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    Cost of Financial Distress

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    A regional company will remain in business for one more year. The probability of a boom year in 60 percent and a recession in 40 percent. It is projected that the company 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 the company'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. The company pays no taxes.

    a. What is the value of the firm's equity?
    b. What is the promised return on the company's debt?
    c. What is the value of the firm?
    d. How much would the company's debt be worth if there were no bankruptcy costs?
    e. What payoff, after bankruptcy costs, do bondholders expect to receive in the event of a recession?
    f. What costs do bondholders expect the company to incur should bankruptcy arise at the end of the year?

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    Solution Summary

    The solution explains how to calculate the cost of financial distress, using step by step equations and formula.