06 Financial Distress Managerial Incentives
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.
0.25
150 135 95 80
1.05
$109.52 million
b.
0.25
100 100 95 80
1.05
$89.28 million
c.
YTM =
100
– 1= 12%
89.29
expected return = 5%
d.
16-2.
equity = 0.25
50 35 0 0
1.05
$20.24 million total value = 89.28 +20.24 = $109.52 million
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?
a.
81 36
10
$4.5 / share
©2011 Pearson Education, Inc. Publishing as Prentice Hall
Berk/DeMarzo • Corporate Finance, Second Edition
16-3.
b.
36
4.5
c.
81
18
203
8 million shares
$4.5 / share
When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of
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.
0.25
150 135 95 80
1.05
$109.52 million
b.
0.25
100 100 95 80
1.05
$89.28 million
c.
YTM =
100
– 1= 12%
89.29
expected return = 5%
d.
16-2.
equity = 0.25
50 35 0 0
1.05
$20.24 million total value = 89.28 +20.24 = $109.52 million
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?
a.
81 36
10
$4.5 / share
©2011 Pearson Education, Inc. Publishing as Prentice Hall
Berk/DeMarzo • Corporate Finance, Second Edition
16-3.
b.
36
4.5
c.
81
18
203
8 million shares
$4.5 / share
When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of