33:390:400 Lecture Notes - Lecture 4: Cash Flow, Capital Structure, The Exes

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28 Jul 2021
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Chapter 17- Practice Problems
1. Good Time Co. is a regional chain department store. It will remain in business for one
more year. The estimated probability of a boom year for next year is .60 and the
estimated probability of a recession year for next year 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 payment next year is $150 million. The firm has
few fixed assets, so assume that after next year is over the firm is liquidated for $0.
Assume the appropriate annual discount rate for cash flows to both equity holders and
debtholders is 12%. There are no corporate or personal taxes.
(a) What is the total value of equity today assuming no bankruptcy costs
(b) If equity has the value you calculated in part (a) and the debt on Good Time is
currently selling for $108.93 million, what is the expected bankruptcy cost for Good
Time?
2. Fountain Corporation economists estimate that the probability of a good business
environment next year is equal to the probability of a bad environment. Knowing
this, the managers of Fountain must choose between two mutually exclusive projects.
Suppose the payoff from the chosen project is the only future cash flow expected by
the firm. Fountain is obliged to make a $500 payment to its bondholders next year.
Here is a description of the projects:
Low Risk Project
Probability
Payoff
Value of
Stock
Value of
Bonds
Boom
.5
500
0
500
Recession
.5
700
200
500
High Risk Project
Probability
Payoff
Value of
Stock
Value of
Bonds
Boom
.5
100
0
100
Recession
.5
800
300
500
Which project will the stockholders prefer? Which project maximizes the value of
the firm? Why are these answers different?
3. The EXES Company is assessing its present capital structure and that structure’s
implications for the welfare of its investors. EXES is currently financed entirely with
common stock, of which 1,000 shares are outstanding. Given the risk of the underlying
cash flows (EBIT) generated by EXES, investors currently require a 20-percent return on
the EXES common stock. The company pays out all earnings as dividends to common
stockholders. EXES expects that for each year in the future operating income will be
$1,000, $2,000, or $4,200 with respective probabilities of 0.1, 0.4, and 0.5. EXES is
contemplating issuing $7,500 in bonds and using the proceeds to repurchase shares.
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Document Summary

Chapter 17- practice problems: good time co. is a regional chain department store. It will remain in business for one more year. The estimated probability of a boom year for next year is . 60 and the estimated probability of a recession year for next year is . 40. Time will have a total cash flow of million in a boom year and million in a recession. Good time"s required debt payment next year is million. The firm has few fixed assets, so assume that after next year is over the firm is liquidated for sh. Assume the appropriate annual discount rate for cash flows to both equity holders and debtholders is 12%. Time: fountain corporation economists estimate that the probability of a good business environment next year is equal to the probability of a bad environment. Knowing this, the managers of fountain must choose between two mutually exclusive projects.

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