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: $147 million, $13 million, $97 million, or $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)?

(Select the best choice below.)

A. The risk free rate raises the share price.

B. Bankruptcy costs lower the share price.

C. Bankruptcy costs raise the share price.

D. The risk free rate lowers the share price.

Answer rating: 100% (QA)

Solution a Initial value of Gladstones quity without l... View the full answer