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 $190 million in a boom year and $81 million in a recession. The company's required debt payment at the end of the year is $115 million. The market value of the company's outstanding debt is $88 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 and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.) b. 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.) c. 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.) a. Payoff % b. Promised return c. Expected return

Answer 1

A. If recession happens, the total cash flow that the company realizesis 81 million. As bondholders have the first right on all cash flows, the payoff for bondholders in the case of a recession is the entire 81 million. Answer: 81000000 b. Promised return on debt = promised amount / current market value-1 Promised amount = 115 million Current market value = 88 million So promised return%on debt = (promised amount I current market value)-1 = (115/88)-1 = 30.68% Answer: Promised return%= 30.68% c. In case boom happens, the realized retum = promised return= 30.68% In case recession happens, the realized retum= (realized payoff/ current market value)-1 = (81/88)-1 =-7.95% So expected return%= probability of boom* realized return%+probability ofrecession* realized return% = 0.6* 30.68%+0.4*-7.95% = 15.23% Answer: Expected return%= 15.23%