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Gladstone Corporation is about to launch a new product
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 next year. Suppose the risk-free interest rate is 5%. Assume there are no taxes.
a) What is the initial value of Gladstone's equity without leverage?
Now assume 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 the expected return?
d) What is the initial value of Gladstone's equity? What is Gladstone's total value with leverage?
Expert Solution
a) Initial value of equity without leverage = $109.52 million
b) Initial value of debt = $89.29 million
c) Computation of the yield to maturity:-
Yield to maturity = (Face value / Initial debt value) -1
= ($100 / $89.29) -1
= 12%
Expected return = 5%
d) Initial value of equity with leverage = $20.24 million
d) Computation of the total value of firm with leverage:-
Total value = Initial value of debt + Initial value of equity with leverage
= $89.29 + $20.24
= $109.52
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