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 $194 million in a boom year and $85 million in a recession. The company's required debt payment at the end of the year is $119 million. The market value of the company’s outstanding debt is $92 million. The company pays no taxes.

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). Payoff during recession= $85 million which is already given

b). Promised Return = (Face Value of Debt/Market Value of Debt) - 1

= ($119 million / $92 million) - 1 = 1.2935 - 1 = 0.2935, or 29.35%

c). Expected Value of Debt = (Value_Boom x Probability) + (Value_Recession x Probability)

= ($194 million x 80%) + ($85 million x 20%)

= $155.20 million + $17 million = $172.20 million

Expected Return = (Expected Value of Debt / Market Value of Debt) - 1

= ($172.20 million / $92 million) - 1 = 1.8717 - 1 = 0.8717, or 87.17%