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 $197 million in a boom year and $88 million in a recession. The company's required debt payment at the end of the year is $122 million. The market value of the company’s outstanding debt is $95 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.)

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 $197 million in a boom year and $88 million in a recession. The company's required debt payment at the end of the year is $122 million. The market value of the company’s outstanding debt is $95 million. The company pays no taxes.

Explanation / Answer

a:

When there is recession at year-end, company will generate $88 million. But the required year-end debt payment is $122 million. Therefore, debt-holders will receive only $88 million and equity holders will receive nothing.

Payoff to bondholders = $88 million

b:

Promised yield = (122/95) – 1 = 0.2842 = 28.42%

c:

At year-end

During recession, bondholders receive = $88 million

During boom, bondholders receive = $122 million (and rest will go to equity-holders)

Expected value of bondholders’ payoff = 0.7*122 + 0.3*88 = 111.80

Expected return = (111.80/95) – 1 = 0.1768 = 17.68%

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