Question

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:

$ 155

​million,

$ 137

​million,

$ 96

​million, and

$ 83

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,

23 %

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​)

Answer 1