You have received two job offers. Firm A offers to pay you $81 comma 000 per year for two years. Firm B offers to pay you $ 84 comma 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 not to quit. If you did quit, you expect you could find a new job paying $81 comma 000 per year, but you would be unemployed for 3 months while you search for it. Asume full year's payment at the beginning of each year. 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.

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:

$ 152

million,

$ 140

million,

$ 95

million, and

$ 84

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,

27 %

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)?

Hawar International is a shipping firm with a current share price of

$ 6.50

and

5

million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing

$ 20

million and repurchasing shares.

a. With perfect capital markets, what will the share price be after this announcement?

b. Suppose that Hawar pays a corporate tax rate of

35 %

,

and that shareholders expect the change in debt to be permanent. If the only imperfection is corporate taxes, what will the share price be after thisannouncement?

c. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to

$ 7.55

after this announcement, what is the PV of financial distress costs Hawar will incur as the result of this new debt?

Consider a firm whose only asset is a plot of vacant land, and whose only liability is debt of

$ 14.5

million due in one year. If left vacant, the land will be worth

$ 10.5

million in one year. Alternatively, the firm can develop the land at an upfront cost of

$ 19.5

million. The developed land will be worth

$ 34.1

million in one year. Suppose the risk-free interest rate is

9.7 %

,

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

$ 19.5

million from the 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 thefirm's debt today?

d. Given your answer to part

(c),

would equity holders be willing to provide the

$ 19.5

million needed to develop the land?

Sarvon Systems has a debt-equity ratio of

1.1

,

an equity beta of

1.8

,

and a debt beta of

0.27

.

It currently is evaluating the following projects,

LOADING...

,none of which would change the firm's volatility (amounts in $ millions).

a. Which project will equity holders agree to fund?

b. What is the cost to the firm of the debt overhang?

a. Which project will equity holders agree to fund?(Select from the drop-down menus.)

Project	A	B	C	D	E
Accept?		No Yes	Yes No	Yes No

If it is managed efficiently, Remel, Inc., will have assets with a market value of

$ 50.1

million,

$ 99.2

million, or

$ 148.9

million next year, with each outcome being equally likely. However, managers may engage in wasteful empire building,which will reduce the market value by

$ 5.2

million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to

48 %

,

10 %

,

and

42 %

,

respectively.

a. What is the expected value of Remel's assets if it is run efficiently?

Suppose managers will engage in empire building unless that behavior increases the likelihood of bankruptcy. They will choose the risk of the firm to maximize the expected payoff to equity holders.

b. Suppose Remel has debt due in one year as shown below. For each case, indicate whether managers will engage in empire building, and whether they will increase risk. What is the expected value of Remel's assets in each case?

i.

$44.6

million, ii.

$46.8

million, iii.

$82.1

million, iv.

$95.7

million.

c. Suppose the tax savings from the debt, after including investor taxes, is equal to

9 %

of the expected payoff of the debt. The proceeds from the debt, as well as the value of any tax savings, will be paid out to shareholders immediately as a dividend when the debt is issued. What is the expected value of Remel's assets, including the tax savings, for each debt level in part

(b)?

Which debt level in part

(b)

is optimal for Remel?

Which of the following industries have low optimal debt levels according to the trade-off theory? Which have high optimal levels of debt?

a. Tobacco firms

b. Accounting firms

c. Mature restaurant chains

d. Lumber companies

e. Cell phone manufacturers

Tobacco firms have

high

low

optimal debt levels (

high

low

free cash flow,

growth opportunities). (Select from the drop-down menus.)