Question

Carrasquillo is a chain of automotive parts store. It has no tax liability. 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. Carrasquillo is expected to generate a total cash flow of $126 million in a boom year and $51 million in a recession. The company’s required debt payment at the end of the year is $75 million. The market value of the company’s debt is $58 million.

a. What payoff do bondholders expect to receive in the event of a recession?

b. What is the promised return on the company’s debt?

c. What is the expected return on the company’s debt?

Answer 1

a. What payoff do bondholders expect to receive in the event of a recession?

In case of recession the Bondholders will receive the cash flow of $51 Million because that is the most amount the company can pay.

b. What is the promised return on the company’s debt?

Promised return = [Required Debt payment / Market Value of Debt] - 1

Promised return = [$75 M / $58 M] - 1

Promised return = 29.37%

c. What is the expected return on the company’s debt?

Expected Cash Flow = Cash flow to bondholder in case of Boom year * respective probability + Cash flow to bondholder in case of recession year * respective probability

Expected Cash Flow = $75 M * 60% + $51 M * 40%

Expected Cash Flow = $65.40 M

Expected return = [Expected Cash Flow to Bondholders / Market Value of Debt] - 1

Expected return = [$65.40 M / $58 M] - 1

Expected return = 12.76%

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