BFF5956 CORPORATE FINANCING DECISIONS 3
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BFF5956 CORPORATE FINANCING DECISIONS
Week 03 Tutorial Questions – Advanced Capital Structure
1. When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of bankruptcy?
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: $147 million, $136 million, $91 million, or $82 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the risk-free interest rate is 5% and that, in the event of default, 26% of the value of Gladstone’s assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as taxes.)
a. What is the initial value of Gladstone’s equity without leverage?
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? What is its expected return?
d. What is the initial value of Gladstone’s 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 $100 million due next year and uses the proceeds to repurchase shares, what will its share price be? Why does your answer differ from that in part (e)?
3. Your firm is considering issuing one-year debt, and has come up with the following estimates of the probability of distress for different levels of debt:
Debt Level ($ million)
0 40 50 60 70 80 90
Probability of Financial Distress 0% 0% 1% 2% 7% 16% 31%
Suppose the firm has a corporate tax rate of 40% and a beta of zero, so that the appropriate discount rate for financial distress costs is the risk-free rate of 5%. Which level of debt above is optimal if, in the event of distress, the firm will have distress costs equal to:
a. $2 million?
b. $5 million?
c. $25 million?
4. Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.
5. On May 14, 2008, General Motors paid a dividend of $0.25 per share. During the same quarter GM lost a staggering $15.5 billion or $27.33 per share. Seven months later the company asked for billions of dollars of government aid and ultimately declared bankruptcy just over a year later, on June 1, 2009. At that point a share of GM was worth only a little more than a dollar.
a. If you ignore the possibility of a government bailout, the decision to pay a dividend given how close the company was to financial distress is an example of what kind of cost?
b. What would your answer be if GM executives anticipated that there was a possibility of a government bailout should the firm be forced to declare bankruptcy?
6. Consider a firm whose only asset is a plot of vacant land, and whose only liability is debt of $15 million due in one year. If left vacant, the land will be worth $10.1 million in one year. Alternatively, the firm can develop the land at an upfront cost of $19.6 million. The developed land will be worth $34.3 million in one year. Suppose the risk- free interest rate is 9.9%, assume all cash flows are risk-free, and assume there are no taxes.
a. If the firm chooses not to develop the land, what is the value of the firm’s equity today? What is the value of the debt today?
b. What is the NPV of developing the land?
c. Suppose the firm raises $19.6 million from equity holders to develop the land. If the firm develops the land, what is the value of the firm’s equity today? What is the value of the firm’s debt today?
d. Given your answer to part (c), would equity holders be willing to provide the $19.6 million needed to develop the land?
7. Petron Corporation’s management team is meeting to decide on a new corporate strategy. There are four options, each with a different probability of success and total firm value in the event of success, as shown below:
Strategy
A B C D
Probability of Success |
93% |
77% |
61% |
45% |
Firm Value if Successful (in $ million) |
55 |
63 |
71 |
79 |
Assume that for each strategy, firm value is zero in the event of failure.
a. Which strategy has the highest expected payoff?
b. Suppose Petron’s management team will choose the strategy that leads to the highest expected value of Petron’s equity. Which strategy will management choose if Petron currently has
(i) No debt?
(ii) Debt with a face value of $16 million?
(iii) Debt with a face value of $32 million?
c. What agency cost of debt is illustrated in your answer to part (b)?
2022-06-23