a) Harvest Corporation is about to launch a new product. Depending on the succes

Question

a)

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.)

The initial value of Harvest Corporation's equity is $ _________ million.

b)

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.)

The initial value of Harvest Corporation's debt is $ __________ million.

Explanation / Answer

The initial value of Harvest Corporation's equity without leverage is:

Initial value of Equity = (150 + 135 + 95 + 80) * 0.25/ 1.05

Initial value of Equity = 109.52

Part B:

As firm's have debt is 100 million, in case of 95 million and 80 million all of the amount will be go to debtholders.

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

Value of Debt = 89.29 million

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