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Gladstone Corporation is about to launch a new product. Depending on the success of the new...

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.

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.

What is the initial value of Gladstone’s debt?

What is the yield-to-maturity of the debt? What is its expected return?

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

Outcome 1

Outcome 2

Outcome 3

Outcome 4

Equity value

150.00

135.00

95.00

80.00

Probability

25.00%

25.00%

25.00%

25.00%

Initial value of equity

without leverage

Outcome 1

Outcome 2

Outcome 3

Outcome 4

Equity value

Debt value

Total to all investors

Probability

b.

Initial value of debt

c.

Promised return

Expected return

d.

Initial value of equity with leverage

Total value with leverage

Solutions

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