The Sawmill expects to generate a cash flow of $59,000 next year if the economy booms and $46,000 if it does not.The probability of a boom is 20 percent.The firm has debt of $52,000 that is due in 1 year and has a current market value of $48,700.The firm plans to close after this coming year.The current promised pretax return on debt is ________ percent,and the expected pretax return on debt is ________ percent.
A)6.78; 1.16
B)6.78; -3.08
C)5.49; 1.16
D)5.49; -2.67
E)6.27; -3.08

Question

Quizplus · Accepted Answer

The firm has two possible cash flows: $59,000 with a probability of 20% and $46,000 with a probability of 80%. The expected cash flow is:
Expected cash flow = ($59,000 × 0.2) + ($46,000 × 0.8) = $48,200
The current market value of debt is $48,700, which is greater than the expected cash flow of $48,200. Therefore, the expected return on debt is negative. To find out the exact amount of expected return, we need to solve for the discount rate that makes the present value of the expected cash flow equal to the market value of debt:
$48,700 = ($59,000 × 0.2)/(1 + r) + ($46,000 × 0.8)/(1 + r)
Solving for r, we get r = -0.0308 or -3.08%, which is the expected pretax return on debt. The current promised pretax return on debt is the interest rate on the debt, which is:
Promised pretax return = $52,000 - $48,700/$48,700 = 0.0678 or 6.78%

The Sawmill Expects to Generate a Cash Flow of $59,000