Slick Support, Inc. is an oilfield service company with a single year of contracts for services, to be paid in arrears. The company requires $75,000 in capital to finance delivery on those contracts and has decided to raise all of that through a debt issue with full repayment due one year hence. The contracts will produce $150,000 in earnings next year if oil prices hold at their present levels. But analysts have assigned a 40 percent chance that prices will fall by half, which will result in an estimated ²/₃ reduction in earnings because clients will renegotiate those outstanding contracts. Whatever becomes the value of those contracts, they represent the total value of Slick Support’s assets. In the event of financial distress, court and other bankruptcy fees are estimated at 10 percent of asset. Ignoring the effects of taxes (for ease of computation and illustration):

1. If the cost of financial distress is 10 percent, what is the magnitude of value that will be consumed by judges, lawyers, and bankers in the event of bankruptcy? What is the remaining value that will be awarded to creditors?
2. If creditors require a 4 percent return for lending to this kind of business, how much must they expect to be repaid next year in order for Slick Support to raise $75,000 in debt capital it needs to finance delivery on those contracts this year? (i.e. what is the balloon payment required of Slick Support next year in order to obtain the $75,000 loan today?)
3. If creditors know they will only receive some share of assets in the event of low oil prices (the net payment received in the event of bankruptcy = the value calculated in part a), what is the value Slick Support must promise them in the event of high oil prices in order for them to expect to receive the payment they require (in order to earn their 4 percent in expectation = the value calculated in part b)?
4. What is the yield to maturity of this promise to creditors in the event of high oil prices (the value calculated in part c)?
5. What is the value of Slick Support equity immediately after acquiring the $75,000 in debt capital? Assume a required return on equity of 20 percent.

Answer rating: 100% (QA)

Earnings Probability Oil Price Debt 150000 60 High 75... View the full answer