Can someone help explain how to get the expected return on this question? Mellor
ID: 2792486 • Letter: C
Question
Can someone help explain how to get the expected return on this question?
Mellors Management has debt of $1.2 Million due at the end of the year (principal and interest). The company’s expected cash flows (ignoring taxes) are $1 million with 40% probability and $2 million with 60% probability. Assuming the equity has an expected return of 25% and the firm is values at $1.4 million, what is the expected return on the firm’s debt? How much does the firm’s value decrease if bankruptcy costs are $0.5 million? What would be the expected return on equity if Mellors had no debt?
Need step by step formula and solution so I can understand work!
http://www.chegg.com/homework-help/questions-and-answers/mellors-management-debt-12-million-due-end-year-principal-interest--company-s-expected-cas-q14106209
Explanation / Answer
Expected cash flow is
$1,000,000 with 40% probability = $400,000
$2,000,000 with 60% probability = $1,200,000
Total expected cash flow = $400,000 + $1,200,000 = $1,600,000
Total debt at the end of the period = $1,200,000
Return on debt = Expected cash flow - Debt repayment
=$1,600,000-$1,200,000 =$400,000