Johnny's Store is struggling.Johnny has incorporated the business and it has limited liability.The businesses inventory is worth about $8,000 if liquidated and the estimated liquidation value of its store building is $335,000.The firm also has $7,000 in cash that cannot be paid to Johnny unless lenders are paid off first. Unfortunately, he has a $20,000 payment due to his bankers soon.His total bank debt is $346,000 (it would be $326,000 after the $20,000 payment if it is made).If he can't make his bank payment he will have to file for bankruptcy to keep the cash needed to keep the firm running.His loan is unsecured and he estimates bankruptcy costs will be about $1000 a month in extra legal and accounting fees.Assume liquidation is costless.

a) Assume Johnnyycould liquidate the firm today, what is the total firm value (his equity in firm plus value of bank debt) and what would the bank get and what would Billy get? Note: Cash is part of liquidation value.

Most of his friends are saying to just sell off the inventory and building and get out of the declining business.Johnny tells friends that there is a rumor that there could be a new fish and game preserve nearby.He and his friends agree that there is only about a 20% chance of that occurring.But if he is right, and most agree with his assessment, then the firm value (debt + equity) would be worth $400,000 in 6 months as a going entity (including the value of all assets of any kind). If not, Johnny figures the business would deteriorate and could be worth only $330,000 in 6 months in liquidation.Both of his estimates ignore the bankruptcy costs that would reduce firm value further.He figures he can stall in bankruptcy court for six months and pay firm bills with cash on hand.At that point, the bankruptcy judge may get impatient with the pace of his restructuring efforts and just hand over the firm's assets to the bank.Johnny figures after 6 months he would give up (if no preserve).This means liquidate and the bank gets $330,000 less bankruptcy costs.If he gets lucky and there is a game preserve he will sell the business for $400,000 less bankruptcy costs

If, Total firm value (debt + equity) is

Liquidation value of assets today if liquidate today

or go into bankruptcy with value =

80% x Value if things don't work out + 20% value if things work out

(If in bankruptcy subtract out 6 months of bankruptcy costs)

b)Assuming interest rates are ZERO, what is expected value of Johnny's firm (Debt + Equity) today if he decides to keep it going in bankruptcy?Note: zero interest rates just mean you don't have to discount future expected values to estimate what firm is worth today - it keeps problem simpler.

c)What would be the value of his equity and the value of the lender's claim if he goes the bankruptcy route and is the optimal way for him to go?

d)What would be the expected financial distress costs of debt here?This is loss of expected firm value relative to a situation where Johnny owned the whole firm.

e)Presumably, at lower debt levels, there would be no distress costs.What is the most debt that could have been issued that would have avoided any financial distress costs and loss of firm value. (hint: The debt level must be at a level so that Johnny does better liquidating.

f)Assume the loan was secured with all of Johnny's assets (inventory, building, and cash in the bank's vault). If the judge could be convinced that the value of the assets standing behind the loan were imperiled in bankruptcy, the judge will force a liquidation of the assets.In this case, would we get a different and better outcome for lenders?