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 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total cash flow of $188 million in a boom year and $79 million in a recession. The company's required debt payment at the end of the year is $113 million. The market value of the company’s outstanding debt is $86 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. The expected payment to bond holders in case of recession = 79 million
Since payoff value is less than market value of debt after 1 year hence 79 million should be paid off.

b. Promised Yield =(Market value/Face value of debt)-1 = 113/86-1 = 31.40%

c. Expected cash flows = 60%*88+40%*79 = 144.40
Since expected cash flow is more than market value of debt the company can easily payoff debt of 113
Expected Yield =(Market value/Face value of debt)-1 = 113/86-1 = 31.40%

Promised and expected yield are same.