a. What is the yield-to-maturity of the debt?
b. What is its expected return?
Question Completion:
Suppose the Gladstone has zero-coupon debt with a $100 million face value due next year.
Answer:
Gladstone Corporation
a) The yield-to-maturity of the debt is:
9.5%
b) Its expected return is:
$5.474 million
Explanation:
Data and Calcualtions:
Zero-coupon debt = $100,000
Risk-free interest rate = 5%
Values from new product = one of $150 million, $135 million, $95 million, or $80 million outcomes equally likely = Total value = $460 million
Expected initial value without leverage = $460 million * 0.25 (1/4) = $115 million
Present value of expected initial value = expected initial value discounted by 5%
= $115 million * 0.952
= $109.48 million
Yield to maturity = (PV - Debt)/Debt = $9.48/$100 * 100 = 0.0948 = 9.5%
Expected return = $109.48 million * 5% = $5.474 million
Expected rate of return = $5.474/$100 * 100 = 5.5%
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