1.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: $150 million, $135 million, $95 million, and $80 million. These outcomes are all equally likely, and this risk is diversifiable. Gladstone will not make any payouts to investors during the year. Suppose the risk-free interest rate is 5% and assume perfect capital markets.

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?

2.Baruk Industries has no cash and a debt obligation of $36 million that is now due. The market value of Baruk’s assets is $81 million, and the firm has no other liabilities. Assume perfect capital markets.

a. Suppose Baruk has 10 million shares outstanding. What is Baruk’s current share price?

b. How many new shares must Baruk issue to raise the capital needed to pay its debt obligation?

c. After repaying the debt, what will Baruk’s share price be?

3.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?

4.Which type of firm is more likely to experience a loss of customers in the event of financial distress:

a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)?

b. Allstate Corporation (an insurance company) or Reebok International (a footwear and clothing firm)?

5.Which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress:

a. An office building or a brand name?

b. Product inventory or raw materials?

c. Patent rights or engineering “know-how”?

6.Suppose Tefco Corp. has a value of $100 million if it continues to operate, but has outstanding debt of $120 million that is now due. If the firm declares bankruptcy, bankruptcy costs will equal $20 million, and the remaining $80 million will go to creditors. Instead of declaring bankruptcy,management proposes to exchange the firm’s debt for a fraction of its equity in a workout. What is the minimum fraction of the firm’s equity that management would need to offer to creditors for the workout to be successful?

7.You have received two job offers. Firm A offers to pay you $85,000 per year for two years. Firm B offers to pay you $90,000 for two years. Both jobs are equivalent. Suppose that firm A’s contract is certain, but that firm B has a 50% chance of going bankrupt at the end of the year. In that event, it will cancel your contract and pay you the lowest amount possible for you to not quit. If you did quit, you expect you could find a new job paying $85,000 per year, but you would be unemployed for 3 months while you search for it.

a. Say you took the job at firm B, what is the least firm B can pay you next year in order to match what you would earn if you quit?

b. Given your answer to part (b), and assuming your cost of capital is 5%, which offer pays you a higher present value of your expected wage?

c. Based on this example, discuss one reason why firms with a higher risk of bankruptcy may need to offer higher wages to attract employees.

8.As in Problem 1, 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: $150 million, $135 million, $95 million, and $80 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, 25% 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)?

9.Kohwe Corporation plans to issue equity to raise $50 million to finance a new investment. After making the investment, Kohwe expects to earn free cash flows of $10 million each year. Kohwe currently has 5 million shares outstanding, and it has no other assets or opportunities. Suppose the appropriate discount rate for Kohwe’s future free cash flows is 8%, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of Kohwe’s investment?

b. What is Kohwe’s share price today? Suppose Kohwe borrows the $50 million instead. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $50 million on the loan. Suppose that Kohwe’s corporate tax rate is 40%, and expected free cash flows are still $10 million each year.

c. What is Kohwe’s share price today if the investment is financed with debt? Now suppose that with leverage, Kohwe’s expected free cash flows will decline to $9 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for Kohwe’s future free cash flows is still 8%.

d. What is Kohwe’s share price today given the financial distress costs of leverage?

10. You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, “If we go bankrupt, we don’t have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt.” Is he right?