chprobSM_ch17

chprobSM_ch17 - Chapter 17: Capital Structure: Limits to...

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Chapter 17: Capital Structure: Limits to the Use of Debt 17.1 a. The value of a firm’s equity is the discounted expected cash flow to the firm’s stockholders. If there is a boom, Good Time will generate cash flow of $250 million. Since Good Time owes its bondholders $150 million, the firm’s stockholders will receive $100 million (= $250 million - $150 million) if there is a boom. If there is a recession, Good Time will generate a cash flow of $100 million. Since the bondholder’s have the right to the first $150 million that the firm generates, Good Time’ stockholders will receive $0 if there is a recession. The probability of a boom is 60%. The probability of a recession is 40%. The appropriate discount rate is 12%. The value of Good Time’s equity is: {(0.60)($100 million) + (0.40)($0)} / 1.12 = $53.57 million The value of Good Time’s equity is $53.57 million. b. Promised Return = (Face Value of Debt / Market Value of Debt) – 1 Since the debt holders have been promised $150 million at the end of the year, the face value of Good Time’s debt is $150 million. The market value of Good Time’s debt is $108.93 million. The promised return on Good Time’s debt is: Promised Return = (Face Value of Bond / Market Value of Bond) – 1 = ($150 million / $108.93 million) – 1 = 0.3770 The promised return on Good Time’s debt is 37.70%. c. The value of a firm is the sum of the market value of the firm’s debt and equity. The value of Good Time’s debt is $108.93 million. As shown in part a , the value of Good Time’s equity is $53.57 million. The value of Good Time is: V L = B + S = $108.93 million + $53.57 million = $162.5 million The value of Good Time Company is $162.5 million. d. The market value of a firm’s debt is the discounted expected cash flow to the firm’s debt holders. Answers to End-of-Chapter Problems B-252
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If there is a boom, Good Time will generate cash flow of $250 million. Since Good Time owes its debt holders $150 million, the firm’s bondholders will receive $150 million if there is a boom. While the firm’s debt holders are owed $150 million, Good Time will only generate $100 million of cash flow if there is a recession. The firm’s debt holders cannot receive more than the firm can afford to pay them. Therefore, Good Time’s debt holders will only receive $100 million if there is a recession. The probability of a boom is 60%. The probability of a recession is 40%. The appropriate discount rate is 12%. If no bankruptcy costs are priced into the debt, the value of Good Time’s debt is: {(0.60)($150 million) + (0.40)($100)} / 1.12 = $116.07 million Therefore, in a world with no bankruptcy costs, Good Time’s debt would be worth $116.07 million. e.
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This note was uploaded on 03/17/2009 for the course ACTSC 371 taught by Professor Wood during the Fall '08 term at Waterloo.

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chprobSM_ch17 - Chapter 17: Capital Structure: Limits to...

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