Chapter 16 Questions V1

Chapter 16 Questions V1 - Costs of Financial Distress 16.1...

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Costs of Financial Distress 16.1 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% and a recession is 40%. It is projected that Good Time will generate a total cash flow of $250 million in a boom year and $100 million in a recession. The firm’s required debt payment at the end of the year is $150 million. The market value of Good Time’s outstanding debt is $108.93 million. Assume a one-period model, risk neutrality, and an annual discount rate of 12% for both the firm’s debt and equity. Good Time pays no taxes. a. What is the value of the firm’s equity? b. What is the promised return on Good Time’s debt? c. What is the value of the firm? d. How much would Good Time’s debt be worth if there were no bankruptcy costs? e. What payoff, after bankruptcy costs, do bondholders expect to receive in the event of a recession? f. What cost do bondholders expect Good Time to incur should bankruptcy arise at the end of the year? 16.2 Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of a recession next year is 20% and the probability of a continuation of the current expansion is 80%. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $0.8 million. Steinberg’s debt obligation requires the firm to pay $750,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay $1 million at the end of the year. Neither firm pays taxes. Assume a one-period model, risk neutrality, and an annual discount rate of 15%. a. Assuming there are no costs of bankruptcy, what is the market value of each firm’s debt and equity? b. What is the value of each firm? c. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s since the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement? 16.3 What are the direct and indirect costs of bankruptcy? Briefly explain each. 16.4 “A firm’s stockholders will never want the firm to invest in projects with negative net present values.” Do you agree or disagree with this statement. Explain your answer. 16.5 Due to large losses incurred in the past several years, a firm has $2 billion in tax-loss carry-forwards. This means that the next $2 billion of the firm’s income will be free from corporate income taxes. Security analysts estimate that it will take many years for the firm to generate $2 billion in earnings. The firm has a moderate amount of debt in its capital structure. The firm’s CEO is deciding whether to issue debt or equity in order to raise the funds needed to finance an upcoming project. Which method of financing would
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This note was uploaded on 04/04/2009 for the course FIN FIN/554 taught by Professor Timothydreyer during the Summer '06 term at University of Phoenix.

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Chapter 16 Questions V1 - Costs of Financial Distress 16.1...

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