Financial Distress Good Time Company is a regional chain department store. It wi

Question

Financial Distress

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 $187 million in a boom year and $78 million in a recession. The company's required debt payment at the end of the year is $112 million. The market value of the company’s outstanding debt is $85 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 70 percent and the probability of a recession is 30 percent. It is projected that the company will generate a total cash flow of $187 million in a boom year and $78 million in a recession. The company's required debt payment at the end of the year is $112 million. The market value of the company’s outstanding debt is $85 million. The company pays no taxes.

Explanation / Answer

Part A)

Since, the tota amount due on debt at the end of the year is $112 million and the company can generate a maximum cash flow of $78 million during recession, the bondholders would be entitled to the entire $78 million.

Total Payoff to Bondholders in the Event of a Recession = $78 million

______________

Part B)

Since, the bondholders are entitled to receive $112 million at the end of the year, the face value of the bond is $112 million only. The formula for calculating promised return is:

Promised Return = Face Value of Debt/Market Value of Debt - 1

______________

Here, Face Value of Debt = $112 million and Market Value of Debt = $78 million

Using these values in the above formula, we get,

Promised Return = 112/85 - 1 = 31.76%

______________

Part C)

To determine the expected return, we need to find out the expected value of company's debt. During recession, the bondholders would receive $78 million. However, during boom, they will receive the entire $112 due to them. The expected value of debt can be calculated with the use of following formula:

Expected Value of Debt = Probability of Boom*112 + Probability of Debt*78

The expected return on debt can be calculated with the use of following formula:

Expected Return = Expected Value/Market Value - 1

______________

Expected Value of Debt = 70%*112 + 30%*78 = $101.80 million

Expected Return = 101.80/85 - 1 = 19.76%

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