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 a recession is 40 percent. 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 percent 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 was 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?
Question Two
The net income of Novis Corporation, which has 10,000 outstanding shares and a 100 percent payout policy, is $32,000. The expected value of the firm one year hence is $1,545,600. The appropriate discount rate for Novis is 12 percent.
A. what is the current value of the firm?
B. What is the ex-dividend price of Novis's stock if the board follows its current policy?
C. At the dividend declaration meeting, several board members claimed that the dividend is too meagre and is probably depressing Novis's price. They proposed that Novis sell enough new shares to finance a $4.25 dividend.
1. Comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations.
2. If the proposal is adopted, at what price will the new shares sell and how many will be sold?
Question Three
Southern Established Inc. has been paying out regular quarterly dividends ever since 1983. It just slashed the dividend by half in the current fiscal quarter and a more severe cut is to be underway. Southern's stock price dropped from $35.25 to $31.75 when the dividend cut was announced. Explain the possible reasons for this price drop.