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Corporate+Finance Tutorial 05 Exercises

This document contains an exercise set on capital structure and financial distress from a corporate finance course. It includes three tasks: 1) A case study on default and bankruptcy in a perfect market involving a company called Gladstone Corporation and its zero-coupon debt. 2) A job offer scenario comparing the present value of wages from a certain offer versus an offer from a company with a risk of bankruptcy. 3) A trade-off theory question involving a company called Marpor Industries that is considering increasing its debt level and the impact on its value.

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76 views2 pages

Corporate+Finance Tutorial 05 Exercises

This document contains an exercise set on capital structure and financial distress from a corporate finance course. It includes three tasks: 1) A case study on default and bankruptcy in a perfect market involving a company called Gladstone Corporation and its zero-coupon debt. 2) A job offer scenario comparing the present value of wages from a certain offer versus an offer from a company with a risk of bankruptcy. 3) A trade-off theory question involving a company called Marpor Industries that is considering increasing its debt level and the impact on its value.

Uploaded by

strategy.inform
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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INSTITUTE FOR CAPITAL MARKETS AND CORPORATE FINANCE

Corporate Finance
(Summer Term 2021)

Exercise Set 5: Capital Structure and Financial Distress

Task 1: Default and Bankruptcy in a Perfect Market


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, or $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.
For the subtasks b), c) and d) suppose that Gladstone has zero-coupon debt with a $100 million
face value due next year.

a) What is the initial value of Gladstone’s equity without leverage?

b) What is the initial value of Gladstone’s debt?

c) What is the yield-to-maturity of the debt? What is the expected return of Gladstone’s
equity?

d) What is the initial value of Gladstone’s equity? What is Gladstone’s total value with
leverage?

Task 2: The Costs of Bankruptcy and Financial Distress


You have received two job offers. Firm A offers to pay you $88,000 per year for two years. Firm B
offers to pay you $91,000 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 $88,000 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 (a), 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.

Corporate Finance / Summer Term 2021 Exercise Set 5: Capital Structure and Financial Distress
-2-

Task 3: Trade-Off Theory


Marpor Industries has no debt and expects to generate free cash flows of $16 million each year.
Marpor believes that if it permanently increases its level of debt to $40 million, the risk of
financial distress may cause it to lose some customers and receive less favorable terms from its
suppliers. As a result, Marpor’s expected free cash flows with debt will be only $15 million per
year. Suppose Marpor’s tax rate is 35%, the risk-free rate is 5%, the expected return of the
market is 15%, and the beta of Marpor’s free cash flows is 1.10 (with or without leverage).

a) Estimate Marpor’s value without leverage.

b) Estimate Marpor’s value with the new leverage.

Corporate Finance / Summer Term 2021 Exercise Set 5: Capital Structure and Financial Distress

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