Good Time Company is a regional chain department store. It will remain in busine

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 $185 million in a boom year and $76 million in a recession. The company's required debt payment at the end of the year is $110 million. The market value of the companys outstanding debt is $83 million. The company pays no taxes. 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, i.e. 1,234,567.) What is the promised return on the company's debt? (Do not round intermediate calculations and round your final answer to 2 decimal places, (e.g., 32.16)) What is the expected return on the company's debt? (Do not round intermediate calculations and round your final answer to 2 decimal places, (e.g., 32.16))

Explanation / Answer

a. If recession happens, the total cashflow that the company realizes is 76 million. As bondholders have the first right on all cashflows, the payoff for bondholders in the case of a recession is the entire 76 million.

Answer: 76,000,000

b. Promised return on debt = promised amount / current market value - 1

Promised amount = 110 million

Current market value = 83 million

So promised return % on debt = (promised amount / current market value) - 1

= (110 / 83) - 1 = 32.53%

Answer: Promised return % = 32.53%

c. In case boom happens, the realized return = promised return = 32.53%

In case recession happens, the realized return = (realized payoff / current market value) - 1

= (76/83) - 1 = -8.43%

So expected return % = probability of boom * realized return % + probability of recession * realized return %

= 0.6 * 32.53% + 0.4 * -8.43% = 16.14%

Answer: Expected return % = 16.14%

Hope this helped ! Let me know in case of any queries.

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