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 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total cash flow of $200 million in a boom year and $91 million in a recession. The company's required debt payment at the end of the year is $125 million. The market value of the company’s outstanding debt is $98 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. Enter your answer in dollars, not millions of dollars (e.g. 1,234,567).) Payoff $ 15640000 b. What is the promised return on the company's debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) Promised return % c. What is the expected return on the company's debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) Expected return %

Explanation / Answer

Solution:

a) Calculation of payoff do bondholders expects to receive in the event of a recession:

The expected payoff to bond holders is the face value of debt or the value of the company, whichever is less. Since the value of the company in a recession is $91 million and the required debt payment in one year is $125 million, bond holders will receive the lesser amount, or $91 million.

b) Calculation of promised return on the company's debt:

Promised return = (Face value of debt / Market value of debt) - 1

Promised return = (125,000,000 / 98,000,000) - 1

= 1.2755 - 1

Promised return = 0.2755 or 27.55%

c) Calculation of expected return on the company's debt:

In part (a), we determined bond holders will receive $91 million in a recession. In a boom, the bond holders will receive the entire $125 million promised payment since the market value of the company is greater than the payment. So, the expected value of debt is:

Expected payment to bond holders = 0.60*(125,000,000) + 0.40*(91,000,000)

= 75,000,000 + 36,400,000

= $111,400,000

So, the expected return on debt is:

Expected return = (Expected value of debt / Market value of debt) - 1

= (111,400,000 / 98,000,000) - 1

= 1.1367 - 1

Expected return = 0.1367 or 13.67%

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