Chapter 16 Financial Distress, Managerial Incentives,

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Chapter 16 Financial Distress, Managerial Incentives, and Information 16-1. 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. 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? a. b. 0.25 × 150 + 135 + 95 + 80 = $109.52 million 1.05 0.25 × 100 + 100 + 95 + 80 = $89.28 million 1.05 100 – 1= 12% 89.29 c. YTM = expected return = 5% d. 16-2. equity = 0.25 × 50 + 35 + 0 + 0 = $20.24 million total value = 89.28 +20.24 = $109.52 million 1.05 Baruk Industries has no cash and a debt obligation of $36 million that is now due. The market value of Baruk’s assets is $81 million, and the firm has no other liabilities. Assume perfect capital markets. a. Suppose Baruk has 10 million shares outstanding. What is Baruk’s current share price? b. How many new shares must Baruk issue to raise the capital needed to pay its debt obligation? c. After repaying the debt, what will Baruk’s share price be? 81 − 36 = $4.5 / share 10 a. ©2011 Pearson Education, Inc. Publishing as Prentice Hall Berk/DeMarzo • Corporate Finance, Second Edition 203 b. c. 16-3. 36 = 8 million shares 4.5 81 = $4.5 / share 18 When a firm defaults on its debt, debt holders

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