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 70 percent and the probability of a recession is 30 percent. It is projected that the company will generate a total cash flow of $191 million in a boom year and $82 million in a recession. The company's required debt payment at the end of the year is $116 million. The market value of the company’s outstanding debt is $89 million. The company pays no taxes.

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.)

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.)

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.)

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.)

Explanation / Answer

a) If there is a recession, Good Time will generate a cash flow of $82 million. Since the bondholder’s have the right to the first $116 million that the firm generates, Good Time’ stockholders will receive $0 if there is a recession

b) Promised Return = (Face Value of Debt / Market Value of Debt) – 1

Since the debt holders have been promised $116 million at the end of the year, the face value of Good Time’s debt is $116 million. The market value of Good Time’s debt is $89 million.

Promised Return = (Face Value of Bond / Market Value of Bond) – 1
=> ($116 million / $89 million) - 1 = 0.303371 or 30.3371%

c) To answer this part, we must have a discount rate, which hasn't been provided in the question. I assume it to be 10%. Replace it by the given discount rate and calculate accordingly:

The market value of a firm’s debt is the discounted expected cash flow to the firm’s debt holders. We know that the debt holders will receive $116 million in a boom and that the market value of the debt is $89 million.

Let X be the amount that bondholders expect to receive in the event of a recession:

$89 million = {(0.70)($191 million) + (0.30)(X)} / 1.10
$97.9 million = $133.7 million + 0.30X
X = $119.33 million

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