Harvest Corporation is about to launch a new product. Depending on the success o

Question

Harvest Corporation is about to launch a new product. Depending on the success of the new product, the company may have one of four values next year: $150 million, $135 million, $95 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 Harvest’s assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as taxes.) Now, suppose Harvest Corporation borrows $100 million dollars on a one-year note to finance the project.

The new, leveraged value of Harvest Corporation's equity is $ __________ million.

Feedback:Use the weighted average of the possible values of the company's equity at the one-year mark, remembering to take into account that the debt must be repaid (if it can be).

Explanation / Answer

Equity Value with debt:

As firm issues debt of 100 million, firm will pay equityholders only in 1st and 2nd case as in theses 2 cases firms value is greater than 100 million

Case 1 firms equity value = 150 - 100 = 50 million

Case 2 firms equity value = 135 - 100 = 35 million

Case 3 and 4 will be 0

Equity = 0.25 * (50 + 35 + 0 + 0)/ 1.05

Equity = 20.24

Debt = 0.25 * (100 + 100 + 0.75 * 95 + 0.75 * 80)/ 1.05

Debt = 78.87

Total leveraged Value = 20.24 + 78.87

Total leveraged Value = $99.11 million

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