-35000 32500 30.00% 19988.5 11375 902.481 30461.0
>35000 45000 50.00% 14277.5 15750 1096.869 28930.6

We notice that the Firm value increases as the Debt Mean increases from 2500
to 27500, and it decreases as the Debt Mean goes from 27500 to 45000. This is
the indication that the optimal debt level belongs in the range of [25’000-30’000].
The optimal debt corresponds to the highest firm value, which is about 36268.1 .

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