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 80 percent and the probability of a recession is 20 percent. It is projected that the company will generate a total cash flow of $192 million in a boom year and $83 million in a recession. The company's required debt payment at the end of the year is $117 million. The market value of the company’s outstanding debt is $90 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, i.e. 1,234,567.)

Payoff $

b. 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))

Promised return %

c. 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))

Expected return %

Explanation / Answer

In the event of recession company expects to generate $83 million in cash flow.

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 $117 million in a boom and that the market value of the debt is $90 million.

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

                            90 million = {(0.80)(117) + (0.20)(X)} / 1.12

90*1.12=93.6 + (0.20)(X)

100.8=93.6+0.2(X)

    X = $36 million

         Therefore, the market value of Good Time’s debt indicates that the firm’s bondholders expect to receive $36 million ($36000000) in the event of a recession.

What is the promised return on the company's debt?

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

                            Since the debt holders have been promised $117 million at the end of the year, the face value of Good Time’s debt is $117 million. The market value of Good Time’s debt is $90 million.

Promised Return=(117/90)-1

Promised Return=0.3 or 30%

c.What is the expected return on the company's debt

The probability of a boom year is 80 percent and the probability of a recession is 20 percent. It is projected that the company will generate a total cash flow of $192 million in a boom year and $83 million in a recession

Expected Cashflow= 80%*192+20%*83=$170.2 Million

If we use discount rate of 12% PV of cash flow= 170.2/(1.12)=$151.96 Million

Therefore, Good Time’s debt would be worth $151.96 million.

Expected Return= (151.96/90)-1

Expected Return=68.84%

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