Question

Mid States 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 $188 million in a boom year and $79 million in a recession. The company's required debt payment at the end of the year is $113 million. The market value of the company’s outstanding debt is $86 million. The company pays no taxes.

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

Payoff           $  

b. What is the promised return on the company's debt? (Do not round intermediate calculations. 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. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Expected return             %

Answer 1

a). The expected payoff to bondholders is the face value of debt or the value of the company, whichever is less. Since the value of the company in a recession is $79 million and the required debt payment in one year is $113 million, bondholders will receive the lesser amount, or $79 million.

b). Promised return = (Face value of debt / Market value of debt) – 1

= ($113 million / $79 million) - 1 = 1.4304 - 1 = 0.4304, or 43.04%

c). In part a, we determined bondholders will receive $79 million in a recession. In a boom, the bondholders will receive the entire $113 million promised payment since the market value of the company is greater than the payment. So, the expected value of debt is:

Expected payment to bondholders = .60($113,000,000) + .40($79,000,000) = $99,400,000

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

= ($99.4 million / $79 million) - 1 = 1.2582 - 1 = 0.2582, or 25.82%