Question

Mid States 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 $197 million in a boom year and $88 million in a recession. The company's required debt payment at the end of the year is $122 million. The market value of the company’s outstanding debt is $95 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           $  

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             %​

Answer 1

a)When there is recession at year-end, company will generate $88 million. But the required year-end debt payment is $122 million. Therefore, debt-holders will receive only $88 million and equity holders will receive nothing.

Payoff to bondholders = $88 million

b:

Promised yield = (122/95) – 1 = 0.2842 = 28.42%

c:

At year-end

During recession, bondholders receive = $88 million

During boom, bondholders receive = $122 million (and rest will go to equity-holders)

Expected value of bondholders’ payoff = 0.7*122 + 0.3*88 = 111.80

Expected return = (111.80/95) – 1 = 0.1768 = 17.68%