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 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total cash flow of $198 million in a boom year and $89 million in a recession. The company's required debt payment at the end of the year is $123 million. The market value of the company’s outstanding debt is $96 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 and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)
b.	What is the promised return on the company's debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c.	What is the expected return on the company's debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

I have answered the question below

Please up vote for the same and thanks!!!

Do reach out in the comments for any queries

Answer:

a. If recession happens, the total cashflow that the company realizes is 89 million.

Answer: 89,000,000

b. Promised return on debt formula is given by promised amount / current market value - 1

Promised amount = 123 million

Current market value = 96 million

So promised return % on debt = (promised amount / current market value) - 1

= (123 / 96) - 1 = 28.13%

Answer: Promised return % = 28.13%

c. In case boom happens, the realized return = promised return = 28.125%

In case recession happens, the realized return = (realized payoff / current market value) - 1

= (89/96) - 1 = -7.29%

So expected return % = probability of boom * realized return % + probability of recession * realized return %

= 0.6 * 28.125% + 0.4 * -7.29% = 13.96%