Good Time Co. is a regional chain department store. It will remain in business for one more year. The estimated probability of a boom next year is 0.60 and the estimated probability of a recession is 0.40. It is projected that Good Time will have a total cash flow of $250 million in a boom year and $100 million in a recession. Good Time’s required debt repayment next year is $150 million. The firm has few fixed assets, so assume that after next year is over the firm will be liquidated for $0. Assume also that investors are risk-neutral and that interest rates are zero (i.e., no discounting is necessary). There are no taxes.
a) Assuming that there were no financial distress costs or bankruptcy costs, calculate the market value of Good Time’s (i) equity and (ii) debt.
b) If the market value of equity is actually $60 million and the market value of debt is actually $125 million, what is the market’s estimate of financial distress/bankruptcy costs?