6. value: 16.70 points Good Time Company is a regional chain department store. I
ID: 2753699 • Letter: 6
Question
6.
value:
16.70 points
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 $195 million in a boom year and $86 million in a recession. The company's required debt payment at the end of the year is $120 million. The market value of the company’s outstanding debt is $93 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))
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 $195 million in a boom year and $86 million in a recession. The company's required debt payment at the end of the year is $120 million. The market value of the company’s outstanding debt is $93 million. The company pays no taxes.
Explanation / Answer
Before solving the question let me remind you that, if a project is financed by a debt and equity and whatever cash flows the project is generating are paid to debt holders first, then remaining cash flows are used to pay equity holders
a) In case of recession, company generate a cash flow of $86 million
Since the debt repayment at the end of the year is $120 million
Entire $86 million is used to pay debt and equity holders get nothing
b) Promised return on debt = (Face Value of Bond / Market Value of Bond) – 1 = 120/93 - 1 = 29.03%
c) Expected cash flow of the company = Prob of Boom * Boom cash flow + Prob of recession * recession cash flow
Expected cash flow of the company = 60% * 195 + 40% * 86 = 151.4 million
Since the expected cash flow of the company is more than the required debt payments, expected value on the company's debt is the total expected cash flow
Expected value of debt = $151.4 million
Expected return = (Expected value of debt / Market value of debt) – 1 = 151.4 / 120 - 1 = 26.17%
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