The Do-All-Right Marketing Research firm has promised payments to their bondholders oneperiod
from now that total $100. The company believes that there is a 85% chance that the
cash flow will be sufficient to meet these claims. However, there is a 15% chance that cash
flows will fall short, in which case total earnings are expected to be $65. If the bonds sell in the
market for $84, what is an estimate of the bankruptcy costs for Do-All-Right? Assume a cost
of debt of 10%.
To estimate the bankruptcy costs for Do-All-Right, we need to calculate the expected value of the bondholder payments and compare it to the market value of the bonds.
First, let's calculate the expected value of the bondholder payments:
- There is an 85% chance that the cash flow will be sufficient, resulting in a payment of $100.
- There is a 15% chance that the cash flows will fall short, resulting in a payment of $65.
Expected payment value = (0.85 * $100) + (0.15 * $65)
= $85 + $9.75
= $94.75
Next, let's calculate the cost of the bonds in the market:
The bonds are selling for $84.
Now, let's calculate the bankruptcy costs:
Bankruptcy costs = Market value of the bonds - Expected payment value
= $84 - $94.75
= -$10.75
Since the bankruptcy costs are negative, it suggests that the market value of the bonds is less than the expected payment value. In this case, the negative value indicates that the cost of bankruptcy to Do-All-Right is $10.75, which means that the bondholders may not receive the full value of their claims.