Question

Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total cash flow of $205 million in a boom year and $96 million in a recession. The company's required debt payment at the end of the year is $130 million. The market value of the company’s outstanding debt is $103 million. The company pays no taxes.

a. What payoff do bondholders expect to receive in the event of a recession? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) Calculate Payoff $

b. What is the promised return on the company's debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Promised return % c. What is the expected return on the company's debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Calculate Expected return %

Answer 1

a) The expected payoff to bondholders is face value of debt or value of the company whichever is less. Since in the year of recession, value of company is $96,000,000 which is less than face value of $130,000,000, bondholders will receive $96,000,000

b) Promised return on debt

Promised return = (Face value of debt/Market value of debt)-1

                        =($130,000,000/$103,000,000)-1

                        =0.2621 or 26.21%

c) In case of recession bondholders will receive $96,000,000 as determined in part (a). And in case of boom bondholders will receive full amount of face value i.e. $130,000,000 as market value of company is greater than payment to bondholders. So expected return will be,

Expected payment to bondholders = (0.60*$130,000,000)+(0.40*$96,000,000)

                                                  = $116,400,000

Expected return =(Expected value of debt/Market value of debt)-1

                        =($116,400,000/$103,000,000)-1

                        =0.1301 or 13.01 %