market’s expectation of possible bankruptcy that should be considered a bankruptcy cost.
Thus
part, but certainly not all, of the drop in stock price may be bankruptcy cost related
.

#5.
Good Time Co. is a regional chain department store.
It will remain in business for one more
year.
The estimated probability of a boom next year is .60 and the estimated probability of a
recession is .40.
It is projected that Good Time will have a total cash flow of $250 million in a
boom year and $100 million in a recession.
Good Time’s required debt repayment next year is
$150 million.
The firm has few fixed assets, so after next year is over the firm’s assets will be
liquidated for $0.
Assume also that investors are risk-neutral and that interest rates are zero (i.e.,
no discounting is necessary).
There are no taxes.
(a) Assuming that there were no financial distress costs or bankruptcy costs, calculate the market
value of Good Time’s (i) equity a
nd (ii) debt.
190
130
60

(b) If the market value of equity is actually $60 million and the market value of debt is actually
$125 million, what is the market’s estimate of financial distress/bankruptcy costs?

#6.
Franklin Corporation estimates that there is
25%
chance of a recession economy next year, a
50%
chance of a normal economy next year, and a
25%
chance of a boom economy next year.
The corporation will exist until the end of next year and then it will cease to exist.
Franklin has
$80 of debt that must be repaid next year.
Assume a 0% discount rate for all cash flows (in other
words, there is no discounting).
(a)
Franklin has a low risk project that yields a cash flow of $70 in a recession, $100 in a normal
economy, and $130 in a boom.
If Franklin chooses this low risk project:
(i) what is the value of Franklin
’s debt?
(ii) what is the value of Franklin
’s equity?
77.50

4
(b)
Franklin has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal
economy, and $160 in a boom.
If Franklin chooses this high risk project: