It is January 2018. Mickey LTD is involved in air conditioning manufacturing and has highly cyclical operations. In its peak year, it generated $600mm in EBITDA, but in the year just ended only $350mm. The primary credit issue facing Mickey LTD is its ability to refinance a 8 1⁄2 % senior secured note due June 30, 2019.

Mickey LTD's Capital Structure, EBITDA and Cash statements as of January 2018 are as follows:

• LTM Period End 12/31/17

• Cash $50mm, Peak EBITDA $600mm, LTM EBITDA $350mm

• Capital Structure:

• 8 1⁄2 % Sen Sec Note 6/30/19

• 10 3⁄4 % Sen Unsec Note 6/30/22

• 9 1⁄2 % Sen Unsec Note 6/30/24

  Total Debt Equity

Amount $600mm $400mm $350mm $1350mm $250mm

Price $94 $83 $74

Market Value $564mm $332mm $259mm

$1155mm $250mm

YTM 13.032% 16.217% 16.097%

(LTM = last 12 months, YTM = yield to maturity, Sen Sec = Senior Secured, Sen Unsec = Senior Unsecured)

1. As a distressed debt investor, what analysis would you conduct and what analytical tools would you use to determine the likelihood that Mickey LTD will default on its 8 1⁄2 % senior secured note due June 30, 2019?

2. After determining in (1) that the default probability on the note due on June 30, 2019 is low enough, you make the decision to go long the 9 1⁄2 % Sen Unsec Note 6/30/24 after assessing that in the case the firm recovers and is able to pay off the senior secured note due on June 30, 2019, the 9 1⁄2 % Sen Unsec Note 6/30/24 would rally and would likely trade up 10 points, that is at a price $84 (the 10 3⁄4 % Sen Unsec Note 6/30/22 would likely trade up 5 points to $88). You also conducted a recovery analysis showing that upon default the two senior unsecured notes would trade at $35. Compute the % price changes of your purchased note under both scenarios of refinancing and bankruptcy in June 30, 2019, and determine the threshold default probability below which your expected return will be positive.

3. To reduce the risk of such a long position, you decide to engage in a hedging strategy. Capital structure arbitrage is a type of hedge investment strategy that allows you to achieve your risk objective. You implement such a hedging strategy by shorting the 10 3⁄4 % Sen Unsec Note 6/30/22, and therefore you end up being long the 9 1⁄2 % Sen Unsec Note 6/30/24 and short the 10 3⁄4 % Sen Unsec Note 6/30/22. What hedge ratio (that is, the number of 9 1⁄2 % Sen Unsec Note 6/30/24 notes to go long over the number of 10 3⁄4 % Sen Unsec Note 6/30/22 bonds to short) would you use to manage your investment risk most efficiently and provide arguments to justify your choice?

4. What are the different factors that as a distressed debt investor you may have used to arrive at a recovery value of $35? Provide detailed arguments on what factors could determine the recovery value.