Question

Grandma's Applesauce, Inc. has a 0.60 probability of a good year with operating cash flow of $50,000; and 0.40 probability of a bad year with operating cash flow of $30,000. The company has a debt of $35,000 with 8 percent interest due next year. Assuming the company has no means of servicing its debt other than operations, and a 0% tax rate, which of the following is true?O Shareholders expected claim is $12,200O Creditors expected claim is $37,800O Creditors expected claim is $34,680O None of the above

Answer 1

Creditors expected claim is $37,800

Step-by-step explanation:

If operation cash flows are enough to pay off the debt, then creditors are expected to claim the whole debt amount while shareholders will claim the residual value. The expected cash flow from operations is:

`CF = 0.6*50,000+0.4*30,000\\CF=\$42,000`

The debt value next year at an 8% interest rate is:

`D = 35,000*1.08\\D=\$37,800`

Since Cash flows exceed debt, creditors are expected to claim $37,800

While Shareholders are expected to claim:

`S= 42,000 - 37,800\\S= \$4,200`

The correct answer is: Creditors expected claim is $37,800.