Question

1) Consider the following two companies:

	Day Corp		Knight Corp
	Boom	Recession	Boom	Recession
Probability	0.6	0.4	0.6	0.4
Cash flow	$100	$50	$125	$85
Payment to debt holders	$60	$50	$90	$70
Distribution to stockholders	$40	$0	$35	$0

Bases on the information above, which of the two companies has bankruptcy risk, bankruptcy cost and if they have a bankruptcy cost what is the cost in $?

A) Both have bankruptcy risk, only Day Corp has bankruptcy cost of $10

B) Both have bankruptcy risk, only Knight Corp has bankruptcy cost of $20

C) Both have bankruptcy risk, only Knight Corp has bankruptcy cost of $15

D) Both have bankruptcy risk, only Knight Corp has bankruptcy cost of $20

E) None of the above.

Answer 1

	Day Corp		Knight Corp
	Boom	Recession	Boom	Recession
1.Probability	0.6	0.4	0.6	0.4
2.Cash flow	100	50	125	85
3.Payment to debt holders	60	50	90	70
Distribution to stockholders	40	0	35	0
	Day Corp			Knight Corp
	Boom	Recession	Expected	Boom	Recession	Expected
	a	b	a+b	c	d	c+d
Most probabale/Expected Cash flow(1*2)	60	20	80	75	34	109
Expected Payment to debt holders	36	20	56	54	28	82
Bankruptcy risk/cost(80-56);(109-82)			-24			-27
ANSWER: E. None of the above.
Both Day Corp. & Knight Corp.have enough probable cash flows to meet the most expected payment to debt holders.
Bankruptcy risk is NIL for both.