GTC [5]

Note: In the question you are asked to assume risk neutrality. This means that the state price probabilities are not colored by risk aversion (fear) so they are equal to the estimated probabilities in the question.

Good Time Co. is a regional chain department store. It will remain in business for one more year. The estimated probability of boom year is 60% and that of recession is 40%. It is projected that Good Time will have total cash flows of $250 million in a boom year and $100 million in a recession. Its required debt payment is $150 million per annum. Assume a one-period model.

Assume risk neutrality and an annual discount rate of 12% for both the stock and the bond.

1. What is the total stock value of the firm?

2. If the total value of bond outstanding for Good Time is $108.93 million, what is the expected bankruptcy cost in the case of recession?

3. What is the total value of the firm?

4. What is the promised return on the bond?