Good Time Co. is a regional chain department store. It will remain in business f

ID: 2804504 • Letter: G

Question

Good Time Co. is a regional chain department store. It will remain in business for one more

year. The estimated probability of a boom next year is 0.60 and the estimated probability of a

recession is 0.40. It is projected that Good Time will have a total cash flow of $250 million in

a boom year and $100 million in a recession. Good Time’s required debt repayment next year

is $150 million. The firm has few fixed assets, so assume that after next year is over the firm

will be liquidated for $0. Assume also that investors are risk-neutral and that interest rates are

zero (i.e., no discounting is necessary). There are no taxes.

a) Assuming that there were no financial distress costs or bankruptcy costs, calculate the

market value of Good Time’s (i) equity and (ii) debt.

b) If the market value of equity is actually $60 million and the market value of debt is

actually $125 million, what is the market’s estimate of financial distress/bankruptcy

costs?

Explanation / Answer

a) Assuming that there were no financial distress costs or bankruptcy costs, calculate the market value of Good Time’s (i) equity and (ii) debt.

Expected Value = Probability * cash flows

Cash flows

Boom

Recession

Expected Value

Total pay off in good times

250 m

100 m

250 * 0.60 +100*0.40 = 190 million

Debt Pay off: It is the face value of debt or value of the company. Whatever is less that will be considered as Debt pay off. Hence, 100 million in recession and 150 million in the boom period are considered as debt pay off

150 m

100

150 * 0.60 +100*0.40 = 130million

Equity Pay off; In the Recession period debt is higher than the value of company, so there is no value for equity but in the boom, the value of debt is 150 and the value of company is 250 the equity pay off is 100 (250 -150)

100

100 * 0.60 +0*0.40 = 60m

b) If the market value of equity is actually $60 million and the market value of debt is actually $125 million, what is the market’s estimate of financial distress/bankruptcy costs?

Total value of the firm as per the calculation given above = 130 +60 = 190 = (Debt payoff + Value of Equity). The value of debt is 130 million.

But the actual value of the firm is 125 + 60 = 185

But the Market value of debt is 125. The financial distress/bankruptcy costs worth is 5 million (130-125)

The financial distress/bankruptcy costs will reduce the cash flows by 12.5 in case of recession.